Elasticity and Its Application

Elasticity . . .
is a measure of how much buyers and sellers respond to changes in market conditions allows us to analyze supply and demand with greater precision. Elasticity of demand measures the responsiveness of the quantity demanded of a good to change in its price, price of other goods and changes in consumers income.

Elasticity is of three types

Price elasticity of demand Elasticity of demand with respect to change in its price Income elasticity of demand Elasticity of demand with respect to change in consumers income Cross elasticity of demand Elasticity of demand with respect to change in its price of substitutes

Price Elasticity of Demand

Price

elasticity of demand is the percentage (rate) change in quantity demanded given a percent change in the price. is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
Price Elasticity = Of Demand
Percentage Change in Qd Percentage Change in Price

Ranges of Elasticity
Inelastic Demand
Percentage change in price is greater than percentage change in quantity demand. Price elasticity of demand is less than one.

Elastic Demand
Percentage change in quantity demand is greater than percentage change in price. Price elasticity of demand is greater than one.

Two extreme situations in price elasticity of demand

1.

Zero Price elasticity In response to change in price ,no change in quantity demanded of a commodity. This implies no extension or contraction of demand . It is called perfectly inelastic demand. (PERFERCTLY INELASTIC DEMAND)

E g. Water -- it's essential for survival Bread -- same as above Prescription drugs needed to save someone's life -most people will pay any amount to save their life

Perfectly Inelastic Demand

- Elasticity equals 0
Price

Demand

$5 1. An increase in price... 4

Quantity 100 2. ...leaves the quantity demanded unchanged.

Two extreme situations in price elasticity of demand

2. Infinite Price elasticity When a very small
change in price causes infinite change in quantity demanded of a commodity. PERFECTLY ELASTIC DEMAND E=
The horizontal line states that any quantity can be purchased at OQ but even at a slightest increase in price beyond OQ means no purchase at all Pink marker pens. If pink marker pens were more expensive than any other color, the demand would drop to zero.

Perfectly Elastic Demand

- Elasticity equals infinity
Price 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Quantity

Demand

Normal Situations of Price Elasticity of Demand

1.
2. 3.

Elasticity of demand = 1 Elasticity of demand > 1 Elasticity of demand <1

Elasticity of demand = 1 Unitary Elasticity of demand

y P R I C D Elasticity of demand equal to utility D curve x deman d

E
0

When the proportionate change in demand is equal to proportionate changes in price, it is known as unitary elastic demand

Unit Elastic Demand

- Elasticity equals 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 75 100 2. ...leads to a 25% decrease in quantity.

Relatively elastic demand

y P R I C E 0 D When the proportionate change in demand Relatively elastic is more than the proportionate demand curve changes in price, it is known as relatively elastic demand. D Total expenditure of a commodity increases in x demand response to decrease in price

Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 50 100 2. ...leads to a 50% decrease in quantity.

Relatively inelastic demand

Y P R I C

Relatively inelastic demand curve

When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand Total expenditure of a commodity decreases in response to its price

E
O deman d

D
X

Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 90 100 2. ...leads to a 10% decrease in quantity.

Measurement Of Price Elasticity Of Demand

There are main methods like 1. Percentage method or proportionate method 2. Total revenue method 3. Geometric method or point method 4. Arc elasticity of demand

Percentage or Proportionate Method

% change in demand is divided by % change in price Ed= - % QD of commodity X % in price of commodity X = - Change in QD/Initial demand Change in price/Initial price = - Q/Q * 100 = - Q/Q * P/P P/P * 100

Computing the Price Elasticity of Demand

Price elasticity of demand Percentage change in quatity demanded Percentage change in price

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

(10 8 ) 100 20 percent 10 2 ( 2.20 2.00 ) 100 10 percent 2.00

Point Elasticity Method

Elasticity computed at a single point on the curve for an infinitely small change in price is called point elasticity

Arc Elasticity of demand

It measures average responsiveness of demand curve

Price elasticity of demand =

Q . (P1 +P2)/2 P (Q1+Q2)/2

(Q 2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]

Revenue Method

The elasticity of demand can be measured on the basis of change in total expenditure in response to a change in price.
Ed = AR AR- MR

Computing the Price Elasticity of Demand

(Q 2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8) 22 percent (10 8) / 2 2.32 (2.20 2.00) 9.5 percent (2.00 2.20) / 2

Determinants of Price Elasticity of Demand

1. Nature of commodity

Necessaries Salt ,water <1 Comforts cooler , scooter = 1 Luxuries AC, car >1 2. Availability of substitutes 3. Goods with different use 4. Postponement of demand 5. Income of the consumer 6. Habit of consumer 7. Proportion of income spent on commodity

Determinants of Price Elasticity of Demand

Demand tends to be more inelastic

If the good is a necessity. If the time period is shorter. The smaller the number of close substitutes.

Determinants of Price Elasticity of Demand

Demand tends to be more elastic :
if

the good is a luxury. the longer the time period. the larger the number of close substitutes.

Income Elasticity of Demand

Income

elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Computing Income Elasticity

Percentage Change in Quantity Demanded Percentage Change in Income

Income Elasticity = of Demand

Income Elasticity
- Types of Goods Normal
Inferior Higher

Goods
Goods

Income Elasticity is positive.

Income Elasticity is negative.

income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Cross Price Elasticity of Demand

Elasticity measure that looks at the impact a change in the price of one good has on the demand of another good. % change in demand of Q1 % change in price of Q2. Positive for Substitutes Negative for Complements.

Importance of Price Elasticity

Determination of price under monopoly If demand is elastic will fix less price of good and vice versa Taxation policy Elastic demand less revenue, ineleastic demand more revenue Distribution of burden of taxes Inelastic goods consumers , elastic goods - producers International trade country will gain if increase in exports and demand of importing country is inelastic

Elasticity of supply

Elasticity of SupplyThe percentage change in quantity supplied in response to percent change in price

MEANING OF ELASTICITY OF SUPPLY :

IT IS DEFINED AS THE RESPONSIVENESS OF THE QUANTITY SUPPLIED OF A GOOD TO A CHANGE IN ITS PRICE.
ELASTICITY OF SUPPLY = % CHANGE IN QUANTITY SUPPLIE D -----------------------------------------------% CHANGE IN PRICE

TYPES OF SUPPLY ELASTICITY:

PERFECT INELASTIC SUPPLY :- If as a result of a change in price, the quantity supplied of a good remains unchanged, we say that the elasticity of supply is zero.
RELATIVELY LESS-ELASTIC SUPPLY :- If as a result of a change in the price of a good its supply changes less than proportionately, we say that elasticity of supply is less than one.

Continue

RELATIVELY GREATER ELASTIC SUPPLY :- If elasticity of supply is greater than one when the quantity supplied of a good is changes substantially in response to small change in price of the good.
UNIT ELASTIC SUPPLY :- If the relative change in the quantity supplied is exactly equal to the relative change in price, the supply is said to be unitary elastic.

PERFECT ELASTIC SUPPLY :- the supply elasticity is infinite when nothing is supplied at a lower price but a small increase in price causes supply to rise from zero to an indefinitely large amount indicating that producers will supply any quantity demanded at that price.

Factors influencing elasticity of supply

1.

Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.
Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market.

2.

Factors influencing elasticity of supply

3. Nature of inputs and factor mobility: Elasticity of supply depends upon nature of inputs used for the production of the commodity.If production of product utilizes inputs that are commonly used to produce other products, it will tend to have more elastic supply.
4. Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield.

Importance of elasticity of supply

Taxation and elasticity of supply