Elasticity of Demand and Supply

Elasticity
Elasticity: measures percentage change in one variable brought about by a 1 percent change in some other variable. Because its measured in percentages, units cancel out-- elasticity is a unit-less measure of responsiveness.

Price Elasticity of Demand

Refers to the degree of change in the demand for a product with respect to change in the given price, while keeping other determinants of demand at constant. The price elasticity of demand ( ) can be expressed by the following formula: =

Types of price elasticity of demand:

Perfectly Elastic Demand Unitary Elastic Demand Perfectly Inelastic Demand

Price Elasticity of Demand

Price elasticity of demand records how QX changes (in percentage terms) given a percentage change in PX. On typical demand curve, P and Q move oppositely: eQ,P will be negative. For example, if eQ,P = -2, a 1 percent increase in price leads to a 2 percent decrease in quantity demanded.

Types of Price Elasticity of Demand

Numerical Value Type of Price Elasticity Perfectly elastic demand Description There is a greater change in demand in response to percentage or smaller change in the price. For example, the demand for a product decreases or completely stops, with a little change in its price and vice versa.

=0

Perfectly inelastic demand

Consumers do not respond to the demand for a product with increase or decreases in its price. This implies that the demand remains the same with change in the price.

>1

Relatively elastic demand

The percentage change in the quantity demanded of a product is greater than percentage change in its price. In such a case, consumers generally switch to new brands when the price of a particular brand increases. However, some consumers are loyal to the same brand.

<1
=1

Relatively inelastic demand

The change in the demand of a product is less than that of change in its price.

Unitary elastic demand

The change in the demand and change in the price of a product is same.

Perfectly Inelastic Demand Curve

Perfectly inelastic demand curve

0 Quantity

Relatively inelastic demand

Y

D
P R

Relatively inelastic demand curve

I
C E

When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand

D
O X demand

Perfectly Elastic Demand Curve

Perfectly elastic demand curve

0 Quantity

Relatively elastic demand

y P R I C E D D Relatively elastic demand curve

demand

When the proportionate change in demand is more than the proportionate changes in price, it is known as relatively elastic demand.

Elasticity of demand equal to unity

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

y P R I C E Elasticity of demand equal to utility curve D

D
0 x

demand

General Formula: Elasticity of Hyperbola Demand Curves

If demand curve takes the following form, price elasticity of demand equals b everywhere along curve:

Q aP (b 0)
b

11

Measuring Price Elasticity

Total Outlay Method

Arc Elasticity Method

Methods of Measuring Price Elasticity

Percentage or Proportionate Method

Point or Geometry Elasticity Method

Proportionate or Percentage Method

Measures the value of elasticity mathematically Gives an exact value to the elasticity of demand
ep = % change in quantity demanded % change in price

ep=

Change in quantity demanded

Change in price

Original price

Original quantity demanded

Proportionate or Percentage Method

Price p1 p2 Quantity Demanded q1 q2 ep=

% change in quantity demanded % change in price

% change in quantity demanded = % change in price = q2 - q1 q1 p2 - p1 p1 p2 - p1 p1

q2 - q1 q1

X 100

x 100 = x 100

ep=

q2 - q1
p2 - p1

p1 q1

Point or Geometry Method

Price Price (Rs) 12

P=8 a P = -2

ep= 10 -2 = -2

Q P .

P Q

10

ep=

8
20

(elastic)

Q = 10
4

Q = 20

D
0 10 20 30 40 50 60

70

Quantity demanded per unit time

Exercise -- Linear Demand

Compute the elasticity at the point indicated in red on the table (X=18,P=24). Slope = -2 1/Slope = -1/2 P/X = 24/18 = 4/3 Elasticity = -2/3
Quantity 10 11 12 13 14 15 16 17 18 19 20 Price 40 38 36 34 32 30 28 26 24 22 20

Arc Elasticity Method

Formula for measuring Arc Elasticity of Demand ; Change in Q.D. Original + New Q.D. Arc Ed = 2 Change in Price Original + New Price 2

Total Revenue or Total Outlay Method

Total Revenue or total outlay refers to the product of price and the quantity demanded, i.e. TR = P X QD. According to this method : i) If change in price brings about change in quantity demanded in such a way that total outlay remains the same, then demand is unit elastic,

Price
60 50 40

QD
100 120 150

Total Outlay
6000 6000 6000

ii) If change in price brings about change in quantity demanded in such a way that total outlay goes on falling, then demand is relatively inelastic,

Price 60

QD 100

Total Outlay 6000

50
40

110
120

5500
4800

iii) If change in price brings about change in quantity demanded in such a way that total outlay goes on increasing, then demand is relatively elastic,

Price 60 50 40

QD 100 150 200

Total Outlay 6000 7500 8000

Factors Influencing Price Elasticity of Demand

Nature of Goods Availability of Substitutes Number of Uses of a Good Distribution of Income Level of Price Proportion of Total Expenditure Time Factor Complementary Goods Possibility of Postponement

Income Elasticity of Demand

The degree of responsiveness of demand with respect to change in consumers income is called income elasticity of demand The income elasticity of demand (ey) can be measured by the following formula: =
Percentage change in quantity demanded Percentage change in income

Types of income elasticity of demand

Positive Income Elasticity of Demand Negative Income Elasticity of Demand

Income Elasticity of Demand

Normal goods: eQ,I positive--income increases lead to increased purchases of good. Inferior goods: eQ,I negative eQ,I > 1, purchase of good increases more on percentage basis than income--good is called luxury good.

23

Positive Income elasticity of demand

D

P A Income D

B S Quantity Demanded

Positive Income elasticity of demand

Income Elasticity Equal to Unity or One Income Elasticity Greater Than Unity Or One Income Elasticity Less Than Unity or One

Negative Income elasticity of demand

Price P

Total Revenue
B S

Quantity Demanded (000s)

Importance Of the Concept of Income Elasticity Of Demand

In production planning and management In forecasting demand when change in consumers income is expected In classifying goods as normal and inferior In expansion and contraction of the firm by the figure of income elasticity of demand Markets situations could be studied with the help of IED

Cross Elasticity of Demand

Cross-elasticity of demand measures the receptiveness of quantity demanded of a good with respect to change in the price of its substitute or complementary good. The symbolic representation of the formula for cross elasticity of demand is as follows: = QX/PY * / PY/QX where X and Y are two goods. Types of Cross Elasticity of Demand
Positive Cross Elasticity of Demand

Cross-Price Elasticity of Demand

If goods are substitutes, increase in price of one good will cause buyers to purchase more of substitute: Cross-price elasticity positive. If goods are complements, increase in price of one good will cause buyers to buy less of that good as well as less of the complementary good: Cross-price elasticity negative.
29

Cross Elasticity of Demand For Substitutes

Y D

Price of Y

D O X

Demand for Y

Cross Elasticity of Demand For Complementary Products Y D

Price of Y

D O Demand for Y X

Cross Elasticity of Demand For Neutral Products Y

D Price of Y O

Demand for Y

Importance of Cross Elasticity Of Demand

The concept is of very great importance in changing the price of the products having substitutes and complementary goods . In demand forecasting Helps in measuring interdependence of price of commodity . Multiproduct firms use these concept to measure the effect of change in price of one product on the demand of their other product

Advertisement Elasticity of Sales

Advertisement elasticity of sales refers to responsiveness of sales with proportionate or percentage change in advertisement expenditure. It helps in determining the optimum level of expenditure on advertisement of an organization. = Change in sales/Change in advertisement cost Factors Influencing Advertisement Elasticity of

Advertising Elasticity of Demand

Proportionate change in Demand for product
Advertising Elasticity of Demand = Proportionate change in Advertising expenditure

i.e.

Advertising Elasticity of Demand =

qx

Relationship Between Advertising Expenditure and Sales

Y S Sales S

Advertising Expenditure

Factors Affecting Advertising Elasticity Of Demand

The stage of the Products Market Development . Reaction of market Rival Firms. Cumulative Effect of Past Advertisement. Influence of Other Factors.

Importance of the Advertising Elasticity Of Demand in Business Decisions

It is useful in competitive industries.
Though advertisement shifts the demand curve to right path but it also increases the fixed cost of the firm.

Importance of Elasticities
Price Elasticity of Demand:
Helps an organization to determine the price of its products in various circumstances specially under monopoly Helps government to plan taxes by taking into consideration the price elasticity of demand

Income Elasticity of Demand:

Help in investment decisions Help in anticipating the demand for goods in future Helps in classifying goods, such as normal goods, essential goods, or inferior goods

Cross Elasticity of Demand:

Helps in determining the nature of relationship between two goods whether they are substitutes, complementary to each other or totally different from each other Enables an organization to anticipate the intensity of monopoly and type of competition in the market

Elasticity of Supply
The degree or extent of change in the quantity supplied of a product in response to change in the price of the product is known as the elasticity of supply. The formula for calculating elasticity of supply ( ) is as follows: =
Percentage change in quantity supplied Percentage change in price

Types of Elasticity of Supply

Perfectly Elastic Supply: =

Differences in Price Elasticity of Supply

Price Perfectly elastic supply Price An elastic supply curve

Quantity Price Perfectly inelastic supply Price

Quantity Inelastic Supply Curve

Quantity

Quantity

 If the supply curve intersects the price axis the curve is ELASTIC
If the supply curve passes through the origin (0) the curve is UNITARY

If the supply curve intersects the quantity axis the curve is INELASTIC

Supply elasticity
Migrant workers can help to relieve shortages of labour and improve the elasticity of supply

In many agricultural markets, the delay between planting and harvesting makes supply very inelastic in the momentary period

Factors Determining Elasticity of Supply

Nature of a Good Production Technology Time Period Scale of Production Agricultural Products