Elasticities Of Demand And Supply

Elasticities of Demand and Supply

ELASTICITY OF DEMAND

PRICE ELASTICITY OF DEMAND 1. The attribute of demand by virtue of which it stretches or contracts under pressure of change in price is known as elasticity of demand [MET:110] 2. Price elasticity of demand is ratio of change in price vs change in demand 3. It is measure of responsiveness of demand relating to price 4. Mathematically: PEoD = Change in quantity demanded / Change in price 5. When price falls, demand goes up and when price rises demand fall therefore elasticity has negative value but negative sign is normally ignored

CLASSES OF ELASTICITY

1.

Perfectly Elastic

◦ Also known as Infinite Elasticity ◦ When price elasticity of demand is perfectly elastic, any increase in the price, no matter how small, will cause demand for the good to drop to zero. ◦ Demand curve is horizontal straight line

2.

Perfectly Inelastic Demand

◦ When price elasticity of demand is perfectly inelastic, changes in the price do not affect the quantity demanded for the good. ◦ The demand curve is a vertical straight line

3.

Unit Elasticity

◦ When the price elasticity of demand for a good is Unit Elastic (or unitary elastic), the percentage change in quantity is equal to that in price. ◦ Demand curve is diagonal line

4.

Relatively Elastic

◦ When the price elasticity of demand for a good is Elastic, the percentage change in quantity demanded is greater than that in price. ◦ Hence, when the price is raised, the total revenue of producers falls, and vice versa.

5.

Relatively Inelastic

◦ When the price elasticity of demand for a good is Inelastic, the percentage change in quantity demanded is smaller than that in price. ◦ Hence, when the price is raised, the total revenue of producers rises, and vice versa.

ARC ELASTICITY 1. The elasticity figure you come up with is different depending on what you use as the start point and what you use as the end point. 2. Elasticity between two points is arc elasticity 3. Mathematically

POINT ELASTICITY 1. Responsiveness of demand at particular point in the demand curve is Point Elasticity 2. Mathematically:

P.E. = ∆Q / ∆

NEGATIVE PRICE ELASTICITIES 1. Giffen Goods have negative elasticities because as price of a giffen commodity rises, ratio of that commodity in budget also rises

FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND FOR A GOOD 1. Demand for necessities of life is less elastic or inelastic 2. Demand for luxuries is elastic ◦ as price rises consumer will feel himself relatively poor 3. Elasticity of goods having substitutes is high 4. Elasticity depends on uses of commodity ◦ If price of water rises it will mostly be used for drinking, not for other uses ultimately reducing its consumption 5. Elasticity depends on necessity of goods ◦ The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it. 6. Change in non-significant price will not exhibit elasticity ◦ Changing in price of car from Rs. 1.1 million to 1 million will not as much difference as price of chocolate from Rs.20 to 5 will exhibit even though difference in price of car is greater 7. Percentage of income ◦ The higher the percentage that the product's price is of the consumers income, the higher the elasticity, as people will be careful with purchasing the good because of its cost 8. Breadth of definition ◦ The broader the definition, the lower the elasticity. For example, Company X's fried dumplings will have a relatively high elasticity, where as food in general will have an extremely low elasticity (see Substitutes, Necessity above)

INCOME ELASTICITY 1. Income elasticity is measure of responsiveness of potential buyers to change in an income 2. Mathematically IEoD = (% Change in Quantity Demanded)/(% Change in Income)

Types Of Income Elasticity 1. A Negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. 2. A Positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. 3. A Zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

CROSS ELASTICITY 1. In economics, the cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the demand of a good to a change in the price of another good. 2. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. 3. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be −20%/10% = −2.

ELASTICITY OF SUPPLY 1. Elasticity of supply indicates responsiveness of supply to a change in price 2. Price elasticity of supply is defined as a numerical measure of the responsiveness of the quantity supplied of product (A) to a change in price of product (A) alone. It is the measure of the way quantity supplied reacts to a change in price. 3. Mathematically

4. Like elasticity of demand, elasticity of supply also have Unit Elasticity, Inelastic Supply and Elastic Supply.

FACTORS AFFECTING ELASTICITY OF SUPPLY 1. Spare Capacity ◦ if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic 2. Stocks of factors of production ◦ if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic 3. Time Period ◦ Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs.