Elasticity

SUPPLY Supply is the willingness and ability of producers to make a specific quantity of output available to consumers at a particular price over a given period of time.

Law of supply  A decrease in the price of a good, all

other things held constant, will cause a decrease in the quantity supplied of the good.  An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.

Supply Determinants Sx = F( Px , Py, Pz,……;P,O,T)

Sx

= Amount of good x supplied

Px

= Py,Pz

market P o T

Price of = =

good x

Prices of other goods in the

Prices of factors of production

= Objective of the producer = State of technology

Factors on which supply depends           

Important shift factors of supply are Changes in the prices of inputs used in production of a good Changes in technology Changes in suppliers expectations Changes in taxes and subsidies Each of these shift factors will cause a shift in supply, whereas a change in price causes a movement along the supply curve. The major variables other than price are Nature of the commodity Limited supply of inputs Events beyond human control like good/bad harvest, weather conditions and natural disasters like floods. Government restriction on quantity to be produced .

Elasticity of supply 

It is defined as the ratio of percentage change in quantity demanded and the



percentage change change in the price of the commodity. Quantity Change in price Es = change in quantity Price

Elasticity The responsiveness of one variable to changes in another  When price rises, what happens to demand?  Demand falls  BUT!  How much does demand fall? 

Elasticity If price rises by 10% - what happens to demand?  We know demand will fall  By more than 10%?  By less than 10%?  Elasticity measures the extent to which demand will change 

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. ◆Journal Question-Name 3 necessities and 3 luxuries that you would buy. ◆

Determinants of Elasticity 

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Time period – the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes – the greater the number of substitutes, the more elastic The proportion of income taken up by the product – the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Types of Elasticity

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Price elasticity of demand Income elasticity of demand Cross elasticity Promotional or Advertisemsent

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Measurement of Elasticity :

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POINT METHOD ARC METHOD

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Point Method Point elasticity: Elasticity measured at a given point of a linear demand (or a supply) curve.

dQ P1 εP = x dP Q1

Arc Method Arc elasticity: Elasticity which is measured over a discrete interval of a demand (or a supply) curve.

Q2 − Q1 P2 − P1 Ep = ÷ (Q1 + Q2 ) / 2 ( P1 + P2 ) / 2 Mid Point Formula

Question 2. A firm increases the price of product A, from 50p to 60p, demand falls from 1000 units a week, to 900 units a week. What is the Price elasticity of demand of the product? A. 2 B. 1.5 C. 0.5

Ed > 1 ⇒ elastic demand (very responsive to price changes). Ed< 1 ⇒ inelastic demand (not very sensitive to prices). Ed = 1 ⇒ unitary elastic (ratio of %∆s = 1).

Price Elasticity of Demand ◆

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

◆

It 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

Determinants of Price Elasticity of Demand ◆

Necessities versus Luxuries

◆

Availability of Close Substitutes

◆

Time Horizon

◆

Weightage in total consumption

◆

Range of usage of good .

y

Perfectly Elasticity of Demand

‘x’ axis = ‘quantity’ demanded ε = α ‘y’ axis = ‘price’

x

x

x

x

1 2 In this case, price reduction is not required to increase the quantity demand. ε=α The producers need not concentrate on price reduction activities to improve the sales if his good comes under the perfectly elasticity of demand.

Perfectly Inelasticity of Demand

y P

0

P P1

E=0 X= units of goods demand. Y= price of the commodity

D

x

In this case, even though the price of commodity decreases, the demand remains the same. ε= ‘0’ The producers need not increase or decrease the price of the commodity to bring change in demand .

y

P

Unitary Elasticity of Demand E= 1

0

P P1

X= units of goods demand. Y= price of the commodity

D

x

x

x

x

1 0 This is a very rare phenomenon that occurs in a business where the demand increases equally with the increase in price.

Relatively Elasticity of Demand

y

E>1 P

0

P1

P D

x

x

0

x

X= units of goods demand. Y= price of the commodity

x 1

ere is a minimum reduction in price and

e demand increases rapidly. So a small

ange in price increases the quantity

manded to large extent to a producer .

:Cell Phones ,Gold.

Relatively Inelasticity of Demand

y E<1 P

0

P1

P X= units of goods demand. Y= price of the commodity

D

x

x 0x

x

1 Even though there is huge decrease in price, the quantity demanded increase only a little. E.g.: Inferior Goods

Example: P0 = 8

P1 = 7

Q0 = 40

Q1 = 48

Step 1: ∆Q = 48 - 40 = 8 ∆P = 7 - 8 = -1 Step 2: Use the formula for Ed.

Step 3: Ed = (∆Qd / ∆P) * P0 / Q0 = (8 /-1) * (8/40) = - 1.6

Step 4: This means that for every 1 % change in price that there is a 1.6 % change in quantity demanded in the opposite direction.

Income Elasticity • 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 Inc ome Ela st ic it y = of De mand

Percenta ge Cha ng e in Qua nt ity Dema nded Perce nta ge Cha nge in Inco me

Income Elasticity - Types of Goods Essential Income Elasticity is positive. ◆ Elasticity is less than one (Ey <1) Comforts Elasticity equal to unity (Ey =1) Income Elasticity is equal to unity . ◆

◆ Luxuries ◆ Elasticity is greater than unity (Ey>1)

Income Elasticity of Demand Normal goods are divided into luxuries and necessities.  Normal Good – demand rises as income rises and vice versa 

YeD mantra… + = normal - = inferior!

Income Elasticity of Demand  Luxuries

are goods that have an income elasticity greater than one.

 Their

percentage increase in demand is greater than the percentage increase in income.

Income Elasticity of Demand Inferior goods are those whose consumption decreases when income increases.  Inferior goods have income elasticities less than zero. 

Income Elasticity of Demand: 

Normal Good – demand rises as income rises and vice versa

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Inferior Good – demand falls as income rises and vice versa

Look out for the sign…! 

A positive sign (+) denotes a normal good

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A negative sign (-) denotes an inferior good

Positive Income Elastic Demand Diagram

Negative Income Elasticity Diagram = Inferior

Zero Income Elasticity 

This occurs when a change in income has NO effect on the demand for goods.

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A rise of 5% income in a rich country will leave the Demand for toothpaste

-

Negative Income Elasticity

• An increase in income will result in a decrease in demand. • A decrease in income will result in a rise in demand.

• ALSO known as INFERIOR GOODS

Look for the signs! NORMAL

+

GOODS

• LUXURY GOODS

+

BETWEEN 0 & 1 +0.5 +0.9 + 0.1

INFERIOR

-

GREATER THAN 1 +2 +5 +27

GOODS

CAN BE A DECIMAL OR A VALUE GREATER THAN 1

Income Elasticity and the Demand for Airline Travel 

Demand for air travel has a positive income elasticity of demand

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The industry is cyclical 

During an upturn, demand rises for business and leisure travel)

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During a recession, the demand tails away

Income elasticity will vary according to the type of air travel 

E.g. difference between low-cost “nofrills” and higher priced scheduled services on low-haul flights

Income Elasticity of Demand for Chocolate Total consumption  USA 0.79  Germany 0.39  United Kingdom 0.44  France 0.60  Japan 0.08  Switzerland 1.06

Which country has the sweeter tooth when it comes to income elasticity for chocolate??

Reference: Henri Jason Trends in cocoa and chocolate consumption with particular reference to developments in the major markets. Malaysian International Cocoa Conference, Kuala Lumpur, (ICCO, ED(MEM) 686)

USES OF INCOME ELASTICITY 

It is useful in demand forecasting ,When a change in personal income is expected

.

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It avoids over or under production.

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It helps to define the good as normal or inferior good

PROBLEMS

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A consumer demands 4kgs of sugar when his income is Rs 2,000. When his income went up to Rs 2,400 ,demand for sugar increased to 5 kgs . Calculate Ye of demand and state whether it is elastic or inelastic in nature ?

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2) If a consumer ‘s demand for a good increases from 100units to 200 units per week when his income rises from Rs 2000 to Rs 3000,Find income elasticity of demand ?

1.2 , 2

Cross-Price Elasticity Measures how sensitive DEMAND for a commodity is to changes in the price of a substitute or compliment commodity

Cross- Elasticity of Demand 

Cross- elasticity of demand – the percentage change in demand divided by the percentage change in the price of another good.

Complements and Substitutes • Substitutes are goods that can be used in place of another. • Substitutes have positive cross-price elasticities.

Complements and Substitutes Complements are goods that are used in conjunction with other goods.  Complements have negative cross-price elasticities. 

Let us assume that two commodities X ‘n’ Y are related the expression of cross elasticity of demand would be

E xy = ∆qx × py ∆py qx

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Same formula is used for both substitutes and complementary goods

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For substitutes cross elasticity is positive

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For complements cross elasticity is negative

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If the goods are non related i.e., neither substitutes nor compliments C.E.D is zero

Problem The price of coffee increases from Rs 50per kg to Rs 70 per kg AS A RESULT THE DEMAND FOR TEA INCREASES FROM 5 Kg to 10 kgs .What is the cross elasticity of demand of tea for coffee ?

∆P coffee =Rs 70-Rs 50 = Rs 20 ∆Qtea = 10kg- 5Kg =5Kg E xy = ∆qTea . ∆pCoffee

pCoffee qTea.

Problem 

A and B are rival products .The price of A decreases from Rs 200 to Rs 150 .The demand for B decreases from 100units to 80 units .Calculate cross elasticity of demand ?

Promotional Elasticity • Measures the responsiveness of demand to changes in advertisements or promotional expenses . • It is very useful for producers to calculate the change in sales as a result of change in advertisement expenditure . • It depends on stage of products development .

FORMULA • Ea = ∆S. A • ∆A. S S = Sales A= Initial Advertisement cost ∆S = change in Sales ∆A = Change in Advertisement cost

Importance of Elasticity Relationship between changes in price and total revenue  Importance in determining what goods to tax (tax revenue)  Importance in analysing time lags in production  Influences the behaviour of a firm 