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Chapter 4
ELASTICITY OF DEMAND AND SUPPLY

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Learning Outcomes

How the sensitivity of quantity demanded to a change in price is measured by the elasticity of demand and what factors influence it How elasticity is measured at a point or over a range How income elasticity is measured and how it varies with different types of goods How elasticity of supply is measured and what it tells us about conditions of production Some of the difficulties that arise in trying to estimate various elasticities from sale data

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Elasticity of Demand and Supply

Demand and supply analysis says about the direction of change. Businessman thinks;
If we rise our price sales will fall

If income increases, demand will increase. But the businessman also want to know By How Much?
We want to know, how responsive demand is to a rise in price. Price Elasticity of Demand: The responsiveness of quantity demanded to a change in price.

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Elasticity of Demand
Measuring the responsiveness of demand to price =
percentage change in quantity demanded

----------------------------------------percentage change in price

The demand elasticity is measured by the ratio. For normal, negatively sloped demand curve, the elasticity is negative, but the relative size of the two elasticities are assessed by comparing their absolute values.

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Example: Calculation of Two Demand Elasticities

Original New 95 1.10 140 % change - 5% 10% - 30% Elasticity - 5/10 = - 0.5%

Good A Quantity Price Good B Quantity 100 1 200 5

- 30/20 = - 1.5%

Price

20%

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Calculation of Two Demand Elasticities Elasticity is calculated by dividing the percentage change in quantity by the percentage change in price. Consider good A. A rise in price of 10p on 1 or 10 percent causes a fall in quantity of 5 units from 100, or 5 percent. Dividing the 5 percent deduction in quantity by the 10 percent increase in price gives an elasticity of -0.5. Consider good B. A 30 percent fall in quantity is caused by a 20 percent rise in price, making elasticity 1.5

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The sign of the measure

When comparing two elasticities, we compare the absolute, not their algebraic values. If product X has elasticity of 2 and product Y has elasticity of 10, we say that product Y has a greater elasticity than product X. The larger absolute value indicates that quantity demanded is highly responsive to a change in price.

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Interpreting price elasticity of Demand

The value of price elasticity ranges from 0 to infinity. Elasticity is zero if quantity demanded is unchanged when price changes. A zero elastic curve is shown by vertical demand curve. It is said to be perfectly or completely inelastic.

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Interpreting price elasticity of Demand

When the elasticity value is greater than one and grater then zero the demand is said to be in- elastic. In case of inelastic demand, the percentage change in quantity is less than percentage change in price. When elasticity is equal to one, the two percentage changes are equal to each other, demand is unit elastic. The demand curve for unit elastic is D3.

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Interpreting price elasticity of Demand

When the percentage change in quantity demanded exceeds the percentage change in price, demand is said to be elastic. When a small change in price results in a larger change in quantity demanded the demand is perfectly or completely elastic. The demand curve for perfectly or completely elastic is shown as D2.

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Three Constant-elasticity Demand Curves

D3

Quantity

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Three Constant-elasticity Demand Curves

D3 D1

Quantity

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Three Constant-elasticity Demand Curves

D3 D1

p0

D2

Quantity

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The Terminology of Elasticity of Demand

Term Numerical Measure of Elasticity Zero Verbal Description

Perfectly In-Elastic In-elastic

Quantity Demanded does not change as the demand change Quantity demanded change by a smaller percentage than does the price Quantity Demanded changes by exactly the same percentage as does the price Quantity Demanded Changes by a larger percentage than does the price Purchasers are prepared to buy all they can at some price and none at a higher price.

Greater than Zero, less than one One

Unit Elasticity Elastic

Grater than One but less than infinity Infinity

Perfectly Elastic

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Three Constant-elasticity Demand Curves

Curve D1 has zero elasticity: the quantity demanded does not change at all when price changes. Curve D2 has infinite elasticity at the price p0: a small price increase from p0 decreases quantity demanded from an indefinitely large amount to zero. Curve D3 has unit elasticity: a given percentage increase in price brings an equal percentage decrease in quantity demanded at all points on the curve Curve D3 is a rectangular hyperbola for which price times quantity is a constant.

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Elasticity and Total Spending

Another way of looking at the price elasticity of demand. TR (total Spending) = P x Q. P : price of the product Q : Quantity Purchased When > 1: A fall in price increases the total spending and rise in price reduces it When <1 : A Fall in price reduces total spending on goods and rise in price increases it.
When = 1: a rise or fall in price, total spending on the goods are unaffected.

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Elasticity on a Linear Demand Curve

0 Quantity

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Elasticity on a Linear Demand Curve

q Quantity

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Elasticity on a Linear Demand Curve

B p q A

q Quantity

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Elasticity on a Linear Demand Curve

Starting at point A and moving to point B, the ratio p/q is the slope of the line. Its reciprocal q/p is the first term in the percentage definition of elasticity. The second term in the definition is p/q, which is the ratio of the coordinates of point A. Since the slope p/q is constant, it is clear that the elasticity along the curve varies with the ratio p/q. This ratio is zero where the curve intersects the quantity axis and infinity where it intersects the price axis.

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Two Intersecting Demand Curves

Ds 0 Quantity

Df

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Two Intersecting Demand Curves

A p p

Ds 0 q

Df

Quantity

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Two Intersecting Demand Curves

p2 p p

p1 A

Ds 0 q

Df

Quantity

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Two Intersecting Demand Curves At the point of intersection of two demand curves, the steeper curve has the lower elasticity. At the point of intersection p and q are common to both curves, and hence the ratio p/q is the same on both curves. Therefore, elasticity varies only with q/p. The absolute value of the slope of the steeper curve, p2/q, is larger than the absolute value of the slope, pl/q, of the flatter curve. Thus, the absolute value of the ratio q/p2 on the steeper curve is smaller than the ratio q/p1 on the flatter curve So that elasticity is lower.

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Elasticity on a Nonlinear Curve

Demand

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Elasticity on a Nonlinear Curve

Demand

A p

Quantity

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Elasticity on a Nonlinear Curve

Demand

A p C

Quantity

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Elasticity on a Nonlinear Curve

Demand

A p C

Quantity

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Elasticity on a Nonlinear Curve

Demand

A p C

Quantity

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Elasticity on a Nonlinear Demand Curve Elasticity measured from one point on a nonlinear demand curve and using the percentage formula varies with the direction and magnitude of the change being considered. Elasticity is to be measured from point A, so the ratio p/q is given. The ratio plq is the slope of the line joining point A to the point reached on the curve after the price has changed. The smallest ratio occurs when the change is to point C. The highest ratio when it is to point E. Since the term in the elasticity formula, q/p, is the reciprocal of this slope, measured elasticity is largest when the change is to point C and smallest when it is to point E.

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Elasticity by the Exact Method

D

Quantity

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Elasticity by the Exact Method

D

Quantity

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Elasticity by the Exact Method

D

Quantity

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Elasticity by the Exact Method

D

a p q b b

Quantity

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Elasticity by the Exact Method

In this method the ratio q/p is taken as the reciprocal of the slope of the line that is tangent to point a. Thus there is only one measure elasticity at point a. It is p/q multiplied by q/p measured along the tangent T. There is no averaging of changes in p and q in this measure because only one point on the curve is used.

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Short-run and Long-run Demand Curves

DL

Quantity

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Short-run and Long-run Demand Curves

p0

E0

Dl

Dso

q0 Quantity

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Short-run and Long-run Demand Curves

E1 p1 p0

E1
E0

Dl

Ds1

Dso

q1 Quantity

q1 q0

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Short-run and Long-run Demand Curves

E2 p2

E2 E1

p1 p0

E1
E0

Dl

Ds2

Ds1

Dso

q2

q2 q1 Quantity

q1 q0

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Short-run and Long-run Demand Curves

DL is the long-run demand curve showing the quantity that will be bought after consumers become fully adjusted to each given price. Through each point on DL there is a short-run demand curve. It shows the quantities that will be bought at each price when consumers are fully adjusted to the price at which that particular short-run curve intersects the long-run curve. So at every other point on the short run curve consumers are not fully adjusted to the price they face, possibly because they have an inappropriate stock of durable goods.

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Short-run and Long-run Demand Curves

For example, when consumers are fully adjusted to price p0 they are at point E0 consuming q0. Short-run variations in price then move them along the short run demand curve DS0. Similarly, when they are fully adjusted to price p1, they are at E1 and short-run price variations move them along DS1. The line DS2 shows short-run variations in demand when consumers are fully adjusted to price p2.

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The Relation Between Quantity Demanded and Income

Quantity 0

Income

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The Relation Between Quantity Demanded and Income

qm

Quantity

Zero income elasticity

y1

Income

y2

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The Relation Between Quantity Demanded and Income

qm Positive income elasticity

Quantity

Zero income elasticity

y1

Income

y2

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The Relation Between Quantity Demanded and Income

qm Positive income elasticity

Quantity

Zero income elasticity

Negative income elasticity [inferior good]

y1

Income

y2

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The Relation Between Quantity Demanded and Income

Normal goods have positive income elasticities. Inferior goods have negative elasticities. Nothing is demanded at income less than y1 , so for incomes below y1 income elasticity is zero. Between incomes of y1 and y2 quantity demanded rises as income rises, making income elasticity positive. As income rises above y2, quantity demanded falls from its peak at qm, making income elasticity negative.

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Three Constant-elasticity Supply Curves

p1

S2

q1 [i]. Zero Elasticity

Quantity

[ii]. Infinite Elasticity

Quantity

S3

Quantity [iii]. Unit Elasticity

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Three Constant-elasticity Supply Curves

p1

S2

q1 [i]. Zero Elasticity

Quantity

[ii]. Infinite Elasticity

Quantity

S3 p q p

q [iii]. Unit Elasticity

Quantity

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Three Constant-elasticity Supply Curves

Curve S1, has a zero elasticity, since the same quantity q1, is supplied whatever the price. Curve S2 has an infinite elasticity at price p1; nothing at all will be supplied at any price below p1, while an indefinitely large quantity will be supplied at the price of p1. Curve S3, as well as all other straight lines through the origin, has a unit elasticity, indicating that the percentage change in quantity equals the percentage change in price between any two points on the curve.

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CHAPTER 4: ELASTICITY OF DEMAND AND SUPPLY Demand Elasticity

Elasticity of demand [also called price elasticity of demand] is defined as the percentage change in price that brought it about. When the percentage change in quantity is less than the percentage change in price, demand is inelastic and a fall in price lowers the total amount spent on the product. When the percentage change in quantity is greater than the percentage change in price, demand is elastic and a fall in price raises total spending on the product. A more precise measure that gives unique value for elasticity at any point on any demand curve replaces q/p measured between two points on the curve with q/p measured along the tangent to the curve at the point in question [symbolised by q/p].

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CHAPTER 4: ELASTICITY OF DEMAND AND SUPPLY

The main determinant of the price elasticity of demand is the availability of substitutes for the product. Any one of a group of close substitutes will have a more elastic demand than the group as a whole. Elasticity of demand tends to be greater the longer the time over which adjustment occurs. Items that have a few substitutes in the short run may develop ample substitutes when consumers consumers ad producers have time to adapt. Income elasticity is the percentage change in quantity demanded divided by the percentage change in income that brought it about. The income elasticity of demand for a product will usually change as income varies.

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CHAPTER 4: ELASTICITY OF DEMAND AND SUPPLY

Cross-elasticity is the percentage change in quantity demanded divided by the percentage change in the price of some other product that brought it about. Products that are substitutes for one another have positive cross-elasticities; products that complement one another have negative cross-elasticities.

Supply Elasticity
Elasticity of supply measures the ratio of the percentage change in the quantity supplied of a product to the percentage change in its price. A commoditys elasticity of supply depends on how easy it is to shift resources into the production of that commodity and how the costs of producing the commodity vary as its production varies.

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CHAPTER 4: ELASTICITY OF DEMAND AND SUPPLY

Measurement of Demand and Supply

Over the years economists have measured many price, income, and cross-elasticities of demand. Being able to do so requires the use of statistical techniques to measure the separate influences of each of several variables when all are changing at once. It also requires a solution of the identification problem, which refers to measuring the separate shapes of the demand and supply curves. This can not be done from price and quantity data alone.