ElasticityPrice Elasticity of DemandIncome Elasticity of DemandCross Elasticity of DemandElasticity of Supply By Misbah javid (1029)

University of Education Lahore

Topic:Elasticity

Micro Economics

Contents Elasticity Its Application Cases Factors Elasticity’s of Demand Price Elasticity of

Demand Curves Income Elasticity of

Demand Cross Elasticity of

Demand

Types of Elasticity’s of Supply

Curves

Elasticity

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this simple equation:

Elasticity = (% change in quantity / % change in price)If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

Factors Affecting Demand Elasticity There are three main factors that influence a demand's price elasticity: 1. The availability of substitutes:This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be . For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good:This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time: The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her

daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

Applications:

To determine the elasticity of a product, the proportionate change of one variable is placed over the proportionate change of another variable (Elasticity = % change of supply or demand / % change in price).

For elastic demand, a change in price significantly impacts the supply and demand of the product.

For inelastic demand, a change in the price does not substantially impact the supply and demand of the product.

Applications to Major Economic Issues One of the most fruitful arenas for application of supply-and-demand analysis

is agriculture. Improvements in agricultural technology mean that supply increases greatly, while demand for food rises less than proportionately with income. Hence free-market prices for foodstuffs tend to fall. No wonder governments have adopted a variety of programs, like crop restrictions, to prop up farm incomes.

A commodity tax shifts the supply-and-demand equilibrium. The tax's incidence (or impact on incomes) will fall more heavily on consumers than on producers to the degree that the demand is inelastic relative to supply.

Governments occasionally interfere with the workings of competitive markets by setting maximum ceilings or minimum floors on prices. In such situations, quantity supplied need no longer equal quantity demanded; ceilings lead to excess demand, while floors lead to excess supply. Sometimes, the interference may raise the incomes of a particular group, as in the case of farmers or low-skilled workers. Often, distortions and inefficiencies result.

Elasticity of Demand

Law of demand will tell you the direction i.e. it tells you which way the demand goes when the price changes. But the elasticity of demand tells you how much the demand will change with the change in price to demand to the change in any factor.Different types of Elasticity of Demand: 1. Price Elasticity of Demand2. Income Elasticity of Demand3. Cross Elasticity of Demand

1. Price Elasticity of Demand: We will discuss how sensitive the change in demand is to the change in price. The measurement of this sensitivity in terms of percentage is called Price Elasticity of Demand. According to Marshall, Price Elasticity of Demand is the degree of responsiveness of demand to the change in price of that commodity.Types of Price Elasticity of Demand:Hypothetical responses of demanders to a 10% increase in four Markets. Percentage changes should always carry the sign (plus or minus).

Positive Changes or increases take a (+).

Negative Changes or decrease take a (-).

Product %Change in price (% P)

% Change in Qd (% Qd)

Elasticity (% Qd/% P)

1-Insulin +10% 0% .0-------> Perfectly inelastic

2-Basic Telephone service

+10% -1% -.1------> Relatively inelastic

3-Beef +10% -10% -1.0-------> Unitary elastic

4-Bananas +10% -30% -3.0----> Relatively elastic

1. Insulin is absolutely necessary to an insulin-dependent diabetic, and the quantity demanded is unlikely respond to an increase in price .when quantity demanded not respond at all to a price change the percentage change in quantity demand is 0 and the elasticity is 0.In this case we can say that the demand for that product is Perfectly inelastic. Quantity demand does not change at all when the price changes, the demand curve is simply Vertical line. For example Life saving Drugs. |Ed|=0

2. Basic Telephone Service is generally considered as a necessity, but not an absolute necessity .If 10% increase in telephone rates result 1 percent decline in the quantity of service demanded elasticity is (-1/10=-.1).when the %change in quantity demanded is smaller in absolute size than the percentage change in price as is the case with telephone service the .Elasticity is less than 1 in absolute size |Ed|<1.This is called Relatively inelastic. Inelastic demand always has a numerical value between zero and -1.And the curve will be Steeper. Other Example: Essential goods (butter,bread,milk)

3. We see that 10 percent increase in beef prices drives down the quantity of beef demanded by 10 percent. Demand elasticity thus (-10/10= -1.0).When the percentage change in quantity of product demanded is the same as the percentage change in price in absolute value , we say that the demand for the product has Unitary elastic. |Ed|=1. The curve will be in the middle of flatter and steeper. Other Example: Most accessories shoes

4. When the percentage change in quantity demanded is larger than the percentage change in price in absolute size, we say that demand is relatively elastic.|Ed|>1 the demand for bananas for example is likely to be quite elastic because there are many substitutes for bananas –other fruits, for instance. If a 10% increase in the price of bananas leads to a 30% decrease in quantity of bananas demanded, the price elasticity of demand for bananas is (-30/10=-3-0).when the absolute value of elasticity exceeds 1, demand is elastic. The curve will be Flatter. Other Example: Luxuries and comforts

5. Finally, if a small increase in the price of product causes the quantity demanded to drop immediately to zero, demand for the product is said to be perfectly elastic.|Ed|=∞.Suppose, For Example That you produce a product that can be sold only at a predetermined, fixed price. If you charged even one rupee more, no one would buy your product because people would simply buy from another producer who had not raised price. This is very close to the reality of farmers, who cannot charge more than the current market price for their crops. The curve will be Horizontal.

a

0

Quantity Demanded

Price

D

10%

20%

Q1

Part (a)

Q2

P1

P2

Ed > 1Elastic

0

Quantity Demanded

Price

D

10%

4%

Q1

Part (b)

Q2

P1

P2

Ed < 1Inelastic

a

0

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Price

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10%

10%

Q1

Part (c)

Q2

P1

P2

Ed = 1Unit Elastic

a

0Quantity Demanded

Price

D1%

Part (d)

Q1

P1P2

Ed = Perfectly Elastic

0Quantity Demanded

PriceD

10%

Part (e)

Q1

P1

P2

Ed = 0Perfectly Inelastic

Practical significance of Price Elasticity of Demand:a) Importance to the businessb) Important to Government

2. Income Elasticity of DemandThe income elasticity of demand measures how the quantity demanded changes as consumer income changes.Inferior Goods:“Other things remain constant, a good for which an increase in income leads to decrease in decrease in demands.”For example: If we travel in a bus. Our income is increase and we travel in an airplane. Demand of bus is decrease due to increase in income. So, bus in inferior good.In inferior goods the relationship between income and quantity demand is negative because income and quantity demand move in opposite direction.

Income Quantity Demand

Y1 5000 Q1 10Y2 8000 Q2 8

Formula:EYI = (Q2 – Q1 / Q2 + Q1) × (Y2 + Y1 / Y2 - Y1)

EYI = (8 – 10 / 8 + 10) × (8000 + 5000 / 8000 - 5000)EYI = (-2 / 18) × (13000 / 3000)EYI = (-1 / 9) × (13 / 3)EYI = - 0.48Normal Goods:“Other things remain constant a good which an increase in income leads to increase in

demand.”For example: If we use a motor bike but our income is increase and we use car. The demand of car is increase. So, due to increase in income, car is normal good.In normal good the relationship between income and quantity demand is positive because income and quantity demand are move in same direction.

Income Quantity Demand

Y1 5000 Q1 8Y2 8000 Q2 10

Formula:EYI = (Q2 – Q1 / Q2 + Q1) × (Y2 + Y1 / Y2 - Y1)

EYI = (10 – 8 / 10+ 8) × (8000 + 5000 / 8000 - 5000)EYI = (2 / 18) × (13000 / 3000)EYI = (1 / 9) × (13 / 3)EYI = 0.48Importance of income of Demand:Income elasticity of demand helps in formulation of taxation policy. The commodities moving positive income elasticity are taxed more and for other moving less elasticity less scale and other indirect taxes are imposed.

3. Cross Elasticity of Demand:• Measures the responsiveness of quantity demanded for a good to a change in

price of ANOTHER good.When would you use Cross Price Elasticity?

• To determine if goods are substitutes or compliments• Ec>0 – substitutes

– % change in quantity demanded and price move in same direction– Two goods that are substitutes have a positive cross elasticity of

demand: as the price of good Y rises, the demand for good X rises– For Example:Polka ice cream price (increase)Walls ice cream demand (increase)

• Ec<0 – compliments– % change in quantity demanded and price move in opposite directions– Two goods that complement each other show a negative cross elasticity

of demand: as the price of good Y rises, the demand for good X falls– For Example:Petrol price (increase)Car Demand (decrease)

• Ec=0 – goods unrelated– Two goods that are independent have a zero cross elasticity of demand:

as the price of good Y rises, the demand for good X stays constant.– For Example:

No existence

Elasticity of supply

Elasticity of supply of a commodity is the degree of responsiveness of the quantity supplies to changes in price. Like the elasticity of demand, the elasticity of supply is the relative measure of the responsiveness of quantity supplied of a commodity to a change in its price.

The, greater the responsiveness of quantity supplied of a commodity to the change in its price, the greater is its elasticity of supply. To be more precise, the elasticity of supply is defined as a percentage change in the quantity supplied of a product divided by the percentage change in price.

Price elasticity of supply:

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate pes.

%change in quantity supply% change in price

While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly elastic.

Consider the following example:

A firm’s market price increases from £1 to £1.10, and its supply increases from 10m to 12.5m. PES is:

+25

+10

= (+) 2.5

The positive sign reflects the fact that higher prices will act an incentive to supply more. Because the coefficient is greater than one, PES is elastic and the firm is

responsive to changes in price. This will give it a competitive advantage over its rivals.

There are five types of elasticity of supply

1. Relatively elastic: |Es|>1 The % change in quantity > % change in price. Es>1. The supply is relatively elastic when a given change in price produces more than proportionate change in Quantity supplied. A doubling in price will result in more Than double the quantity supplied. The supply curve has a Flatter slope.

2. Relatively Inelastic: |Es|<1

It is the reverse of elastic. Es<1The % change in quantity < % change in price When a certain change in price causes a smaller proportionate Change in quantity supplied of a Commodity, the supply is Said to be relatively less elastic. The percentage change in Price is more than the percentage change in quantity supplied. The supply curve is steeply sloped.

3. Unit elasticity: |Es|=1The % change in quantity = % change in price.Es=1 From the diagram below we see a change in price brings about an exact change in the quantity supplied. A 2% change in price brings about a 2% change in quantity supplied.

4. Perfectly elastic’s: |Es| =∞

It is a case where a very slight change in price causes an Infinite change in supply. A slight fall in prices brings quantity supplied to zero. In such a case the supply curve runs parallel to X -axis. The supply curve takes the shape of a horizontal straight line.

At the market going price P*, the quantity supplied is infinite.

So by the formula of elasticity:

Ed (perfectly elastic) = (% change in Qs) ÷ (% change in price) =∞÷0

5. Perfectly inelastic: |Es|=0The % change in quantity is zero. At any price, the quantity supplied is the same.A perfectly inelastic supply curve is a vertical straightLine which is parallel to OY-axis. 

So by the formula of elasticity:

(% change in Qs) ÷ (% change in price) = 0÷∞ =0

a

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Quantity Supplied

Price

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10%

20%

Q2

Part (a)

Q1

P1

P2

Es > 1Elastic

0

Quantity Supplied

Price

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10%

4%

Q2

Part (b)

Q1

P1

P2Es < 1Inelastic

a

0Quantity Supplied

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10%

10%

Q2

Part (c)

Q1

P1

P2Es = 1Unit Elastic

a

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Price

S

Part (d)

Q1

P1

Es = Perfectly Elastic

0

Quantity Supplied

PriceS

10%

Part (e)

Q1

P1

P2

Es = 0PerfectlyInelastic