Elasticities of Demand and Supply Summary

Concept of Elasticity

  • Elasticity measures responsiveness of variable Y to changes in variable X.

  • A change in X influences Y, establishing a causal relationship.

Demand Elasticity

  • Measures responsiveness of demand to changes in:

    • Price of a commodity

    • Related products' prices

    • Consumer's income

    • Tastes and preferences

  • Types of demand elasticity include:

    • Price Elasticity of Demand (εp)

    • Income Elasticity of Demand (εI)

    • Cross-Price Elasticity of Demand (εXY)

Price Elasticity of Demand (εp)

  • Measures demand's responsiveness to price changes.

  • Calculated as a percentage change in quantity demanded divided by percentage change in price:
    extεp=racextPercentagechangeinQuantityDemandedextPercentagechangeinPriceext{εp} = rac{ ext{Percentage change in Quantity Demanded}}{ ext{Percentage change in Price}}

  • Types:

    • Arc elasticity: large price changes

    • Point elasticity: small price changes

  • Price elasticity of demand is always negative due to the law of demand (focus on absolute values).

Categories of Price Elasticity of Demand

  • | ext{εp}| > 1: Elastic

  • | ext{εp}| < 1: Inelastic

  • ∣extεp∣=1| ext{εp}| = 1: Unitary Elastic

  • Perfectly Elastic Demand: ∣extεp∣oext∞| ext{εp}| o ext{∞}

  • Perfectly Inelastic Demand: ∣extεp∣=0| ext{εp}| = 0

Factors Affecting Price Elasticity of Demand

  1. Nature of the good - Necessities have low elasticity; luxuries have high elasticity.

  2. Availability of substitutes - More substitutes lead to higher elasticity.

  3. Time period - Demand becomes more elastic over time.

  4. Proportion of income spent - Expensive goods often have higher elasticity.

  5. Habit - Habitual products are less elastic.

Cross Price Elasticity of Demand (εXY)

  • Measures responsiveness of quantity demanded for Y to price changes in X:
    extεXY=racextPercentagechangeinQuantityDemandedofYextPercentagechangeinPriceofXext{εXY} = rac{ ext{Percentage change in Quantity Demanded of Y}}{ ext{Percentage change in Price of X}}

  • Positive: Substitutes; Negative: Complements; Zero: Unrelated.

Income Elasticity of Demand (εI)

  • Measures demand's responsiveness to income changes:
    extεI=racextPercentagechangeinQuantityDemandedextPercentagechangeinIncomeext{εI} = rac{ ext{Percentage change in Quantity Demanded}}{ ext{Percentage change in Income}}

  • Categories include:

    • $| ext{εI}| > 1$: Luxuries

    • $| ext{εI}| < 1$: Necessities

    • Positive: Normal goods; Negative: Inferior goods.

Meaning of Elasticity of Supply

  • Measures responsiveness of quantity supplied to price changes:
    extPriceElasticityofSupply(εp)=racextPercentagechangeinQuantitySuppliedextPercentagechangeinPriceext{Price Elasticity of Supply (εp)} = rac{ ext{Percentage change in Quantity Supplied}}{ ext{Percentage change in Price}}

Determinants of Supply Elasticity

  1. Time Period: Immediate, short run, and long run.

  2. Existence of Excess Capacity: Influences elasticity.

  3. Resource Mobility: Ease of moving resources affects elasticity.

  4. Product Durability: Durable goods generally have elastic supply.

  5. Diversification: firms producing varied products tend to have elastic supply.

Applications of Elasticity

  1. Pricing Strategies - Helps firms determine feasible product pricing based on demand elasticity.

  2. Wage Determination - Elastic demand leads to different wage dynamics.

  3. Government Policies - Taxes/Subsidies and trade policies rely on understanding elasticity.