EC1002 - Elasticity of Demand and Supply Notes

Elasticity of Demand and Supply Notes

Learning Outcomes

  • Understand how elasticities measure responsiveness of demand and supply.
  • Define and calculate Price Elasticity of Demand (PED).
  • Identify determinants of price elasticity.
  • Relate demand elasticity to revenue.
  • Understand the fallacy of composition.
  • Describe cross-price elasticity in relation to complements and substitutes.
  • Define and calculate Income Elasticity of Demand.
  • Use income elasticity to identify inferior, normal, and luxury goods.
  • Define and calculate elasticity of supply.
  • Analyze how supply and demand elasticities affect tax incidence.

Price Elasticity of Demand (PED)

  • Definition: PED is the percentage change in quantity demanded divided by the percentage change in price:
    PED = \frac{%\Delta QD}{%\Delta P}

  • Interpretation:

    • PED is usually negative because supply and demand move in opposite directions (as price rises, quantity demanded typically falls).
    • To express PED positively, the absolute value is taken.

  • Example: If price rises by 1% and quantity demanded falls by 2%, then:
    PED=−21=−2PED = \frac{-2}{1} = -2

Types of Elasticity
  1. Elastic Demand: If |PED| > 1; quantity demanded changes significantly with price changes. (e.g., luxuries like designer clothing)
  2. Inelastic Demand: If |PED| < 1; quantity demanded changes little with price changes. (e.g., necessities like bread)
  3. Unit Elastic: If |PED| = 1; percentage change in quantity demanded equals the percentage change in price.
  4. Perfectly Elastic: If |PED| = ∞; any price change leads to an infinite change in quantity demanded.
  5. Perfectly Inelastic: If |PED| = 0; quantity demanded doesn’t change with price.
Determinants of Price Elasticity of Demand
  • Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries have elastic demand.
  • Availability of Substitutes: More substitutes available lead to more elastic demand.
  • Definition of the Market: Narrowly defined markets are generally more elastic.
  • Time Period: Demand tends to be more elastic in the long run than in the short run as consumers adjust.
  • Proportion of Income: Higher-priced goods relative to income tend to have more elastic demand.
  • Possibility of Postponing Purchase: If purchases can be delayed, demand becomes more elastic.

Income Elasticity of Demand (IED)

  • Definition: Measures responsiveness of quantity demanded to a change in income:
    IED = \frac{%\Delta QD}{%\Delta M}

  • Types of Goods:

    • Normal Goods: Positive IED; demand increases as income increases (e.g., luxury goods).
    • Necessities: 0 < IED < 1; demand increases but at a decreasing rate when income increases.
    • Inferior Goods: Negative IED; demand decreases as income increases.

Cross-Price Elasticity of Demand

  • Definition: Measures responsiveness of quantity demanded of one good to price changes of another:
    XED = \frac{%\Delta QD{good i}}{%\Delta P{good j}}

  • Types:

    • Substitutes: Positive XED; increase in the price of one leads to an increase in demand for the other.
    • Complements: Negative XED; increase in the price of one leads to a decrease in demand for the other.

Price Elasticity of Supply (PES)

  • Definition: Measures responsiveness of quantity supplied to a change in price:
    PES = \frac{%\Delta QS}{%\Delta P}

  • Characteristics:

    • EoS > 1: Supply is elastic (flatter supply curve).
    • EoS < 1: Supply is inelastic (steeper supply curve).
    • EoS = 0: Perfectly inelastic supply (vertical curve).
    • EoS = ∞: Perfectly elastic supply (horizontal curve).

Tax Incidence

  • The burden of a tax depends on the elasticities of demand and supply:

    • More inelastic demand leads to consumers bearing the greater tax burden.
    • More inelastic supply leads to suppliers bearing the greater tax burden.

  • Key Formula:

    • The ratio of the price change received by producers to the price change paid by consumers can be represented as:
      ΔP<em>dΔP</em>s=E<em>sE</em>d\frac{\Delta P<em>d}{\Delta P</em>s} = \frac{E<em>s}{E</em>d} where:
    • $P_d$ = price paid by buyers,
    • $P_s$ = price received by sellers.

Fallacy of Composition

  • The fallacy implies that what is true for an individual is not necessarily true for the whole group. E.g., if one farmer reduces output, it doesn't affect market prices, whereas if all farmers reduce output, market prices will increase.