In Depth Notes on Elasticities of Demand and Supply

Definition of Elasticity

  • Elasticity: An economic concept that measures responsiveness of one variable to changes in another.

Price Elasticity of Demand (PED)

  • Defined: Measures how much the quantity demanded of a good responds to price changes.
  • Calculation: Percentage change in quantity demanded divided by percentage change in price.
    • Formula:
      [ E_d = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}} ]
  • Step to Calculate Percentage Change in Price:
    • Formula:
      [ \text{Percent Change in Price} = \frac{\text{New Price - Initial Price}}{\text{Initial Price}} \times 100 ]
Examples:
  1. Price rises from $3 to $5:
    • Calculation:
      [ \frac{5 - 3}{3} \times 100 = 66.67\% ]
  2. Price drops from $5 to $3:
    • Calculation:
      [ \frac{3 - 5}{5} \times 100 = -40\% ]
Average Method (Midpoint Method):
  • Why Use?: Avoids direction issues in percentage changes.
  • Formula:
    [ \text{Percent Change} = \frac{\text{New Price - Initial Price}}{(\text{New Price + Initial Price})/2} \times 100 ]
Types of Elasticity:
  1. Perfectly Inelastic: E_d = 0, demand does not change as price changes.
  2. Inelastic Demand: E_d < 1, quantity demanded changes less than price.
  3. Unit Elastic: E_d = 1, quantity demanded changes proportionately with price.
  4. Elastic Demand: E_d > 1, quantity demanded changes more than price.
  5. Perfectly Elastic: E_d = ∞, even a small price change results in an extreme change in quantity demanded.

Factors Influencing PED:

  • Availability of Substitutes:
    • More substitutes = more elastic demand.
  • Necessity vs. Luxury:
    • Necessities (e.g., food) = inelastic; luxuries (e.g., vacations) = elastic.
  • Time Frame:
    • Greater time elapsed from price change = more elastic demand.
  • Proportion of Income:
    • Higher portion spent on a good = more elastic demand.

Total Revenue and PED:

  • Total Revenue = Price × Quantity Sold.
  • Total Revenue Test:
    • If price increase -> TR decreases = elastic.
    • If price increase -> TR unchanged = unit elastic.
    • If price increase -> TR increases = inelastic.

Price Elasticity of Supply (PES)

  • Definition: Measures extent to which quantity supplied changes as price changes.
  • Formula:
    [ E_s = \frac{\text{Percentage Change in Quantity Supplied}}{\text{Percentage Change in Price}} ]
Types of PES:
  1. Perfectly Elastic Supply: E_s = ∞, even tiny price change results in significant supply change.
  2. Elastic Supply: E_s > 1, supply changes more than price change.
  3. Unit Elastic Supply: E_s = 1, supply changes in exact proportion to price change.
  4. Inelastic Supply: E_s < 1, supply changes less than price.
  5. Perfectly Inelastic Supply: E_s = 0, supply does not change regardless of price.
Influences on PES:
  • Production Possibilities: Elastic for goods that can be produced easily; inelastic for fixed quantity goods.
  • Storage Capabilities: Highly elastic supply for goods that are storable.

Cross Elasticity of Demand (CED)

  • Definition: Measures responsiveness of demand for one good when the price of another good changes.
  • Formula: Cross Elasticity of Demand = Percentage change in quantity demanded of Good A / Percentage change in price of Good B.
Types of CED:
  1. Positive Cross Elasticity: Goods are substitutes; price drop in one increases demand for the other.
  2. Negative Cross Elasticity: Goods are complements; price drop in one increases demand for the other.

Income Elasticity of Demand (IED)

  • Definition: Measures demand change in response to income change.
  • Formula: Income Elasticity of Demand = Percentage change in quantity demanded / Percentage change in income.
  • Classification:
    • Normal Goods: IED > 0; luxury goods (IED > 1) and necessities (IED < 1).
    • Inferior Goods: IED < 0; demand decreases as income rises.
Conclusion
  • Understanding elasticity concepts is crucial in economics for predicting consumer behavior and making informed business decisions.