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To begin to understand what 'elasticity' is all about, just keep in mind that it means 'responsiveness'. Here we are concerned with the price elasticity of demand and the price elasticity of supply. We wish to know the extent to which a change in the price, of say, petroleum products will cause the quantity demanded and the quantity supplied to change, other things held constant.
Elasticity Animation
Price Elasticity of Demand
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:
For calculations the longer form is sometimes more useful. This is called the mid-point method and the one you'll need to know for Bursary.
The following table gives all the situations with regard to elasticity of demand.
Numerical Value
Description
Diagram
Explanation
E of D = 0
Perfectly Inelastic
Change in price has NO EFFECT AT ALL on the QD.
E of D < 1
Inelastic
% change in price is GREATER than % change in QD. ( Total expenditure UP if price goes up)
E of D = 1
Unit Elasticity
% change in price EQUALS % change in QD. (Total expenditure unchanged)
E of D > 1
Elastic
% change in price is LESS than % change in QD. (Total expenditure DOWN if price up)
E of D = °
Perfectly Elastic
Change in price causes demand to DISAPPEAR.
Look at the following graphs and the calculations for price elasticity of demand.
Fig 4.1 Inelastic and Elastic Demand.
Determinants of Elasticity of Demand
The elasticity of a product is influenced by:
the number of substitutes available
whether it could be described as a luxury or a basic commodity
the proportion of the purchaser's income it represents
the durability of the product
How do we decide if a good is inelastic or elastic?
Elastic Demand
Inelastic Demand
many substitutes
few substitutes
luxuries
necessities
high proportion of income
low proportion of income
durable
less durable
Income Elasticity of Demand
We also have income elasticity of demand which measures the responsiveness of quantity demanded to changes in income. The formula for income elasticity of demand is:
The equation is the same as that for price elasticity of demand except the price has been changed for income(Y). Income elasticity of demand can be used to help producers forecast demand for their products and distinguish between different types of goods. Where the coefficient is greater than zero, or positive, we can classify the good as a normal good. We can different types of normal goods. If a 10% increase in income brought about a 10% increase in quantity demanded, we can say the income elasticity of demand is unitary. If EY>1 we classify the good as a luxury, and if EY<1, a basic commodity.
If EY = 0 consumers will still buy the same quantity regardless of income. This is seen with necessities, such as basic foodstuffs.
Inferior goods have EY less than zero, or negative. Economists sometimes refer to inferior goods as Giffen Goods, those that consumers will buy more of as income decreases. The table below explains each stage of Income Elasticity of Demand.
Numerical Value
Description
Explanation
Income E of D < 0
Negative elasticity
Rise in Y causes QD to fall(+vv) - INFERIOR GOOD
Income E of D = 0
Zero Elasticity
Change in Y has NO EFFECT on QD.
Income E of D < 1
Income Inelastic
% change in Y is GREATER THAN % change in QD. NECESSITY GOOD.
Income E of D = 1
Unit Elasticity
% change in Y EQUALS % change in QD.
Income E of D > 1
Income Elastic
% Change in Y is LESS THAN % change in QD. LUXURY GOOD.
Income E of D = °
Perfectly Income Elastic
Change in Y causes an infinite change in QD.(Theoretical only)
Cross-price Elasticity of Demand
Cross-price elasticity of demand is a measure of the responsiveness of one good's quantity demanded to changes in a related good's price. When two goods are substitutes, the cross-price elasticity of demand will be positive. For example when the price of margarine goes up , the quantity demanded of butter will go up to. If goods are compliments, the cross-price elasticity will be negative. For example when the price of CD's goes up, the quantity demanded of CD players is likely to fall. The calculation is:
Numerical Value
Description
Explanation
Relationship between X and Y
Cross E of D < 0
Negative Cross Elasticity
Rise in price of X causes QD of Y to fall
Complements
Cross E of D = 0
Zero Cross Elasticity
Change in price of X has NO EFFECT on QD of Y
Independent
Cross E of D < 1
Cross Inelastic
% change in price of X is GREATER THAN % change in QD of Y
Poor Substitutes
Cross E of D > 1
Cross Elastic
% change in price of X is LESS THAN % change in QD of Y
Good Substitutes
Cross E of D = °
Infinite Cross Elasticity
Fall in price of X causes demand for Y to DISAPPEAR
Perfect Substitutes
It is also important to remember that elasticity of demand varies along a straight line demand curve - see fig 4.1
Fig 4.1 How elasticity varies along a demand curve.
Price Elasticity of Supply
Elasticity of supply refers to the ability of producers to adjust supply to a change in PRICE, and is thus basically a SHORT-TERM idea. It can be measured by the following formula:
In general, the E of S will tend to GREATER, the LONGER the time period under question, and the greater the degree of SUBSTITUTABILITY between the factors of production. In other words, each short run supply curve is succeeded by another of greater elasticity.
The following TIME PERIODS should be committed to memory.
VERY SHORT RUN - no change in output possible(resort to STOCKS ONLY).
SHORT RUN - variable factors only can be increased.
LONG RUN - ALL factors can be increased(i.e. SIZE of firm may alter).
VERY LONG RUN - change in TECHNIQUES of production possible.
NONE OF THE ABOVE CAN BE REGARDED AS A SPECIFIC PERIOD OF TIME.
The following basic supply curve shapes should also be known.
Numerical Value
Description
Diagram
Explanation
E of S = 0
Perfectly Inelastic
Change in price has NO EFFECT AT ALL on the QS.
E of S < 1
Inelastic
% change in price is GREATER than % change in QS.
E of S = 1
Unit Elasticity
% change in price EQUALS % change in QS.
E of S > 1
Elastic
% change in price is LESS than % change in QS.
E of S = °
Perfectly Elastic
Change in price causes Supply to DISAPPEAR.
Note in particular that any supply curve which is a straight line through the origin(middle graph above) is of unit elasticity.
Keypoints
Price elasticity is a measure of the responsiveness of the quantity demanded and supplied to a change in price.
The price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price.
The price elasticity of demand changes as we move down a straight-line demand curve; it becomes relatively more inelastic.
The determinants of price elasticity of demand are: the number of substitutes available, whether it could be described as a luxury or a basic commodity
whether it could be described as a luxury or a basic commodity, proportion of the purchaser's income it represents, the durability of the product.
Income elasticity measures the responsiveness of quantity demanded to income changes.
Cross-price elasticity of demand is the percentage change in the demand for one good divided by the percentage change in the price of the related good.
