5 elasticity of demand_and_supply

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5 elasticity of demand_and_supply

  1. 1. In This Lecture… Types -Price Elasticity of Demand, Income Elasticity of Demand, Cross Elasticity of Demand Determinants of Elasticity of Demand Measurement of Elasticity of Demand
  2. 2. In This Lecture… Types - Elasticity of Supply Determinants of Elasticity of Supply Measurement of Elasticity of Supply
  3. 3. Elasticity of Demand Elasticity of Demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.
  4. 4. Types of Elasticity of Demand • Price Elasticity of Demand • Cross Elasticity of Demand • Income Elasticity of Demand
  5. 5. Price Elasticity of Demand A measure of the responsiveness of quantity demanded to changes in price. %Δ P → %Δ Q
  6. 6. Factors Determining Price Elasticity of Demand - Availability of close substitute - Consumer’s loyalty - Necessities versus luxuries - Proportion of income spent on the product - Postponement of the Use - Time
  7. 7. Elastic vs Inelastic Elastic – when change in price has greater effect on demand Inelastic – when change in price has lesser effect on demand
  8. 8. Availability of Close Substitutes The demand for a good is price elastic which have substitutes like tea and coffee, orange juice and lime juice. It is because when the price of a commodity falls in relation to its substitutes, the consumers will go on for it and demand increases. Goods having no substitutes like Cigarettes, liquor etc. have inelastic demand.
  9. 9. Consumer’s Loyalty The demand for a good is price inelastic if consumers are habituated in buying that good and are unwilling to use substitutes – eg. Cigarettes, tobacco, coffee, liquor etc. - and vice versa if the good is price elastic
  10. 10. Necessities versus luxuries Generally, the more that a good is considered a luxury (a good that we can do without) rather than a necessity (a good that we can’t do without), the higher the price elasticity of demand.
  11. 11. Proportion of Income spent on the product The demand for a good is price inelastic if the good takes only small proportion of income and the consumers will not react significantly – eg. Boot-polish, needles, newspapers etc. - and vice versa if the good is price elastic.
  12. 12. Postponement of the Use The demand for a good is price inelastic if the goods whose demand cannot be postponed – eg. Education, health services - and vice versa (constructing a house).
  13. 13. Time The longer the time period the more elastic is the demand and vice versa. It is because in the long run a consumer can change his habits more conveniently than in short period.
  14. 14. Measurement of Price Elasticity of Demand Percentage / Proportionate Method Total Expenditure Method Point Method Arc Method
  15. 15. Percentage / Proportionate Method Percentage / Proportionate Method : It refers to the price elasticity as the ratio of percentage change in quantity demanded to the percentage change in price.
  16. 16. Percentage / Proportionate Method Symbolically, eD = - Percentage Change in quantity demanded Percentage in price ΔQ eD = - ---------- P X ---------- ΔP Q The absolute value of the coefficient of elasticity of demand ranges from zero to infinity ( 0≤ eD ≤ ∞)
  17. 17. “-” sign in the formula for ed Since there is inverse relationship between price and quantity demanded, elasticity of demand is ought to be negative like -1, -2, -3 etc. However, mathematically, -3 is lesser than -2 but in the context of elasticity of demand -3 shows higher elasticity than -2 . Therefore, in order to avoid this complexity – sign is prefixed in the formula for elasticity of demand.
  18. 18. Five Coefficient of Price Elasticity of Demand - Perfectly Inelastic Demand (eD = 0) - Inelastic / Less than Unit Elastic Demand (eD < 1) - Unitary Elastic Demand (eD = 1) - Elastic / More than Unit Elastic Demand (eD > 1) - Perfectly Elastic Demand (eD = ∞)
  19. 19. Graphical Representation of Perfectly Price Inelastic Demand (eD = 0) Quantity demanded does not change as price changes.
  20. 20. Graphical Representation of Price Inelastic / Less than Unit Demand (eD < 1) The percentage change in quantity demanded is less than the percentage change in price. Quantity demanded changes proportionately less than price changes. Applicable in necessary goods like salt, kerosene.
  21. 21. Graphical Representation of Price Unitary Elastic Demand (eD = 1) The percentage change in quantity demanded is equal to the percentage change in price. Quantity demanded changes proportionately to price changes.
  22. 22. Graphical Representation of Price Elastic/More than unit Elastic Demand (eD > 1) The percentage change in quantity demanded is greater than the %age change in price. Quantity demanded changes proportionately more than price changes. Applicable in luxuries like AC, costly furniture etc
  23. 23. Graphical Representation of Perfectly Elastic Demand (eD = ∞) A small percentage change in price causes an extremely large percentage (infinite) change in quantity demanded (from buying all to buying nothing).
  24. 24. Price Elasticity of Demand Summary
  25. 25. Price Elasticity and Total Revenue Total revenue (TR) of a seller equals the price of a good times the quantity of the good sold (P x Q).
  26. 26. Total Expenditure / Revenue Method • This is also known as Total Outlay Method propounded by Alfred Marshall • How much and in what direction total expenditure/ revenue changes determines the Price Elasticity of Demand of a commodity.
  27. 27. Total Expenditure Method (contd.) Situation Price $ Quantit Total y Expen lb diture Effect on Total Expenditure Elasticity of Demand A 2 1 4 8 8 8 Same Total Expenditure Unitary Elastic Ed = 1 B 2 1 4 10 8 10 Total Expenditure Increases Greater than Unitary Ed > 1 C 2 1 3 4 6 4 Total Expenditure Decreases Less than Unitary Ed < 1
  28. 28. Elastic Demand and Total Revenue I If demand is elastic, the percentage change in quantity demanded is greater than the percentage change in price. Elastic (Ed >1) %ΔQ > %ΔP; P↑→TR↓ P↓→ TR↑
  29. 29. Elastic Demand and Total Revenue (Contd.) Demand is elastic between points A and B. A fall in price, from P1 to P2, will increase the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ2. A rise in price, from P2 to P1, will decrease the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1. In other words, when demand is elastic, price and total revenue are inversely
  30. 30. Inelastic Demand and Total Revenue (Contd.) If demand is inelastic, the percentage change in quantity demanded is less than the percentage change in price. Inelastic (Ed < 1) %ΔQ < %ΔP; P↓→TR↓ P↑→ TR↑
  31. 31. Inelastic Demand and Total Revenue (Contd.) Demand is inelastic between points A and B. A fall in price, from P1 to P2, will decrease the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ 2. A rise in price, from P2 to P1, will increase the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1. In other words, when demand is inelastic, price and total revenue are directly related.
  32. 32. Unit Elastic Demand and Total Revenue If demand is unit elastic, the percentage change in quantity demanded is equal to the percentage change in price. Unit Elastic (Ed =1) %ΔQ = %ΔP; P↑→TR ___ P↓→TR
  33. 33. Unit elastic Demand and Total Revenue Demand is unit elastic between points A and B. A fall in price, from P1 to P2, will not change the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ 2. A rise in price, from P2 to P1, will not change the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1. In other words, when demand is unit elastic, price and total revenue are equal.
  34. 34. Elasticity, Price Changes, and Total Revenue
  35. 35. Point/ Geometric Method It measures elasticity of demand at different points on demand curve. Ed (at a point on = lower segment demand curve ) upper segment
  36. 36. Point Method (Contd.) Ed = ∞ Ed > 1 Ed = 1 Ed < 1 E=0
  37. 37. Arc Elasticity It measures the elasticity of demand over a ranges of prices. Rather than using initial or the final price, we use average of the two, P; for the quantity demanded Q. Ed = Δ Q ΔP x P Q P = Average Price Q = Average Quantity
  38. 38. Arc Elasticity (Contd.) So, the formula for measuring arc price elasticity is, ED= ΔQ x (P1 + P2 ) /2 ΔP ( Q 1 + Q 2) / 2 (Q2 – Q1) = ----------------------------- (P2- P1) (P1+ P2) x --------------------------- (Q1 + Q2 )
  39. 39. Arc Elasticity (Contd.) For example, When the price of a good falls from Rs.15 to Rs.10 per unit, the quantity demanded increases from 100 units to 200 units. The arc elasticity will be, (Q2 – Q1) Ed = ----------------------------- (P2- P1) (P1+ P2) x --------------------------- (Q1 + Q2 ) = - 100/5 x 25/300 = - 20 x 1/12 =5/3 = 1.66
  40. 40. Calculating Price Elasticity of Demand – Arc Method We identify two points on a demand curve. At point A, price is $12 and quantity demanded is 50 units. At point B, price is $10 and quantity demanded is 100 units.
  41. 41. Calculating Price Elasticity of Demand - Arc Method (Contd.) When calculating price elasticity of demand, we use the average of the two prices and the average of the two quantities demanded. The formula for price elasticity of demand is:
  42. 42. Calculating Price Elasticity of Demand - Arc Method (Contd.) For example, the calculation is:
  43. 43. Cross Elasticity of Demand Measures the responsiveness in quantity demanded of one good to changes in the price of another good. = % ΔQD of A % ΔP of B = PB X ΔQDA QDA ΔPB
  44. 44. Cross Elasticity of Demand Ec > 1 → Goods are substitutes Ec < 1 → Goods are complements Ec = 1 → Goods are independent
  45. 45. Cross Elasticity of Demand Cross Elastic - The percentage change in quantity demanded of a good is greater than the percentage change in price of other good. Cross Inelastic - The percentage change in quantity demanded of a good is less than the percentage change in price of other good. Cross Unit Elastic - The percentage change in quantity demanded of a good is equal to the percentage change in price of other good
  46. 46. Cross Elasticity of Demand Independent Complements Substitutes
  47. 47. Income Elasticity of Demand Measures the responsiveness in quantity demanded to changes in income = % ΔQD % ΔY = Y QD X ΔQD ΔY Ey > 1 Superior Good Ey > 1 Normal Good Ey < 1 Inferior Good
  48. 48. Income Elasticity of Demand (Contd.) Income Elastic - The percentage change in quantity demanded of a good is greater than the percentage change in income. Income Inelastic - The percentage change in quantity demanded of a good is less than the percentage change in income. Income Unit Elastic - The percentage change in quantity demanded of a good is equal to the percentage change in income
  49. 49. Income Elasticity of Demand (Contd.) An Engel Curve shows the amount of a good demanded at different levels of income. QD YED = 1 YED > 1 YED < 1 Income (Y) Normal Good Inferior Good
  50. 50. Price Elasticity of Supply Measures the responsiveness of quantity supplied to changes in price.
  51. 51. Factors Determining Elasticity of Supply - Nature of Inputs Used - Natural Constraints - Risk Taking - Nature of Commodity - Technique of Production - Time
  52. 52. Nature of Inputs Used If specialized FOP are used then the supply will be inelastic. If common FOP are used then the supply will be elastic.
  53. 53. Natural Constraints If more teak wood is to be produced, it will take years of plantation before it becomes usable. Supply of teak will be less elastic.
  54. 54. Risk Taking Higher the risk taking element among the entrepreneurs the supply will be more elastic and vice versa.
  55. 55. Nature of Commodity Perishable goods are less elastic in supply while durables are more elastic as its easier to store.
  56. 56. Technique of Production If complicated technique of production is used that needs large stock of capital then the supply of that commodity will be less elastic and vice versa.
  57. 57. Time The longer the time period more is the time available to adjust the supply and more elastic will be the supply curve. Very Short Period : perfectly inelastic Short Period : elastic Long Period : more elastic
  58. 58. Measurement of Elasticity of Supply Percentage / Proportionate Method Point Method
  59. 59. Percentage / Proportionate Method Percentage / Proportionate Method : It refers to the price elasticity as the ratio of percentage change in quantity supplied to the percentage change in price.
  60. 60. Percentage / Proportionate Method Symbolically, eD = Percentage Change in quantity supplied Percentage in price ΔQ eD = P ---------- X ---------- ΔP Q The absolute value of the coefficient of elasticity of supply ranges from zero to infinity ( 0≤ eD ≤ ∞)
  61. 61. Five Coefficient of Price Elasticity of Supply - Perfectly Inelastic Supply (eS = 0) - Inelastic / Less than Unit Elastic Supply (eS < 1) - Unitary Elastic Supply (eS= 1) - Elastic / More than Unit Elastic Supply (eS > 1) - Perfectly Elastic Supply (eS = ∞)
  62. 62. Graphical Representation of Elastic Supply The percentage change in quantity supplied is greater than the percentage change in price: Es > 1 and supply is elastic.
  63. 63. Graphical Representation of Inelastic Supply The percentage change in quantity supplied is less than the percentage change in price: Es 1 and supply is inelastic. .
  64. 64. Graphical Representation of Unit Elastic Supply The percentage change in quantity supplied is equal to the percentage change in price: Es = 1 and supply is unit elastic.
  65. 65. Graphical Representation of Perfectly Elastic Supply A small change in price changes quantity supplied by an infinite amount: Es = ∞ and supply is perfectly elastic.
  66. 66. Price Elastic Graphical Representation of Supply A change in price does not change quantity supplied: Es = 0 and supply is perfectly inelastic.
  67. 67. Point/ Geometric Method It measures elasticity of supply depending on the origin of supply curve. There are three possible situations of elasticity of supply according to this method: Situation 1 : Es =1 Situation 2 : Es > 1 Situation 3 : Es < 1
  68. 68. Point/ Geometric Method Situation 1 : Es = 1 is when supply curve starts from the origin. Price Es = 1 Es = 1 Es = 1 O Quantity
  69. 69. Point/ Geometric Method Situation 2 : Es > 1 is when supply curve starts from Y axis. Price Es > 1 O Quantity
  70. 70. Point/ Geometric Method Situation 3 : Es < 1 is when supply curve starts from X axis. Price Es < 1 O Quantity
  71. 71. Summary of the Four Elasticity Concepts

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