Elasticity of Demand and Supply
o In order to turn supply and demand into truly useful tool, we need to know how much supply and demand response to changes in price
o That's why the concept of elasticity is applied. That is, How the consumer respond to their demands due to the changes in price can be measured through elasticity of demand and supply.
Price elasticity of Demand
o Goods vary enormously in their price elasticity or sensitivity to their price changes.
o When the price elasticity of a good is high, we say that the good has elastic demand, which means that its quantity demanded responds greatly to price changes. Substitute goods like luxurious item can be termed as elastic as due to their change in price changes the demand as a whole. Example: automobile.
o When the price elasticity of a good is low, we say that the good has inelastic demand, which means that its quantity demanded responds little to price changes. Example: food which is a necessity item for which demand tends to be inelastic.
o Economic factors that define the size of price elasticity for individual goods:
n Elasticities tend to be higher for
i. Luxuries goods
ii. Substitute products
iii. The length of time
Luxuries goods- For necessities like food, fuel and prescription drugs demand tend to be inelastic. Such items are the stuff of the life and cannot easily be foregone when the prices rise. By contrast, one can easily substitute other goods when luxurious item like Italian designer clothing rise in price.
Substitute products- Goods that have ready substitute products tend to have more elastic demand than those that have no substitutes. For example –if the prices of food items increase people hardly stop eating. So, food item is price-inelastic.
On the other hand, if mad–cow diseases drives up the price of British beef , people can turn to beef from other countries or to lamb or poultry for their meet needs. So, British beef shows a high price –elasticity.
The length of time-In the long run people adjust their behavior to the changes in higher prices of goods rather than in the short-run.
For example-If the price of gasoline suddenly increases the people do not sell their car or abandon their vacation. So, in the short-run the demand for gasoline may be very in-elastic. But in the long run the people can adjust their behavior to the higher price of gasoline.
Elasticity and Revenue
q Whether raising price will raise or lower the revenues can be analyzed through developing relationship between price and elasticity.
o Total revenue=Total revenue is equal to price and quantity( Or Price x quantity).
o Suppose, if consumers buy 5 units at $3 each , total revenue would be $15.
Price elasticity of supply
o Measures how much the quantity supplied of a good changes when its price changes.
o Price elasticity of supply: It is the percentage change in quantity supplied divided by the percentage change in price.
o We can calculate the coefficient of price elasticity numerically according to the following formula.
Price elasticity of supplied (ES) = (Percentage change in quantity supplied / Percentage change in price)
o When the price elasticity of a good is high, we say that the good has elastic supply, which means that its quantity supplied responds greatly to price changes.
o When the price elasticity of a good is low, we say that the good has inelastic supply, which means that its quantity supplied responds little to price changes.