ELASTICITY OF DEMAND AND SUPPLY - MARKETS IN ACTION

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1 WEEK 3 /LECTURE 3 NOTES ELASTICITY OF DEMAND AND SUPPLY - MARKETS IN ACTION Introduction We begin this session by examining elasticity, one of the most important concepts in economics. Let s assume that the price of university tuition fees to study economics fall. The School of Economics and Financial Studies can sell more places for enrolments in the study of Economics. But, would this be good or bad news for both the providers (supply) of economics tuition and the applicants (demand) for the study of economics? Well, this all depends on just how much the price (economics tuition fee) falls, and this depends on the price elasticity of demand for economics. In economics jargon, this concept is referred to as the measure of how responsive demand is to a change in price. However, it is important to realize that it is not just the responsiveness of demand that is important in determining the functioning of markets. Equally important is the responsiveness of supply. Price elasticity of demand It is fairly obvious that when the price of a good rises, the quantity demanded falls. But we want to know more than just this. We want to know just how much the quantity demanded will fall. In other words, we want to know how responsive demand is to a rise in price. Economists refer to this responsiveness of demand to a change in price as the price elasticity of demand. Why is this important? It is important because if we know the price elasticity or the responsiveness of demand for a product, we can pretty much predict the effect on price and quantity of a shift in the supply curve for that particular product. Measuring the price elasticity of demand What we are interested in is to compare the size of the change in quantity demanded with size of the change in price. The problem however is due to the fact that price and quantity are measured in different units, so the only sensible way we can compare the size of the change in quantity demanded with the size of the change in price is to use percentage or proportionate changes. Accordingly we use a specific formula for the price elasticity of demand for a product which is: The percentage change in quantity demanded divided by the percentage change in price. Interpreting the figure for elasticity The reason elasticity is measured in proportionate or percentage terms is to: Allow the changes in two qualitatively different things that are measured in two different types of units, for example quantity changes with monetary changes to be compared. It is the only sensible way of deciding how big a change in price or quantity is. We ve learnt that demand curves are generally downward sloping, which means that price and quantity change in opposite directions. For example, a rise in price (positive figure) will cause a fall in the quantity demanded (a negative figure), and vice versa. Similarly, a fall in price will cause a rise in the quantity demanded. So when we work out the price elasticity of demand, we divide either a negative figure by a positive figure, and vice versa. Either way, we end up with a negative figure.

2 Elasticity of demand is said to be: Elastic when a change in price causes a proportionately larger change in the quantity demanded. The value of elasticity in this instance will be greater than 1. Inelastic when the change in price causes a proportionately smaller change in the quantity demand. Elasticity in this case will be less than 1 since we are dividing a smaller figure by a larger figure. Unitary when the price and quantity demanded change by the same proportion. Hence, elasticity is equal to 1 since we are dividing the figure by itself. Determinants of price elasticity of demand The price elasticity of demand varies enormously from one product to another. Accordingly we need to ask why some products have a highly elastic demand, while others have a highly inelastic demand. Below are some of the factors that determine the price elasticity of demand. Obviously, the most important determinant of demand price elasticity is the number and closeness of substitute goods. Secondly, the higher the proportion of our income we spend on a good, the more we will be forced to reduce consumption when its price rises (hence, the bigger the income effect and the more elastic the demand). Thirdly, when price rises, people may take time to adjust their consumption patterns and find alternatives. Consequently, the longer the time period after a price change, the more elastic the demand is likely to be. Price elasticity of demand and total consumer expenditure The question we need to ask is this: How much do we spend on a good at a given price? One of the most important applications of price elasticity of demand concerns its relationship with the total amount of money that consumers spend on a product. We obtain the value for Total consumer expenditure on a product (TE) per period of time simply by multiplying price by quantity purchased. TE = P x Q. It is important to realise that total consumer expenditure will be the same as the total revenue (TR) received by firms from the sale of the product (before taxes and other deductions). But what will happen to total consumer expenditure (and hence firms

3 revenue) if there is a change in price? The answer depends on the price elasticity of demand. Elastic demand As price rises, so quantity demanded falls, and vice versa. When demand is elastic, quantity demanded changes proportionately more than price. Thus a change in quantity demanded has a bigger effect on total consumer expenditure than a change in price. For example, when the price rises there will be such a large fall in consumer demand that less will be spent than before. We can summarise this as follows: P rises; Q falls proportionately more; therefore TE falls P falls; Q rises proportionately more; there TE rises Inelastic demand When demand is inelastic, it is other way round. Price changes proportionately more, than quantity. Thus, a change in price has a bigger effect on total consumer expenditure than a change in quantity! Following is a summary of the total effects: P rises; Q falls proportionately less; therefore TE rises P falls; Q rises proportionately less; there TE falls Special cases Having said that, it is important to recognize three special cases below: Totally inelastic demand which is shown by a straight line that no matter what happens to price, quantity demanded remains the same. Infinitely elastic demand which is shown by a horizontal straight line. This seemingly unlikely demand curve is said to be relatively common for an individual producer. Unit elastic demand where price and quantity change in exactly the same proportion, such that any rise in price will be exactly offset by a fall in quantity, leaving total revenue unchanged! Price elasticity of supply Not only do we want to know the responsiveness of demand to a change in price, we are also interested to know just how responsive quantity supplied is to a change in price! The measure we use is the price elasticity of supply. What we need to understand is that the effect on price and quantity of a shift in the demand curve will depend on the price elasticity of supply.

4 We use the following formula for price elasticity of supply: Percentage change in quantity supplied / Percentage change in price We see that the formula is identical to that for the price elasticity of demand, except that quantity in this case is quantity supplied. Thus, if a 10% rise in price caused a 25% rise in quantity supplied, the price elasticity of supply would be: 25% / 10% = 2.5 And if a 10% rise in price caused only a 5% rise in the quantity, the price elasticity of supply would be: 5% / 10% = 0.5 Notice that in the first case, supply is elastic (>1) in the second, it is inelastic (<1). Furthermore, we notice that unlike the price elasticity of demand, the figure is positive (assuming that the supply curve is upward sloping). The reason for is that price and quantity supplied change in the same direction. The determinants of price elasticity of supply Obviously, the less the additional costs of producing additional output, the more time firms will be encouraged to produce for a given price rise and the more elastic supply will be. Thus supply is more likely to be elastic if firms have plenty of spare capacity. Also, the elasticity of supply will increase the longer the period that occurs between the change in price and the adjustment of supply. In this instance, it is important to identify three significant adjustment periods: Immediate time period where firms are unlikely to increase supply by much... Short run where if a slightly longer time period is allowed to elapse, some inputs (for example, raw materials) can be increased while others will remain fixed (e.g. heavy machinery). Even so, it is evident that supply can increase somewhat! Long run where there is sufficient time for all inputs to be increased and for new firms to enter the industry. Supply, is likely to be highly elastic, in this case. Other elasticities One other important considerations of elasticities (or responsiveness) relate to how demand responds to changes in income and to changes in the price of other goods! Income elasticity of demand So far we have looked at the responsiveness of demand and supply to a change in price. But price is just one of the determinants of demand and supply. Notwithstanding all the other determinants and different types of elasticity of demand and supply, we are more concerned with just two other elasticities that are particularly useful to us: and both are demand elasticities. The first is the income elasticity of demand which measures the responsiveness of demand to a change in consumer incomes (Y). This is useful to us in predicting how much the demand curve will shift for a given change in income.

5 The formula for income elasticity of demand is: Percentage change in quantity demand / Percentage change in income We can see that the formula is identical to that for the price elasticity of demand, with the exception that we are dividing the change in demand by the change in income that caused it, rather than by a change in price. Thus, if a 2% rise in income cause an 8% rise in a product s demand, its income elasticity of demand would be: 8%/2% = 4 Another important point to note here is that a major determinant of income elasticity of demand is the degree of necessity of the good. Moreover, income elasticity of demand is an important concept to firms considering the future size of the market for their product. If the product has a high income elasticity of demand, sales are likely to expand rapidly as national income rises but may also fall significantly if the economy moves into recession. Cross-price elasticity of demand We refer to the cross-price elasticity of demand as the measure of the responsiveness of demand for one product to a change in the price of another (either a substitute or a complement). Cross-elasticity of demand allows us to predict how much the demand curve for the first product will shift when the price of the second product changes. Let s take the example of Coca-Cola and Pepsi! Knowledge of the cross-elasticity of demand for Coca-Cola to the price of Pepsi would allow Coca-Cola to predict the effect on its own sales if the price of Pepsi were to change. The formula for cross-price elasticity of demand is: Percentage change in quantity demanded of good a / Percentage change in price of good b So we find that if good b is a substitute for good a, a s demand will rise as b s price rises. In this case, cross-elasticity will be a positive figure. If however, good b is complementary to good a, a s demand will fall as b s price rises and the quantity of b demanded falls. In this case, cross-elasticity of demand is a negative figure. We note that the major determinant of cross-elasticity of demand is the closeness of the substitute or complement. When making production plans, firms need to know the cross-elasticity of demand for their product when considering the effect on the demand for their product of a change in the price of a rival s product or of a complementary product. One other example of the usefulness of the concept of cross-elasticity of demand is in the field of international trade and the balance of payments. A government will want to know how a change in domestic prices will affect the demand for imports. If there is a high cross-elasticity of demand for imports (because they are close substitutes for home-produced goods) and if prices at home rise due to inflation, the demand for imports will rise substantially, thus worsening the balance of payments!