Economics

Quantity demanded of a commodity changes with a change in price. According to the law of demand, quantity demanded increases with a fall in price and declines with a price rise. Producers of goods and services the world over, seeking ways to increase revenues, face a trade-off between increase (or decrease) in price versus fall (or rise) in demand. Whether an increase in price will yield higher revenues despite fall in quantity demanded is the question that permeates their thoughts. The answer to this question is obtained by examining the elasticity of a product. It measures responsiveness of change in percentage of one variable, called the dependent variable, with respect to a percentage change in another variable, known as the independent variable. Total revenue is equal to price of one unit times units sold. When a change in demand is less than the change in price, a price hike may succeed in increasing revenues. Conversely, if demand falls drastically in comparison to price, producers may incur revenue losses on price hikes.
   
Elasticity of demand and supply are widely used concepts in economics. Further, demand elasticity can be divided into three categories, namely, price, income and cross elasticity of demand. Price elasticity of demand measures responsiveness of quantity demanded of a commodity to a 1 percent change in its price. Commonly represented by eD, price elasticity of demand is calculated as percentage change in quantity demanded   percentage change in price. Since the law of demand, states that prices and demand move in opposite directions, eD is always a negative quantity. Elasticity is different from a lines slope as it measures percentage changes while the latter measures simply changes along vertical and horizontal access. Arc elasticity is one way to measure a commoditys elasticity and uses the average values of each of the dependent and independent variables. It gives the average value of elasticity over a range of percentage change. For more accurate estimations, small percentage changes should be used. Movement along a linear demand curve reveals that absolute value of eD is different for different pairs of points on the demand curve and decreases with low prices and high quantities demanded. If the absolute value of eD is greater than 1 for a commodity, it is said to have price elastic demand. When eD  0, the good has perfectly inelastic demand. If the absolute value of eD is less than 1 for a commodity, it is said to have price inelastic demand. When eD  , the good has perfectly elastic demand. Finally, if eD  1, then the commodity has unit elastic demand. A price hike increases total revenue for a price inelastic good while a price decrease lowers total revenues. In case of elastic demand, a price increase lowers revenues while a price decrease increases them. Total revenues remain unaltered for change in price of unit elastic commodities. A single linear demand curve may have both elastic and inelastic regions. Non-liner curves, on the other hand, have constant eD along the curve. Price elasticity of demand is influenced by the availability of close substitutes, household importance and time. Greater the number of close substitutes available and time to respond to price change and less the importance of a commodity in household budget, higher will be the absolute value of eD. A second type of demand elasticity is income elasticity of demand, denoted by eY. It is the ratio of change in percentage of quantity demanded to a percentage change in income, ceteris paribus. Income elasticity may be positive or negative. Rise in income increases the quantities demanded of normal goods and lowers the demand for inferior goods and services. Cross elasticity of demand is the final type of demand elasticity. It measures responsiveness of quantity demanded of a commodity x relative to a percentage change in the price of commodity z. Cross elasticity of demand is positive for substitutes, negative for complements and zero for unrelated goods.
   
Elasticity can also be measured from the supply side. Price elasticity of supply is the responsiveness of quantity supplied of a good or service to a one percent change in it price. According to the law of supply, supply and price move in the same direction. Consequently, price elasticity of supply, denoted by eS, is generally positive. A commodity has elastic, inelastic or unit elastic supply depending on whether eS  1, eS  1 or eS  1, respectively. Supply elasticity increases with increase in time available to suppliers to respond to a price change. Price elasticity of supply, when applied to labor, shows the effect of wage increases on the quantity of supplied labor. In some cases, labor input for people in high paying jobs declines as they devote more time to leisure activities, giving a negatively sloping labor supply curve.