Supply and Demand
Elasticity of demand Q2 Q1 P2 P1
Q1 Q2 P1 P2
A good is said to be elastic if a change in price causes a change in quantity demanded, inelastic if a change in price causes only a little change in quantity demanded. Numerical elasticity coefficients (or elasticity values) can be negative or positive but the signs are usually dropped, for only the absolute values are of significance. The coefficients for inelastic goods is Ed 1, while for elastic goods, it is Ed 1.
For goods with a coefficient of 1, it is said to be unit-elastic. Take, for example, a look at the graph. Let us say that the price of good A is initially at 80, so the good demanded was only 1 unit. But when the price was dropped to 10, the demand for good A increased to 8 units. Computing for the coefficient of elasticity will result to 1.
Cross-price elasticity shows how responsive the demand for good 1 is to a change in the price of good 2. It is given by the equation
Cross-price elasticity change quantity demanded of good 1 change in price of good 2
There are two kinds of pairing of goods that can be aptly described by cross-price elasticity. Substitutes are goods which have a positive price elasticity. Substitutes are goods which are interchangeable, thus when the price of a good increases, the demand for it decreases but the demand for its substitute good increases, example of which is butter and margarine. Margarine can be an alternative of butter. If butter increases in price, it is more likely that the demand for butter will increase since it is a cheaper alternative. On the other hand, complements are goods which have demands that behave similarly when a change in price is encountered. An example of complements is keyboard and computer. You would not buy a computer without buying a keyboard. It is evident that the keyboard is a complement of a computer, for an increase in the price of computers lowers the demand in keyboards, thereby resulting to a negative cross-price elasticity.
Income elasticity of demand relates the percent change in the quantity demanded for a percent change in income. It is given by the equation
Income elasticity of demand Q2 Q1 I2 I1
Q1 Q2 I1 I2
Commodities that have positive income elasticity are called normal goods negative income elasticity are inferior goods. Normal goods pertain to most commodities though they have varying income elasticity. Necessities (food, clothing, electricity, to name a few) are normal goods with low income elasticity ( i 1) while luxuries (cars, gadgets, travels, etc.) have an income elasticity greater than 1. All these goods experience an increase in demand if income is increased. On the other hand, inferior goods are products that undergo a decline in their quantity demanded if the income has increased, an example of which is subway rides. A person prefers to ride the subway, a cheaper means to commute, but if he gets an income increase, he can now afford to ride a cab.
Elasticity of demand, cross-price of elasticity and income elasticity of demand should not be confused with one another. Elasticity of demand examines the effect of the product s price change with its own demand. Cross-price elasticity is the elasticity of demand of a product relative to the price changes of its substitute or complement. Lastly, income elasticity of demand relates the elasticity of demand of the product with respect to the income of the consumer necessities and luxuries are a priority when an increase in income is experienced.
There are three determinants of elasticity demand, namely, availability of substitutes, share of consumer s income devoted to a good, and consumer s time horizon. Demand is elastic when there is a wide array of available substitutes. It is obvious when the price of a good increases, but there is a viable alternative which happens to be cheaper, there will be an increase in the demand for the substitute. However, this will not be the case if there are no other good choices present the demand for the product will be inelastic. For example, ballpens had an increase in price and a good substitute of ballpen is pencil. Therefore, demand for pencils will go up due to the price hike of ballpens.
The second determinant is the share of consumer income devoted to a good. If the income allotted to a product is small, the demand for the product remains inelastic. An example is toothpick. It is a good which eats up only a tiny fraction of a consumer s budget. An upsurge in the price of toothpicks will not do any significant dent on the budget.
Lastly, the consumer s time horizon affects also the elasticity of demand. It is best described by the two laws of demand as stated in the following text
The first law of demand says that buyers will respond predictably to a price change, purchasing more when the price is lower than when the price is higher., if other things remain the same. The second law of demand says that the response of buyers will be greater after they have had time to adjust more fully to a price change (Gwartney et al., 2006, pp.432).
To illustrate this third determinant, examine the demand for fuel. Fuel price hikes lead to instantaneous response of decrease in demand. However, given several months, people will find alternatives such as increase in the use of public transportation or use of eco-friendly cars thereby affecting a more substantial fall in the demand for fuel.
Business decision making makes use of the determinants in setting prices that will maximize revenues and yield. If there are available substitutes, it is not logical to raise prices because it will translate to a loss of customers which leads to a decrease in revenue. Unavailability of substitutes, in cases of monopolies or oligopolies, equates to an inelastic demand. Raising prices simply leads to increase in revenue and of course, profit maximization. The same is true to goods which only have a little share in the consumer s budget. A sharp increase in price will not affect the budget as a whole the consumer will not resort to looking for substitutes and will simply purchase the good thereby increasing the company s revenues. Consumer s time horizon, on the other hand, gives the company some leeway. Initial increase of the price may decrease demand but will enable the company to generate profits. However, when the consumer has recovered from the price hike and had identified alternate means, the company should brace itself to the further decrease in demand (Gwartney et al., 2006).
Elasticity demand also has two extreme cases perfectly elastic demand and perfectly inelastic demand. For perfectly elastic demand, any change in the price of the good (be it increase or decrease) leads to an instant zero demand of the product. The elasticity coefficient equals infinity. The graph for this type of good is characterized by a horizontal line as shown in the figure below.
EMBED Microsoft Excel 97-Tabelle
But for the perfectly inelastic demand, the quantity demanded remains the same regardless of the price change. Its elasticity coefficient is zero and can be described by the graph below.
EMBED Microsoft Excel 97-Tabelle
For the given graph above, the price elasticity coefficient of demand only applies to the downward sloping portion of the graph. The upper part corresponds to an elastic range, the middle to a unit-elastic range, while the lower portion of the curve gives an inelastic range. Note that the upper part relates to few quantities but of very high price. A large percentage change can be seen if the quantity demanded changes by only 1 unit. The converse is true for the lower part high quantity demanded at lower prices. A change in the quantity demanded does not greatly affect the revenue. Therefore, for businesses, it is advisable to be within the inelastic range.