Elasticity of demand is an important concept in economics, because it measures how responsive consumers are to changes in prices. Elasticity of demand is the degree to which a given quantity of a good or service can be produced in response to changes in the price of that good or service.
It is the tendency for the quantity demanded to vary in response to changes in price. This means that a change in price can cause a change in quantity demanded.
The elasticity of demand for a product or service can be positive, negative, or zero. If a firm’s elasticity of demand is positive, it means that it can increase production as the market demands more and vice versa. If the elasticity is negative, then it means that as the market demands less, production will also reduce and vice versa if it’s zero then there will be no change in production levels.
Elastic Demand: In elastic demand, a small change in price can lead to a significant change in quantity demanded.
Inelastic Demand: In inelastic demand, a big change in price can lead to a small or insignificant change in the demand.
Mathematical Equation for “ Elasticity of Demand ”
The price elasticity of demand is calculated as the percentage change in quantity divided by the percentage change in price.
Elasticity of Demand = Percentage change in Quantity/Percentage change in Price
e(D) = (dQ/Q)/(dP/P)
e(D)= Elasticity of Demand
d(Q)= Change in Demand
d(P)= Change in Price
Q= Quantity of Demanded Good
P= Price of Demanded Good
Types of Elasticity of Demand
There are three types of Elasticity of Demand :
- Price Elasticity of Demand
- Income Elasticity of Demand
- Cross Elasticity of Demand
Price Elasticity of Demand
Price elasticity of demand refers to the responsiveness of the quantity demanded of a good or service to a change in its price. This can be calculated as the percentage change in quantity demanded divided by percentage change in price. It is also known as responsiveness to price change.
The higher the price elasticity, the more responsive consumers are to price changes and vice versa.
Price Elasticity = Proportionate change in quantity demanded/Proportionate change in price
Case 1: Perfectly Elastic Demand
When a small change in price leads to an infinitely large change in quantity demanded, it is called perfectly or infinitely elastic demand. Here E=∞
When even a large change in price does not impact the quantity demanded, it is perfectly inelastic demand. Here, E = 0
When change in demand is more than the proportionate change in price, then it is considered as a relatively elastic demand i.e. a small change in price leads to a very big change in demand. Here, E > 1
When change in demand is less than the proportional change in the price, such demand is relatively inelastic demand i.e. A large change in price leads to a small change in demand. Here, E < 1
It is the condition when the change in demand is exactly equal to the change in price. Here, E=1
Income Elasticity of Demand
This refers to the responsiveness of the quantity demanded of a good or service to a change in its income. This can be calculated as the percentage change in quantity demanded divided by percentage change in income.
Income Elasticity = Proportionate change in quantity demanded/Proportionate change in income
Case 1: Zero Income Elasticity
When even a large change in money income does not impact the quantity demanded, it is perfectly inelastic demand. Here, Ey = 0
When income increases, quantity demanded falls. In this case, income elasticity of demand is negative. Here, Ey < 0
When an increase in income brings about a proportionate increase in quantity demanded, it is unit income elasticity. Here, Ey = 1
When an increase in income brings about a more than proportionate increase in quantity demanded. Here, Ey > 1
When increase in income increases the quantity demanded but less proportionately. Here, E < 1
Cross Elasticity of Demand
Cross elasticity of demand is a measure of how sensitive demand for one good is to changes in the price of another. It is calculated by the following formula:
Cross Elasticity = Proportionate change in quantity demanded of X/Proportionate change in income Y
Case 1 : Cross Elasticity in Substitute Goods (Coffee and Tea)
When the price of coffee increases, the quantity demanded of tea increases. Tea and coffee are substitute goods.
Cross elasticity of complements is negative. When the increase in price of one commodity X leads to decrease in quantity demanded Y and vice versa.
Cross elasticity of unrelated commodities is zero. A change in the price of commodity X will not affect the quantity demand of commodity Y when commodities are not related. Here, E = 0
- Elasticity is one of the important factors of defining the price of the commodity. If demand for a product is elastic, price is considerate and vice versa.
- Production function is highly dependent on elasticity of demand. Producers consider the production decision based on the elasticity of demand.
- Elasticity of demand is important for the factor of production. The elasticity of factors of productions lead to the bargain position of FOP.
- Elasticity of demand enables the government to decide on capital investment strategies regarding industries and other plants.
- This plays an important role in taxation and policies related to taxation. Government and policy makers consider the elasticity and behavior of goods for imposing tax on it. The nature of the commodity reflects the elasticity.
Reference
Demand Theory
Limitations of Law of Diminishing Marginal Utility
Factor of Production
Introduction to Economics
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You may be asked "Given the following data, calculate the price elasticity of supply when the price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk you through answering this question.
First we need to find the data we need. We know that the original price is $9 and the new price is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity supplied (make sure to look at the supply data, not the demand data) when the price is $9 is 150 and when the price is $10 is 110. Since we're going from $9 to $10, we have Q Supply(OLD)=150 and Q Supply(NEW)=210, where "Q Supply" is short for "Quantity Supplied". So we have:
Price(OLD)=9
Price(NEW)=10
QSupply(OLD)=150
QSupply(NEW)=210
To calculate the price elasticity, we need to know what the percentage change in quantity supply is and what the percentage change in price is. It's best to calculate these one at a time.
Calculating the Percentage Change in Quantity Supply
The formula used to calculate the percentage change in quantity supplied is:
[QSupply(NEW) - QSupply(OLD)] / QSupply(OLD)
By filling in the values we wrote down, we get:
[210 - 150] / 150 = (60/150) = 0.4
So we note that % Change in Quantity Supplied = 0.4 (This is in decimal terms. In percentage terms it would be 40%). Now we need to calculate the percentage change in price.
Calculating the Percentage Change in Price
Similar to before, the formula used to calculate the percentage change in price is:
[Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get:
[10 - 9] / 9 = (1/9) = 0.1111
We have both the percentage change in quantity supplied and the percentage change in price, so we can calculate the price elasticity of supply.
Final Step of Calculating the Price Elasticity of Supply
We go back to our formula of:
PEoS = (% Change in Quantity Supplied)/(% Change in Price)
We now fill in the two percentages in this equation using the figures we calculated.
PEoD = (0.4)/(0.1111) = 3.6
When we analyze price elasticities we're concerned with the absolute value, but here that is not an issue since we have a positive value. We conclude that the price elasticity of supply when the price increases from $9 to $10 is 3.6.
Five Types of Elasticities of Supply:
1. Unit Elastic Supply: When change in price of X brings about exactly proportionate change in its quantity supplied then supply is unit elastic i.e. elasticity of supply is equal to one, e.g. if price rises by 10% and supply expands by 10% then, change in the quantity supplied the supply is relatively inelastic or elasticity of supply is less than one.
Es = % change in Quantity Supplied of X
% change in price of X
2. Relatively Elastic Supply: When change in price brings about more than proportionate change in the quantity supplied, then supply is relatively elastic or elasticity of supply is greater than one.
3. Perfectly Inelastic Supply: When a change in price has no effect on the quantity supplied then supply is perfectly inelastic or the elasticity of supply is zero.
4. Perfectly Elastic Supply: When a negligible change in price brings about an infinite change in the quantity supplied, then supply is said to be perfectly elastic or elasticity of supply is infinity.
All the five types of Elasticities of supply can be shown by different slopes of the supply curve. Fig. (1) Shows the supply is unit elastic because change in price from OP to OP1 brings about exactly proportionate change in the quantity supplied of commodity X viz., from OM to OM1. In this case Es = 1.