Microeconomics: Elasticities of Supply and Demand
Let’s now develop on the fact that we know the demand for a
good not only depends on price but also the price of other goods, tastes and
income. Similarly, supply of a good depends on both price and factors that
affect the cost of production. Logically it makes sense to know by how much
levels of supply and demand will rise/fall. This asks the question: ‘how
sensitive is demand or supply to a change in one of its determining factors?’ –
In other terms it’s elasticity.
This leads us to a definition of elasticity: the percentage
change in one variable resulting for a 1% increase in another.
As an example, take the price elasticity of demand. It
measures the sensitivity of the quantity demanded to changes in price. It tells
us what the percentage change in quantity demanded will be following a 1%
increase in the price of a particular good.
PED (Price Elasticity of Demand) usually takes the form of a
negative number because as the price of a good increases, the quantity demanded
usually falls – it has an inverse relationship.
In practice, economists sometimes refer to the magnitude of
price elasticity i.e. its actual size. So, say that PED = (-)3, then the
elasticity is 3 in magnitude.
When PED > 1 we say that it is PRICE ELASTIC because the
percentage fall in quantity demanded is greater than the percentage increase in
price.
When PED < 1 we say that it is PRICE INELASTIC because
the percentage fall in quantity demanded is less than the percentage increase
in price.
Generally speaking, PED for a good depends on the
availability of its substitutes. When there are close substitutes for a good
then a price increase for that good will cause the buyers to purchase less of
it and to buy more of its substitute. In this case demand will be highly
elastic (PED>1). On the other hand, when there are no close substitutes for
a product then demand will be highly inelastic.
From previous theory lesson posts, we have seen that demand
can be represented graphically with a linear downward-sloping curve. For the
mathematicians out there, you will know that elasticity can be described with a
differential equation. This is because PED is the change of quantity associated
with the change in price i.e. (ΔQ / ΔP). To develop this into the linear demand
curve we need to times it by the ratio of price to quantity (P / Q). However,
due to the fact that as you move down the demand curve the (ΔQ / ΔP) may change
and the (P / Q) will always change, the PED must be measured at a PARTICULAR
POINT on the demand curve. To make this latter point clearer, because it
depends on the ratio of (P / Q) the PED is higher at higher prices as ‘P’ will
be larger.
Mathematically, because we draw demand and supply curves
with price on the vertical axis and quantity on the horizontal one, for any
price-quantity combination the steeper the slope of the demand curve is, the
less elastic is demand.
This leads us on to two special cases. Perfectly inelastic
and elastic demand. Perfectly elastic demand develops on the idea that
consumers will buy as much of a god as they can get at a single price. However,
for a higher price the level of demand falls to zero while any lower price
causes the level of demand to increase without limit. Here, a tiny change in
price will cause a massive change in demand and so the demand curve is
perfectly elastic.
On the contrary, we have perfectly inelastic demand. It is
defined as the idea that buyers will buy a fixed quantity of a good regardless
of its price. In this scenario, (ΔQ / ΔP) = 0 due to the fact that the quantity
demanded will always be the same irrespective of its price.
Perfectly
Elastic
Perfectly
Inelastic
There are, obviously,
other demand elasticities within the study of economics. Often we are
interested in income elasticity of demand (YED) and cross elasticity of demand
(XED). In terms of supply we are also concerned with the price elasticity of
supply (PES).
Income elasticity of demand (YED) is the percentage change
in the quantity demanded resulting from a 1% increase in income. We also have
XED which incorporates the fact that demand for some goods is affected by the
price of its related goods. XED refers to the percentage change in the quantity
demanded for a good resulting in a 1% increase in the price of another.
YED > 1, income elastic i.e. an increase in income causes
an increase in demand for the good
YED < 1, income inelastic i.e. an increase in income
causes a decrease in demand for the good
YED = 1, perfectly income elastic i.e. a 1% increase in
income causes a 1% unit increase in demand for the good
XED > 1, cross-price elastic i.e. the goods are
substitutes for each other
XED < 1, cross-price inelastic i.e. the goods are
complements for each other
XED = 0, goods have no relation to one another
Price elasticity of supply (PES) is the percentage change in
the quantity supplied resulting from a 1% increase in price. This usually is
positive as a higher price of a good gives the producer more of an incentive to
produce said good. It should also be noted that elasticities of supply can be
referred to with respect to wage rates or interest rates or the prices of raw
materials/factors of production. For example, the elasticity of supply with
respect to the cost of raw materials is negative because an increase in the
cost of these materials with mean higher costs for the firm and so the quantity
supplied will fall ceteris paribus.
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