Elasticity in Economics

Elasticity of Demand

• Elasticity measures how one dependent variable responds to a change in another independent variable.
• Elasticity of demand refers to the responsiveness of quantity demanded of a good to a change in its own price, income, price of other goods, advertising, population, etc.

Price Elasticity of Demand (PED)

• PED is a numerical value measuring the responsiveness of quantity demanded of a good to a change in its own price.
• PED is calculated by the formula: (Percentage change in quantity demanded) / (Percentage change in price)
• PED can be classified into:
  • Perfectly inelastic (PED = 0): quantity demanded remains unchanged despite any change in price.
  • Inelastic (PED < 1): quantity demanded varies less-than-proportionately to the change in price.
  • Unitary elastic (PED = -1): the percentage change in quantity demanded is equal to the percentage change in price.
  • Elastic (PED > 1): quantity demanded varies more-than-proportionately to the change in price.
  • Perfectly elastic (PED = ∞): a price rise causes demand to disappear.

Determinants of PED

• The number and closeness of substitute/competitor goods
• The proportion spent on the commodity relative to income
• The degree of necessity
• Time period

Who Requires Knowledge of PED?

• The business sector: to determine the effect of price changes on quantity demanded and revenue.
• The government: to influence consumption through taxes or subsidies.
• Trade unions: to estimate the demand for workers following a rise in wages.

Elasticity of Demand Along a Linear Demand Curve

• PED varies along the entire length of the demand curve.
• PED rises as we move up the demand curve, i.e., at higher price levels.

Income Elasticity of Demand (YED)

• YED is a numerical value measuring the degree of consumers' responsiveness to a given change in income.
• YED is equal to the percentage change in demand divided by the percentage change in income.
• If YED is negative, the product is an inferior good.
• If YED is positive and less than 1, the product is a necessity.
• If YED is positive and greater than 1, the product is a superior or luxury good.

Determinants of YED

• Degree of necessity
• The level of income of consumers
• The rate at which the desire for a good is satisfied as consumption increases

The Importance of YED

• YED provides information about how demand varies as income changes.
• YED is useful in planning for both business organizations and governments.
• YED can contribute to an understanding of patterns of specialization and development.

Cross-Price Elasticity of Demand (CED)

• CED is a numerical value measuring the degree of responsiveness of demand for good A to a change in the price of good B.
• CED is equal to the percentage change in the demand for commodity A divided by the percentage change in the price of good B.
• If CED is positive, the two goods are in competitive demand (substitutes).
• If CED is negative, the two goods are in joint demand (complements).
• If CED is zero, the two products are unrelated (independent goods).

Determinants of CED

• Closeness of a substitute or a complement
• The better are the substitutes or complementary goods, the bigger will be the value of the cross-price elasticity.

The Importance of CED

• CED is useful in identifying the impact of rival pricing strategies on the demand for a product.
• CED helps firms to tie consumers to buy not just one of their products but a whole range of complementary ones.

Price Elasticity of Supply (PES)

• PES is a numerical measure of the responsiveness of supply to any given change in the price of the commodity caused by variations in demand alone.
• PES is calculated by dividing the percentage change in the quantity supplied by the percentage change in product's own price.
• The degree of suppliers' responsiveness may vary from zero to infinity.

Determinants of PES

• Time period
• The amount that costs rise as output rises
• Firm's objective
• Certainty or uncertainty
• Barriers to entry

The Importance of PES

• The degree of suppliers' flexibility is of great importance in determining the effect of changes in demand on market equilibrium prices and quantities.