UNIT 8: ELASTICITY OF DEMAND AND SUPPLY
Key unit competence: To be able to apply elasticity of demand and supply in making rational economic and entrepreneurial decisions
Introductory activity
Case study: Mutoni’s shopping experience.
One day Mutoni went shopping, reaching the market, she found the price of rice had increased from Frw 1200 to Frw 1500. Since Mutoni’s budget couldn’t allow it, she changed her mind and instead of buying 20kg of rice, she decided to buy 10 kg due to the increase in price. On the other hand, she experienced an opposite price change. This time, since sugar’s price had fallen from FRW1000 to FRW500, she occasionally bought 20 Kg instead of 5Kg.
Required:
1. Among the following phenomena, choose one which best describes what Mutoni experienced.
Give reasons to justify your answer
a) Scarcity
b) Elasticity
c) Choice
2. Suppose the prices for sugar had risen too. What do you think Mutoni would do during her shopping?
3. Which of the two between the demand for rice and demand for sugar was elastic? Give reasons for your answer.
8.1. Introduction to elasticity
Learning activity 8.1
Using the internet or library, search on the term “elasticity” as used in Economics. Learning activity
Generally, the term elasticity has different meanings. For instance, in physics, elasticity means the ability of a body to resist a distorting influence or deforming force and to return to its original size and shape when that influence or force is removed.
In Economics, elasticity is the degree of responsiveness of dependent variables to independent variables. Dependent variables may be quantity demanded or quantity supplied. Independent variables are factors which influence the above dependent variables. An independent variable is a factor that has an influence on another associated factor (that is called a dependent variable). Price of a commodity, income of the consumer and price of related commodities are examples of independent variables. These independent variables have a direct influence on dependent variables such as quantity demanded, or quantity supplied. For instance, when the price of beans is FRW1,000, Muhirwa can buy 15Kg with his FRW15,000 budget.
You can imagine what can happen when the price increases to 1,500Frw. Now, Muhirwa’s budget cannot allow to buy 15 Kg of beans, instead he can buy 10Kg of beans only. On the other hand, when the price of beans decreases from FRW1,000 to FRW500, Muhirwa will be able to buy 30Kg with his FRW15,000 budget. The subject of economics has several concepts that need attention. These concepts explain different phenomena. Elasticity is one of such concepts in economics.
There are different types of elasticity. Each of these types explains the effect of changes on a specific variable. Elasticity of demand and elasticity of supply are the two main types of elasticity in economics. However, they are further classified into sub-categories as illustrated below:
Application Activity 8.1
Suppose Muhire experienced the following while he was shopping at the nearby market. Carrot prices had changed from FRW1000 per kg to FRW1500 per kg, consequently buyers decided to buy less carrot quantities. Imagine that instead of 15 kg, only 10 kg were bought!
Required:
Complete the following sentence with the appropriate economic term from the list provided in brackets (income elasticity of demand, price elasticity of supply, price hiking, price change, elasticity)
The change in quantity demanded of carrots from 15kg to 10kg as a response to change in the price of carrots from 1,000Frw to 1,500Frw is………………………….
8.2. Types of elasticity
Learning activity 8.2
1. Using the library or internet as well as the knowledge acquired from the previous lesson, discuss the following types of elasticity:
– Elasticity of demand,
– Elasticity of supply
2. Read the following situations and answer the questions thereafter:
i) Muhoza, a student at G.S Umurava went to a bookstore near her school to purchase books. When she arrived, she discovered that the price of a book had increased from FRW 6,000 to FRW9,000. She bought 2 books instead of 3 books she had planned to buy.
ii) Company A manufactures a certain brand of juice. The market price for each packet of juice increased from Frw 500 to Frw 600. In return, the company increased its supply weekly from 1,200 to 1,600 packets.
Questions: Precise which situation represents elasticity of demand or elasticity of supply between the two. (2. (i) and 2. (ii) and why?
8.2.1. Elasticity of demand
Elasticity of demand is a measure of the degree of responsiveness of quantity demanded of a commodity to changes in factors that affect demand. When factors that influence quantity demanded such as price of the commodity, income of the consumer, or price of related commodities change, the quantity demanded of a commodity responds. However, the main concern is the percentage of this response. Elasticity of demand thus measures the percentage of such response. Elasticity of demand has 3 main types. i.e., price elasticity of demand, income elasticity of demand, and cross elasticity of demand.
a. Price elasticity of demand (PED)
Price elasticity of demand refers to a measure of the degree of the responsiveness of quantity demanded of a commodity to changes in its own price. When the price of a commodity increases or decreases, its quantity demanded reacts to a certain extent. Quantity demanded may reduce, increase, or even remain constant. Price elasticity of demand therefore measures the extent of this reaction.
Price elasticity of demand is measured as a percentage change in quantity demanded to the percentage change in price.
Elasticity is like a rubber band, when it pulls in one direction, they simply pull in the other. If the price of a commodity increases, the quantity demanded decreases. If the price decreases, the quantity demanded increases.
Consider the table below:
This means that an increase in price of 50% leads to a decrease of 20% in quantity demanded. Calculating the elasticity of demand with respect to price is equal to the percentage change in demand over the percentage change in price
(Formula: PED = % change in price)
Elasticity computation
Price elasticity of demand, PED= -20/50= - 0.4<0. so, here the answer is less than 0
When the elasticity is negative, normally that is logical. This is to mean that change in price generates a constrained change in demand. If the price of a commodity increases, the quantity demanded of a commodity decreases and vice-versa.
Consider the following table:
This means that a decrease in price of 40% leads to an increase of 50% in quantity demanded. The price elasticity of demand, PED = 50/-40 = 1.25<0. Here, you can see that the answer is less than 0
You should note that negative elasticity is normal. For most of the commodities, when the price of a commodity decreases, and when the price decreases, the quantity demanded increases. But also, in some cases, the elasticity is positive or even zero.
Consider the table below:
If you calculate the price elasticity of demand: PED = 0/-50 = 0. Here, you find that the price elasticity of demand is inelastic i.e. a change in price does not cause any change in the quantity demanded. This phenomenon can occur when there is no substitute commodity, a commodity that can replace this commodity whose price has increased. For instance, if the price of salt increases, its quantity demanded remains constant
The elasticity can be positive; this concerns luxury commodities. People who want to maintain a high social status will increase their demand as the price increases. This is called the snob effect, the social positioning effect.
Consider the table below.
If you calculate the price elasticity of demand, PED = 20/50 = 0.4>0
This is the situation when there is a group of buyers who want to position themselves, belong to a high social class.
How will we interpret the elasticity?
If the elasticity is between -1 and 1, we can say that the elasticity is low, we can even say that it is inelastic when it approaches zero.
PED = ϵ [-1,1] elasticity is low, see inelastic ≈ 0. Here, a small change in price causes a small change in quantity demanded. There is no influence between a change in price and change in quantity demanded. When elasticity is equal to zero, this is to say that the change in price does not cause any change in quantity demanded. On the other hand, if the answer exceeds -1, -2, -3, -. and/or 1,2,3… we say that the elasticity is strong.
Mathematically, this can be illustrated as follows:
Where,
∆Q is change in quantity demanded of the commodity, ∆P is change in price of the commodity Q is the original quantity demanded of the same commodity P is the original price of the commodity ∆ stands for change in. The word change here means an increase or a decrease.
Example: Given the price of beef increased from FRW 2000 to FRW2500 per kg and as a result, quantity demanded reduced from 4 kg to 2 kg. Calculate the price elasticity of demand for beef.
Solution:
= 4 2000 (2500 2000) (2 4) 1 1 ( 2 1) ( 2 1)
× − − × = − − − Q P P P Q Q = (-) 2 2000 4000 = − , This means that the price elasticity of demand is 2
Note:
– Elasticity does not have units
– To make the answer positive, a negative sign is multiplied in the formula of price elasticity. This is done to make easy interpretation of price elasticity of demand.
b. Categories and interpretation of elasticity of demand
i) Elastic demand: demand is elastic when a small change in price causes a proportionately bigger change in quantity demanded.
Elasticity demand curve:
ii) Perfectly elastic demand: demand is perfectly elastic when price is constant, and quantity demanded changes infinitely
Perfectly elastic demand curve:
This is when price elasticity of demand equals to infinity meaning that buyers are prepared to buy all they can at or below the same price and none at all even at slightly higher price. This is illustrated in the following figure. At or below op 1 OP1 nothing is purchased at all.
iii) Inelastic demand:
demand is inelastic when a big change in price causes a proportionately small change in quantity demanded.
iv)Unitary elastic demand:
demand is unitary elastic when the percentage change in price causes the same percentage change in quantity demanded.
This is when price elasticity of demand is equal to one. This gives rise to a rectangular hyperbola demand curve. Note that the area below the demand curve is uniform. E.g. OP2 AQ2 = OP1BQ1
v) Perfect inelastic demand: demand is said to be perfectly inelastic when a change in price doesn’t affect the quantity demanded.
This is when price elasticity of demand is zero. It means that quantity demanded does not respond to change in price at all. This is illustrated in figure below. Change in price from OP1 to 0P2 leaves quantity demanded (OQ1 ) unaffected. E.g. demand for cigarettes.
vi) Relationship between price elasticity of demand and total revenue
▲Total revenue is equal to the price of a good times the quantity of the goods sold. TR =Q × P
c. Income elasticity of demand
Income elasticity of demand measures the relationship between the consumer’s income and the demand for a certain commodity. It may be positive or negative, or even non-responsive for a certain product. The consumer’s income and product’s demand are directly linked to each other. It is the measure of the degree of responsiveness of quantity demanded of a commodity due to a change in consumer’s incomes.
Where: ∆Q is the change in quantity demanded
∆My: Is the change in the consumer’s money income
My: Is the original money income
Q: Is the original quantity demanded of the commodity.
Where: Q2= New level of demand
Q1= Original level of demand
Y2= New level of income of the consumer
Y1= Original level of income of the consumer.
Example: Given the following market schedule
Compute the income elasticity
Solution:
Exercise on YED
Given the following information, you are required to calculate the income elasticity of demand
Interpretation of income elasticity of demand
d. Income elastic demand
This is when income elasticity of demand is greater than one meaning that quantity demanded changes proportionately more than change in incomes, ceteris paribus. i.e. slight increase in consumer’s money income leads to a very large increase in quantity demanded whereas a slight fall in consumers’ money income leads to a large reduction in quantity demanded.
Example 1:
Demand schedule
Example 2:
Demand Schedule
e. Income inelastic demand
This is when income elasticity of demand is less than one but greater than zero (0
Example:
f. When income elasticity of demand is negative, it means that the commodity is inferior. That is to say, as income increases people buy commodities in less quantity.
Example:
The demand schedule
g. When it is zero, it means that the commodity is a necessity. This means that, as incomes increase, quantity demanded remains constant e.g., salt.
Example:
The demand schedule
When it is positive, it means that the commodity is a normal good i.e., as incomes increase, quantity demanded increases and vice-versa.
Note: Income elasticity of demand may be different for the same commodity at different income levels. This is illustrated graphically in the figure below.
Income elasticity of a commodity at different income levels.
From this figure, it should be noted that the commodity can be a normal good, necessity or inferior good depending on the income levels of the households. The consumer may buy more of the commodity as his/her income increases (there it would be a normal good). Later he/she buys the same amount even if his/ her income increases (the commodity becomes a necessity). Finally, he /she may start buying less of the commodity and to consume more expensive commodities as his/her income increases (the commodity becomes an inferior good).
1. Cross elasticity of demand
Cross elasticity of demand is a measure of the degree of responsiveness of the quantity demanded of a commodity to changes in prices of other commodities. The cross elasticity of demand measures the relationship between changes in the demand for a commodity and the price of its other related goods.
Where: CED: Cross elasticity of demand
∆Qx : is the change in quantity demanded of commodity (X)
∆P y : is the change in the price of other commodities (Y)
P y : is the original price of commodity (Y)
Qx : Is original quantity demanded of the commodity (X)
Calculation and interpretation of cross elasticity of demand
1. When cross elasticity of demand is positive, the commodity (X) and (Y) are substitutes. This means that the increase in the price of other commodities (Y) leads to an increase in quantity demanded of the commodity. For example, when the price of peas increases, the quantity demanded of beans increases because consumers would substitute cheap beans for expensive peas.
Example:
Given the following market demand schedule of substitutes
Cross Elasticity of demand
The Cross elasticity is positive. This means that the commodities potatoes and sweet potatoes are substitutes. The increase in price of Irish potatoes leads to an increase in the quantity demanded of sweet potatoes.
2. When cross elasticity of demand is negative, then commodities (X) and (Y) are complements (or joint products). This means that the increase in prices of other commodities (Y) leads to a decrease in quantity demanded of the commodity (X).
For example, if the price of cars increases, the quantity demanded of petrol decreases because of the fall in quantity demanded of cars.
Example:
The market demand schedule of complements
Cross Elasticity of demand
3. When the cross elasticity of demand is zero, then the two commodities are not related at all i.e., quantity demanded of the commodity X is not affected by change in prices of other commodities (Y)
Example: The demand schedule of non-related commodities
Cross Elasticity of demand
Here, it means that two commodities (block and rice) are not related at all. i.e. quantity demanded of rice is not affected by change in price of blocks and vice-versa.
2. Determinants of price elasticity of demand
– Availability of substitutes: If a commodity has many substitutes, its demand will tend to be price-elastic, i.e., if its price increases, consumers immediately switch to substitutes. If a commodity has few or no substitutes, its demand will tend to be price inelastic, i.e., if its price increases, the quantity demanded remains more or less the same because consumers have no substitutes to switch to.
– Degree of necessity: The price elasticity of demand for necessities tends to be inelastic because they are indispensable. For example, even if the price of salt increases, the quantity demanded would remain nearly the same, since an increase in price cannot induce buyers to abandon the commodity. Luxury goods are dispensable and therefore have a high price elasticity of demand. When luxury goods prices rise, consumers abandon them because they are things one can survive without.
– Price of complements: When goods are complementary (i.e., they are used together), they have inelastic demand e.g., if the price of tea has not changed, a change in price of bread may not seriously affect the demand. – Incomes of consumers: When there are many low-income earners, price elasticity of demand tends to be high. When the price increases, the poor leave the commodity or buy less of it. When there are many rich people, price elasticity of demand is very low because the rich can afford to buy the same quantity at any price.
–Incomes of consumers: When there are many low-income earners, price elasticity of demand tends to be high. When the price increases, the poor leave the commodity or buy less of it. When there are many rich people, price elasticity of demand is very low because the rich can afford to buy the same quantity at any price.
– Cost of the commodity: When a commodity takes a small fraction of consumers income, its demand tends to be price inelastic. Example: a matchbox. When the commodity accounts for a large portion of consumer’s income, its demand tends to be price-elastic as the price increase would be easily felt.
– Habit in use of the commodity: This makes the demand for the commodity price inelastic. Example demand for cigarettes or alcoholic drinks may not be easily affected by changes in their prices.
– Price expectations: Demand is inelastic if the price of a given commodity is expected to increase in future. This is because customers would want to buy now knowing that the price of that commodity would be higher in future. On the other hand, if the price of a commodity is expected to decrease in future, demand would be elastic because consumers would buy less today and expect to buy in future at a decreased price.
– Durability of the commodity: Durable commodities such as computers, cars, etc. have a fairly low-price elasticity of demand. Even if the price of such commodities falls, one may not buy another one (when he/she already has one). Demand for perishable products like milk is inelastic because when the price falls, consumers may not buy more because they cannot easily store such products for a long time. Products which are easy to store e.g., beans, grains etc., have a higher elasticity of demand i.e. when the price falls, consumers buy more and keep them in stores for future consumption.
3. Practical application of price elasticity of demand
a) Producers: Price elasticity of demand helps producers to make decisions on whether to increase or reduce the price.
– (Elastic demand: Total revenue would increase if the price is reduced because quantity demanded would increase when the price is reduced. (Note TR=Px Q). However, increase in price leads to a reduction in total revenue since quantity demanded would fall with increase in price.
– Inelastic demand: Total revenue would increase when the price is increased since quantity demanded would remain more or less the same. When the price is reduced, total revenue would fall because quantity demanded would not increase much.
– Unitary elastic demand: When the price is increased, quantity demanded reduces by the same percentage leaving the total revenue the same. When the price is reduced, quantity demanded increased by the same percentage, leaving total revenue the same.
b) Devaluation (legal reduction of value of currency in terms of other currencies): This refers to the legal reduction of the value of the country’s currency in terms of other currencies aiming at earning more foreign exchange (by increasing exports and reducing imports). It is successful only when price elasticity of demand for imports and exports is high.
c) Taxation: Commodities with inelastic demand should be taxed more because it would not affect their consumption and production. Commodities with elastic demand should be taxed less so as not to affect their production and consumption. Taxation on imports would reduce the inflow only if their demand is price elastic.
d) Tax incidence: Elasticity of demand is helpful in determining how much of tax the consumer and the producer have to pay. When demand is inelastic, more of tax would be paid by the consumer because the seller would manage to shift the tax to the consumer in form of a high price. When the demand is elastic the producer (seller) would pay more of the tax because he/she would not succeed in shifting it on to the consumers (buyers) in form of high price.
e) It helps the government to determine commodities which it should control. If demand is inelastic the government may want to control the marketing of the commodity to protect consumers from being exploited by private firms.
8.2.2. Elasticity of supply
Elasticity of supply is a measure of the responsiveness of the quantity supplied to changes in determinants of quantity supplied. Elasticity of supply usually means price elasticity of supply. This is because apart from price, other determinants of quantity supplied are difficult to measure. In this unit, we are going to describe price elasticity of supply only
Where: ∆Qs= is the change in quantity supplied of the commodity
∆P=is the change in the commodity’s own price
P= is the original price of the commodity
Qs= is the original quantity supplied of the commodity
Where: Q2=New level/amount of quantity supplied
Q1=Original quantity supplied
P2=New price level
P1=Original price level
∆Q=Change in quantity supplied
∆P=Change in price i.e., P2-P1
Example: Calculate the price elasticity of supply when the price of the commodity falls from 60 Frw to 40 Frw and the quantity supplied falls from 8,000 units to 4,000 units
Exercise on PES
Given that the price of commodity Y reduced from FRW 600 to FRW 450 resulting in a decrease of its quantity supplied from 800kg to 200kg. Determine its price elasticity of supply.
a. Determinants of elasticity of supply
– The cost and availability of factors of production: when factors of production are scarce and expensive, supply cannot be easily increased even if the price of the commodity rises. Thus, it becomes inelastic. But when they are readily available and cheap, supply becomes elastic.
– Nature of the commodity: Perishables have inelastic supply such that when prices reduce, almost the same quantity will be supplied. This is because they cannot be stored to be supplied in future when prices are favorable. Durables have elastic supply. As a result, they can be stored, and supply varies depending on the price level.
– Gestation period (maturity period): This is the time lag between when the decision to supply a commodity is taken and when it is actually supplied. Commodities with a short maturity period have elastic supply. Their supply can be increased quickly and easily when prices increase. Those with long gestation periods have inelastic demand.
– Time: In the short run, supply becomes inelastic because it cannot be increased easily even if prices increase. In the long run, supply becomes elastic since time is enough to allow supply to increase with increase in prices.
– Method of production used: Advanced methods of production make supply elastic. This is because it is easier and quicker to produce and increase supply. Use of traditional, inefficient, and past methods of production slows down the rate of production, making supply inelastic.
– Government policy: Rigid, bureaucratic tendencies, unattractive policies or high tax rates backslides production, making supply inelastic. Subsidization of producers reduces costs of production and makes it easy to increase supply and so make it elastic.
– Freedom of entry of new firms into the industry: Freedom of entry of new firms into the industry makes supply elastic. Restricted entry makes supply inelastic.
– Mobility of factors of production: Mobility of production both occupational and geographical quickens and simplifies production. This makes supply elastic. Immobility of factors makes supply inelastic.
– The amount of stock kept in store: When producers are holding large stock of commodities in their stores, supply for such commodities will be elastic and vice versa, other factors remaining constant.
– Full employment situation: In a situation of full employment, the supply of most goods and services will be inelastic and vice versa.
– Factors mobility: When factors of production are easily relocated from one line of production to another, elasticity of supply is high. If resources are immobile, elasticity of supply is below because it would be difficult to shift resources to or from other tasks.
b. Categories and interpretation of elasticity of supply Price elasticity of demand may be categorized as follows:
• Perfectly inelastic supply
• Inelastic supply
• Unitary elastic supply
• Elastic supply
• Perfectly elastic supply. i. Perfectly inelastic supply (ES=0)
This is a situation where the quantity supplied does not change despite changes in the price. The supply curve is vertical (straight line).
ii. Inelastic supply
This is a situation where change in price brings about a less proportionate change in quantity supplied. i.e. a big change in price brings about a small change in quantity supplied. A big change in price and a small change in the quantity supplied.
iii. Unitary elastic supply (Es=1)
This is a situation when a change in price results into a proportionately equal change in quantity supply. Suppliers respond to changes in price. A change in price leads to a relatively equal change in quantity supplied.
iv. Elastic supply
This is a situation where a change in price brings about a more than proportionate change in the quantity supplied i.e. a small change in price brings about a more than proportionately bigger change in the quantity supplied.
v. Perfectly elastic supply (Es=∞)
This is a situation when the price of a commodity is fixed or stays constant at all levels of supply i.e., at constant price, supply changes to various levels and the supply curve is horizontal.
Price remains constant at OP1, but quantity supplied changes from OQ1 to OQ2.
Application Activity 8.2
1. Given that the price of rice reduced from 600 Frw to 450Frw. As a result, the quantity demanded of rice increased from 120kgs to 200kgs. Determine its price elasticity of demand.
2.Jacob’s income increased from FRW50,000 to FRW70,000, leading to a reduction in the quantity demanded of commodity X from 70 kg to 40kg
i) Find the income elasticity of demand.
ii) What kind of commodity is X?
3. Given that the price of commodity Y increased from FRW 2,000 to FRW7,000 leading to a reduction in the quantity demanded of commodity X from 50 kg to 30 kg
a) Find the cross elasticity of demand. b) State the relationship between commodity Y and X.
4. The quantity demanded of commodity X increased from 400 litres to 750 litres as a result of a 20% increase in price of commodity Y. Determine the cross elasticity of demand and the relationship between commodity X and Y. 5. The price of commodity X increased from 100kgs to 300kgs as a result of a 20% increase in its quantity supplied. Determine its price elasticity of supply.
Skills Lab 8
Given that the price of the business club’s liquid soap increased from FRW7,000 to FRW 12,000 leading to a reduction in the quantity demanded of UBWIZA shop located nearby the school from 50 kg to 30 kg,
i) Find the cross elasticity of demand.
ii) State the relationship between the business clubs’ product and UBWIZA’s product.
End of Unit 8 assessment:
1) Distinguish between elasticity of demand and elasticity of supply.
2)
Using the figures from the table,
(i) Calculate the price elasticity of demand for commodity Z
(ii) What category of price elasticity of demand does commodity Z have?
3) The quantity demanded of commodity Y reduced from 70 kg to 65 kg as a result of a 20% increase in the price of another commodity X from 2,000 Frw to 4,000 Frw.
Required:
(a) Determine the cross elasticity of demand between commodities Y and X
(b) State relationship between commodities Y and X
(c) Give two examples of such commodities.
4) Explain the relevance of price elasticity of demand to government’s taxation policy.
5) How important is the knowledge of price elasticity of demand to the producer?
6) Given that the price of a commodity reduced from FRW 3,000 to FRW 1500 leading to a decrease in its quantity supplied from 100kg to 50kg, determine the elasticity of supply for this commodity and give its category.
7) What is measured by the following?
(i) Elasticity of supply
(ii) Cross elasticity of demand
(iii) Price elasticity of demand