Outline: Show
Elasticity is the measure of how one economic variable (demand, supply) responds to a change in another. Once we understand elasticity we can answer questions such as:
Let's focus on price elasticity for now; the measure of how responsive the quantity demanded or supplied of a good is to a change in price. Generally, you can describe a product as either elastic–very responsive–unit elastic, or inelastic–not very responsive.
We measure price elasticity as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. It's a differential calculus problem - we're measuring the responsiveness of one variable to changes in another. The causative variable is, in this case, price. The good thing about elasticity as a concept is that it is a unitless ratio, meaning it is independent of the type of quantities. This is what allows us to compare a change in price to a change in demand. Like utility, elasticity is one of the most important concepts of neoclassical economics. It'll help you understand the incidence of indirect taxation, marginal concepts, distribution of wealth, and how consumers pick different goods (the theory of consumer choice). Price elasticity: supply and demandBoth the supply and demand curves show us the relationship between price and the number of units supplied or demanded. Price elasticity takes this idea one step further, showing us how a percentage change in supply (or demand) corresponds to a percentage change in price. In simple terms, it shows us how changing the price affects the quantity supplied and the quantity demanded in concrete terms.
Generally, something is elastic if the change in quantity divided by change in price is greater than one, unitary if equals one, and inelastic if less than one. One thing to consider is that the elasticity of a good can change depending on the current quantity demanded/supplied and the price. Elasticity varies between productsElasticity can vary between products because some things are more essential than others, or they don't have any good substitutes. Demand for necessities (food, water, housing) tends to be less sensitive to price changes than other goods because consumers will continue to need (and buy) these products despite price increases. Inversely, goods that are far less necessary (like a Coke) tend to be far more elastic, because the opportunity cost of buying the product becomes too high. The goods that tend to have the highest price elasticity are ones that are readily available and have good alternatives. A classic example of this is Coke and Pepsi. If the price of Coke rises, people may swap to Pepsi. This leads us onto the three main factors that can affect the elasticity:
In general, the more good substitutes a good has, the more elastic the demand will be. Inversely, the more necessary a good is for survival the less elastic the demand will be. Time is a little different to both as it's more of a multiplier. Imagine if coffee went up by $2 at your local coffee shop. You might like the coffee there so there aren't any ‘good’ available substitutes, so you continue to buy coffee despite the increase in price. This would suggest that coffee is inelastic because the change in price hasn't affect the quantity you demand. However, if you find that you can't afford that additional $2 a day, or you find a new coffee shop you like, the price elasticity of coffee for you may become elastic over the long term. Extreme cases of elasticityThere are two extreme cases of elasticity:
There is also the unique case of constant unitary elasticity, but let's touch of the two above examples first. Zero elasticity (or perfect inelasticity) is when a percentage change in price, no matter how large, results in zero change in quantity. The demand and supply curves in this case are vertical.  While this is unlikely, goods that have limited supply often have inelastic supply. Think about Leonardo Da Vinci paintings - no matter how high the price will go, the supply can't change. Inelastic demand is also unlikely, but necessities with no substitutes are likely to have highly inelastic demand. Think about life-saving drugs - people are willing to pay a lot. Infinite elasticity (or perfect elasticity) is when quantity demanded (or supplied) changes by an infinite amount in response to any change in price. In both cases, the demand (or supply) graph is horizontal. Again, this isn't realistic, but goods that are easy to produce like books tend to have highly elastic supply curves. Similarly, goods that have readily available substitutes tend to have highly elastic demand curves, a car is a good example. Closing outUnderstanding elasticity is useful because it allows you to understand how pricing affects supply and demand. If you can do that, you can understand how to maximise revenue by either, raising your prices or lowering them. This plays a key role in any business because it allows you to determine whether increasing costs will add a net benefit (or loss) to the bottom line of the business. The key concept to think about is the price elasticity of demand. If the good you are selling is price inelastic, raise the price. But keep in mind that just because the quantity demanded hasn't changed in the short term doesn't mean it won't. Remember that time is a factor, and both quantity supplied and quantity demanded are often slow to react to changes in price, but in the long term they tend to. This is because suppliers tend to find it easier to expand production after they know that the demand will continue. After all, if the demand is short-lived but they've increased supply, they won't be able to sell the additional goods (unless they lower the price to meet demand).
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Learning Objectives
The price elasticity of supply measures how much quantity supplied changes in response to a change in the price. The calculations and interpretations are analogous to those we explained above for the price elasticity of demand. The only difference is we are looking at how producers respond to a change in the price instead of how consumers respond. Price elasticity of supply is the percentage change in the quantity of a good or service supplied divided by the percentage change in the price. Since this elasticity is measured along the supply curve, the law of supply holds, and thus price elasticities of supply are always positive numbers. Recall that there are two ways to calculate elasticities: the point elasticity approach and the mid-point elasticity approach. The point approach computes the percentage change in quantity supplied by dividing the change in quantity supplied by the initial quantity, and the percentage change in price by dividing the change in price by the initial price. Thus, the formula for the point elasticity approach is [(Qs2 – Qs1)/Qs1] / [(P2 – P1)/P1]. The more accurate mid-point formula divides the change in quantity supplied and price by their average values (Qs2 – Qs1)/[(Qs2+Qs1)/2] and (P2 – P1)/[(P2+P1)/2]. Thus, the formula for the mid-point elasticity approach is (Qs2 – Qs1)/[(Qs2+Qs1)/2] / (P2 – P1)/[(P2+P1)/2]. We describe supply elasticities as elastic, unitary elastic and inelastic, depending on whether the measured elasticity is greater than, equal to, or less than one.
Assume that an apartment rents for $650 per month and at that price 10,000 units are offered for rent, as shown in Figure 2, below. When the price increases to $700 per month, 13,000 units are offered for rent. By what percentage does apartment supply increase? What is the price sensitivity? Figure 2. Price Elasticity of Supply. The price elasticity of supply is calculated as the percentage change in quantity divided by the percentage change in price. Step 1. We know that [latex]\displaystyle\text{Price Elasticity of Supply}=\frac{\text{percent change in quantity}}{\text{percent change in price}}[/latex] Step 2. From the midpoint method we know that [latex]\displaystyle\text{percent change in quantity}=\frac{Q_2-Q_1}{(Q_2+Q_1)\div{2}}\times{100}[/latex] [latex]\displaystyle\text{percent change in price}=\frac{P_2-P_1}{(P_2+P_1)\div{2}}\times{100}[/latex] Step 3. We can use the values provided in the figure in each equation: [latex]\displaystyle\text{percent change in quantity}=\frac{13,000-10,000}{(13,000+10,000)\div{2}}\times{100}=\frac{3,000}{11,500}\times{100}=26.1[/latex] [latex]\displaystyle\text{percent change in price}=\frac{700-650}{(700+650)\div{2}}\times{100}=\frac{50}{675}\times{100}=7.4[/latex] Step 4. Then, those values can be used to determine the price elasticity of demand: [latex]\displaystyle\text{Price Elasticity of Supply}=\frac{26.1\text{ percent}}{7.4\text{ percent}}=3.53[/latex] Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and is read as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. Since 3.5 is greater than 1, this means that the percentage change in quantity supplied will be greater than a 1% price change. If you’re starting to wonder if the concept of slope fits into this calculation, read on for clarification.
Watch this video to see a real-world application of price elasticity. You can view the transcript for “Elasticity and Slave Redemption” here (opens in new window).
These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions. elastic supply: supply responds more than proportionately to a change in price; i.e. the percent change in quantity supplied is greater than percent change in price inelastic supply: supply responds less than proportionately to a change in price; i.e. the percent change in quantity supplied is less than percent change in price price elasticity of supply: percentage change in the quantity supplied divided by the percentage change in price unitary elastic supply: supply responds exactly proportionately to a change in price; i.e. the percent change in quantity supplied is equal to the percent change in price Contribute!Did you have an idea for improving this content? We’d love your input. Improve this pageLearn More |
When the percentage change in the quantity supplied is less than the percentage change in the price of a product is called as?
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