Applications of demand and supply elasticity
The application of plasticity to the basics of demand and supply lands itself well to the solution or a resolution of many buyers and sellers decision-making dilemma in personal consumption, business finance, corporate finance and social or a public finance settings.
Elasticity, in the broad sense, relate to the responsiveness to price changes.
Normally we expect that as a price of a particular good increases, suppliers or producers will wish to increase the amount they provide to the market provided all other conditions stay the same. The only hand consumers will reduce demands they wish to buy on the same product with its price increase. There are some exceptions to this normality as a reviewed Giffen goods and inferior goods.
So how sensitive are consumers to a price change in terms of the quantities they are willing to consume? Should they be expected to stop buying bentley when its price increases from $8 000 to $10 000 for a vehicle? This appears as a consumer decision, but it is also a producer's question. As a producer of Bentley what effect will the $2 000 increase have on your sales and total revenue? To answer the latter question the producer has to estimate the degree of sensitivity to price changes from the consumers. This is the origin of elasticity.
There are some basic concepts which are crucial in understanding of elasticity:
1. P*Q = TR
Thus, if price (P) increases by 10% and quantity demanded (Q) decreases by 10%, total revenue (TR) will stay the same. This is called a unit elastic or proportional change.
If price increases by 10% and quantity decreases by 20%, the total revenue will degrease. This is called an elastic or greater than proportional change.
Is price increases by 10% and quantity decreases by 5%, the total revenue will increase. This is called an inelastic or less than proportional change.
2. Price elasticity of demand = (% change in quantity demanded) / (% change in price)
Consider the previous example:
In the first case the value of the ratio was 1 since the percentage change in quantity is demanded equals to the percentage change in price. This is called unit elastic.
In the second case the value of the ratio equals to 20/10 or 2. The response is elastic or greater than 1.
In the third case the value of the ratio is equal to 5/10 or 0,5. The response is inelastic or a ratio value is less than 1.
3. Price elasticity of supply users are essentially the same formula accepted that as price increases quantity supplied also increases rendering the total revenue check useless in the supply case.
Limits and degrees of elasticity
Perfectly elastic coefficient of elasticity is infinity. This means that the buyer is so sensitive to price changes that if one seller raises his price, the buyer will switch to another seller. This situation implicitly assumes that there are many sellers so that no one seller or a group of sellers can exercise it is significant control over the terms of exchange: prices, quantities, market share, etc. nowhere is this better exemplified that in the norm for competition in a product market that is perfect competition. The seller is a "price taker", that is, the market of all buyers and sellers for a particular good determines the price that the seller must charge all those business to other competitors who produce the identical product that becomes a perfect substitute.
This curve can be called perfectly elastic. As demand curves approach this horizontal function, they become relatively more elastic until they reach the horizontal shape. On demand curves approach the perfectly vertical function perfectly inelastic, they become relatively more inelastic. Hence the perfectly elastic and in perfectly inelastic curves set the mathematical or graphical limits on elasticity. The perfectly inelastic demand function could be illustrated as follows:
Price elasticity of demand can vary along the demand curve.
The slope does not change along a linear curve but elasticity does.
This is illustrated by the following:
Also price elasticity of demand will vary between the short run and the long run. In the short run buyers have more limited choices because of the relative scarcity of products and resources. Over the long run the choice of products and resources become greater and hence, buyers are more resistant to price increases for any given product or resource.
Therefore is a long run demand function for any given product will be relatively more elastic than the demand function in the short run. The degree of elasticity also depends on the competitive structure of the market, but we will discuss that later.
Degrees of elasticity also depend upon the nature of the product. Goals that are considered luxuries will be a relatively more sensitive to price increases that will go that are considered necessities. Consider Bentley and a cup of coffee.
Cross - elasticity of demand
As abstract as this sounds it is actually an important part of marketing decisions, merger or acquisition decisions, and antitrust court decisions. The essential question to which this concert is addressed is, "what effect on quantities demanded of one product with a price change in another product have?"
The estimation or empirical evidence of the answer to this question will, in turn, give us clues to market share, the degree of competition that may extend from one market to another when the related leverage a dominant product in one market may have on products in another market.
Cross price elasticity of demand (CPED) = (% change in quantity demanded of product Y) / (% change in price of the product X)
Is this ratio is positive, then products X and Y are substitutes.
Is this ratio is negative, then they are compliments.
If this ratio equals 0, then products are neutral.
Determinants of price elasticity of demand
1. The period of adjustment or the long run versus the short run.
The short run is the time over which supply cannot fully adjust to changes in demand so that there is a real relative scarcity of goods compared to the change in demand for the goods. Therefore in the short run prices as missionaries of the relatively scarce goods in other words the prices are "bid-up" by the excess demand. There are more buyers willing to purchase these goods, then goods available. The result being that the goods go to the highest bidders. Over the long run, when more choices are available (supply having adjusted to the increase in demand) consumers have more choices and are more sensitive (higher price elasticity of demand) to price changes.
2. The ratio of the cost of a particular product to the total budget of the consumer
$ Cost of Product A / Total budget
In general, the higher the value of this ratio, for a particular product, the more sensitive or more elastic the consumer will be to any price changes.
3. The consumer will have more choices of products and substitutes the more competitive the product market. Thus, more competition among producers will develop over in the long run, making the consumer more sensitive to price changes.
Income elasticity of demand
In addition to consumers being constrained by prices in their purchasing decisions, they are also constrained by the budgets or incomes. Thus, we consider consumers' sensitivity in terms of their responses to changes in both prices and incomes.
Income elasticity of demand = % change in consumption of a good / % change in consumer's income
This reshuffle of all my goods will have a positive sign, that is, as consumer income increases we expect that consumption of a normal good will also increase. If the increase in consumption is more than proportional to increase in income, then the value of the ratio is greater than one and the response is more than proportional to the change in income, making the response elastic.
If the change in consumption is less than proportional to the change in income in other words ratio is less than one, then the response is inelastic but still with a positive sign. If the change in consumption is exactly proportional to change in consumer's income, than the value of the ratio is one and the response is unit elasticity.
Price elasticity of supply
The basic relationship of the degree of the response of quantities supplied to changes in prices is the same as that for quantity demanded. For supply, however, the normal reaction of suppliers to changes in the prices of their goods in the market is to increase amounts willing to be supplied as prices increase, a direct relationship as opposed to the inverse relationship with price elasticity of demand.
Price elasticity of supply = % change in quantity supplied / % change in price
Incidence of tax on suppliers and consumers
Is the government imposes a tax on a supplier,part of the burden can be in the form of an increase in the price that the consumer pays for the product and/ or a burden on the supplier who can produce less (cost in the form of the tax) can result in less production. The degree to which the burden falls more on the consumer or the supplier is determined by the relative price elasticity of demand; the consumer may have a highly elastic response to any text passed on to him or her by the supplier.
Thus, the consumer facing relatively inelastic demand function will take more of the incidence of the tax in the form of paying a high price then will the supplier who has a relatively small reduction in quantity supplied. With a relatively more elastic demand function the supplier takes on the higher burden within the consumers.