ELASTICITY OF DEMAND AND SUPPLY

ELASTICITY OF DEMAND AND SUPPLY

As we learned in our discussion of demand, the price of a commodity can greatly influence our behavior as consumers. We want to take a closer look at consumer behavior. How responsive is consumers’ demand to change in the price of food. Medicine, or luxury items such as cars and the like. The measure of our responsiveness to change in price is called price elasticity of demand. In this chapter, we will study the price elasticity of demand, its effects, and its determinants.

We should review the basic concept of demand

The law of demand expresses the relationship between price and quantity demanded. When the price of a good is decreased, a greater quantity demanded. When the price of a good is increased, a lesser quantity of it is demanded. This law assumes that all other factors underlying demand are held constant.

Introduction to Elasticity of Demand

Although the law of Demand states that as the price of a good decreases, more of it is demanded, the degree of responsiveness to a price change will depend on:

· How important the commodity is to the buyer’s well-being; for example, changes in the price of medicine, food, stereo, car, or hamburgers will create different responses.

· The relative degree of the price of the commodity with respect to the purchaser’s resources or income.

· The availability of substitute goods.

The degree of sensitivity of consumer behavior to price changes is called the Price Elasticity of Demand.

1. Demand is Elastic when the relative change in the quantity demanded of a commodity is greater that the relative change in price.

2. Demand is inelastic when the relative change in the quantity demanded of commodity is less than the relative change in the price.

You should notice in the definitions of elastic and inelastic demand that the phrase relative change is important. Elasticity is a measure of the sensitivity or the responsiveness of changes in quantities demanded resulting from changes in price. This responsiveness refers to the degree to which the quantity demanded changes compared to the amount the price changes.

As consumers, the fact that we demand goods involves making expenditures when we purchase the goods. Our expenditures as buyers constitute receipts of revenue for sellers, where revenue is defined as the amount of money received from the sale of a commodity. As the first step in explaining the concept of elasticity, we will use the demand schedule to derive a total revenue schedule. Then we will illustrate total revenue graphically.

The total revenue schedule

A demand schedule is a schedule which shows the quantity of a good that will be demanded at each price. A total revenue schedule can derived from demand schedule simply by multiplying the quantity of the good that would be demanded at each price, by the price. Therefore, for every price on a demand schedule there is a total revenue value. Consider the following demand schedule: ( see table 1 )

Table 1

A total revenue schedule

(1)	(2)	(3)
Price	Quantity Demanded	Total Revenue
8.00	1	P8.00
6.00	2	12.00
4.00	3	12.00
2.00	4	8.00

Every point on a demand curve represents a unique price and a unique quantity, if you draw lines. If you draw lines connecting any point on a demand curve to the price and quantity axes, you will have a negative slope, means line is in decline position. ( see figure 1 )

An important implication of elasticity is the effect on total revenue when price increases or decreases. Let us first look at the changes in total revenue caused by a price change in the quantity where demand is elastic. Remember in this case, changes in the quantity demanded are greater relatively than the changes in price.

Elastic Demand and Total Revenue

When demand is elastic, a fall in price results in an increase in total revenue. This is because the loss in revenue due to a lower price per unit is relatively less than the gain in revenue due to the greater quantity of sales. In other words, the response in terms of quantity demanded is very high.

When demand is Inelastic, an increase in price results in a decrease in total revenue. This is because the gain in total revenue resulting from the higher unit price is relatively less than the loss in revenue resulting from decline in quantity sold.

Inelastic Demand and Total Revenue

When demand is inelastic, a decline in price will cause total revenue to decrease. The small increase in quantity

purchased will not be enough to make up for the decline in revenue per unit; therefore, total revenue decrease

When demand is inelastic, an increase in price will cause total revenue to increase. The gain in total revenue resulting from the higher unit price is greater than the loss in revenue resulting from the fall in sales.

Unitary Elastic Demand and Total Revenue

There is a special case called unitary elastic, this occurs when an increase or decrease in price does not change total revenue. In the case of Unitary elastic, the loss of revenues due to the lower price will just be offset by the increase in revenue, due to a larger quantity purchased. The gain in revenues due to

the higher price will just be offset by the decrease in revenues caused by the smaller quantity purchased.

It is very important that you understand elasticity and its effect on total revenue. You will find a chart which summarizes the three cases we have just discussed.

Summary of Elasticity of Demand and Total Revenues

IF	THEN	AND	DEMAND IS
Price Decrease	Quantity demand increase	Total revenue increase	Elastic
Price Decrease	Quantity demanded Increase	Total revenue Decrease	Inelastic
Price Increase	Quantity Demanded Decrease	Total Revenue Increase	Inelastic
Price Increase	Quantity Demanded Decrease	Total Revenue Decrease	Elastic
Price Increase	Quantity Demanded Decrease	Total Revenue Constant	Unitary Elastic
Price Decrease	Quantity Demanded Increase	Total Revenue Constant	Unitary Elastic

Finally, lets look at two special cases of elasticity of demand. These two extreme or limiting cases are known as perfectly inelastic demand and perfectly elastic demand.

When a very large relative change in price causes only a slight change in relative quantity demanded, demand is inelastic. The extreme or limiting cases occurs when there is no change in quantity demanded no matter what the change in price. This situation is shown by a perfectly inelastic demand curve as in figure 4.

So far we have been speaking about elasticity of demand in general terms. It is much more convenient to have a quantitative measure of elasticity. This is achieved by computing the coefficient of elasticity. The two coefficient of elasticity are as follows:

Economic Approach

Coe= Qd2 - Qd1 P2-P1

------------- ---------

Qd2 + Qd1 P2+P1

------------- ---------

2 2

whereas

Qd1 – Original Quantity demand

Qd2 – New Quantity demand

P1 – Original Price

P2 – New Price

Example:

The price of Pandesal per piece is P1.25. it leads to daily total sales of 25,000 pieces among the Valenzuela area. The price then rises to P1.50 per piece which leads to a total sales of 22,350 pieces or a reduction in quantity by 2,650 pieces. From the given data, what is the consumer response with respect to the changes in price.

Solution:

Economics Method

Given:

Q1 – 25,000

Q2 – 22,350

P1 – P1.25

P2 – P1.50

22,350 - 25,000 1.50 – 1.25 2,650 .25

---------------------- ÷ ---------------- = --------------- ÷ -------

22,350 + 25,000 1.50 + 1.25 47,350 2.75

---------------------- --------------- --------------- -------

2 2 2 2

= 2,650 .25

----------- X ---------

23,675 1.375

= 3,643.75

--------------

5,918.75

= .6 inelastic

Statistic Approach

∆ in QD ∆ in Price

------------------- ÷ ----------------------

Q1 P1

Whereas:

∆ - change

∆ in QD - Qd2 - Qd1

∆ in Price - P2 - P1

2,650 .25 3,312.5

= ------------- X -------- = --------------

25,000 1.25 6,250

= .53 inelastic

In the following demand schedule for banana per piece, the elasticity are derived the same way using the economic method.

Table 3

Demand schedule for banana per piece

Price per piece	Quantity demanded per week	Elasticity coefficient
.50	1
.45	2	6.33 elastic
.40	3	3.40 elastic
.35	4	2.14 elastic
.30	5	1.44 elastic
.25	6	1.00 unitary
.20	7	.69 inelastic
.15	8	.47 inelastic
.10	9	.29 inelastic

Note that this demand curve has an elastic, unitary, and inelastic portion. We can read this from the column showing coefficient of elasticity.

Interpreting the Coefficient of Elasticity

When demand is elastic and the elasticity coefficient is greater than 1, the percentage change in quantity demanded is larger that the percentage change in price

When the demand is inelastic, the elasticity coefficient is less than 1. this is because a percentage change in price results in a smaller percentage change in quantity demanded

When demand is unitary, the elasticity coefficient is 1. this is because a percentage change in price results in an equal percentage change in quantity demanded .

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