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S6 Economics

The Concept of Elasticity of Demand

ELASTICITY 

Elasticity refers to the measure of the degree of responsiveness of the dependent variables to   the independent variables Dependent variables may be the quantity demanded or quantity supplied while independent variables are the factors which influence the above dependent variables e.g. Price of the commodity Price of other commodities, consumer’s income.

Elasticity can be taken to mean reaction or response of producers or consumers.  

Elasticity is of two types:

  1. Elasticity of demand
  2. Elasticity of supply 

 

ELASTICITY OF DEMAND

This refers to a measure of the degree of responsiveness of quantity demanded of a commodity to changes in the factors that affect demand. E,g.price of the commodity, Consumer’s level of income  and price  of related commodities.

Elasticity is considered for only three major determinants of demand namely: 

  • Price  of the commodity in question
  • Price of related commodities
  • The level of income of the consumer 

 

Therefore there are three different concepts of elasticity of demand namely  

  • Price elasticity of demand
  • Cross  elasticity of demands
  • Income elasticity of demand 

 

PRICE ELASTICITY OF DEMAND 

This refers to a measure of the degree of responsiveness of quantity demanded of a commodity to changes in the price of the commodity in question. i.e. it shows how much quantity demanded of a commodity responds to a change the price of that commodity. 

Mathematically it is given by the following formula 

NB:  A  negative  sign  is  multiplied  into  the  formular  to  make  the  answer  positive,  since  price elasticity of demand never in negative.  

INTERPRETATION OF PRICE ELASTICITY OF DEMAND

1.PERFECTLY  /COMPLETELY  INELASTIC  DEMAND: Perfectly  inelastic  demand  is  one where price changes have no effect at all on quantity demanded of a commodity. This means that quantity demanded remains constant in spite the price changes. The coefficient is equal to zero (PED = 0).  

A graph illustrating a perfectly inelastic demand curve: 

3.  FAIRLY INELASTIC DEMAND.  

This is   one where a very big percentage change in price leads to a small percentage change in quantity demanded of a commodity.  The coefficient is greater than zero but less than one (PED>0<1). 

Unitary elasticity of demand. Unitary elasticity of demand is one where the percentage change is  price  is  exactly equal  to  percentage  change  in  quantity  demanded  of  a  commodity.  The coefficient is equal to one (PED = 1). 

Fairly elastic demand/ Elastic demand. This is one where a very small percentage change in price leads to a big percentage change in quantity demanded of a commodity. The coefficient is greater than one but less than infinity (PED>1<∞). 

Perfectly  elastic  demand.  Perfectly  elastic  demand  is  one  where  at  a  prevailing  price consumers are willing to purchase the commodity infinitely.(as much as they want) and none at all at even a slightly higher price. The coefficient is equal to infinity (PED = ∞). 

An illustration of   a perfectly elastic demand curve: 

In the graph above consumers are willing to buy as much as they want at the prevailing price i.e.  OP1 and none at all even at all even a t a slightly higher price. 

 

Methods of Measuring Elasticity of Demand

1.  Point elasticity of demand. Point elasticity of demand is one that is measured at one point on the demand curve.  

 

FACTORS  DETERMINING/AFFECTING/INFLUENCING  PRICE  ELASTICITY  OF DEMAND 

Availability of substitutes; Commodities with close substitutes have price elastic demand because an increase in the price of the commodity with close substitutes leads to a big reduction in quantity demanded of that commodity. This is so because consumers have alternative goods which they can turn  to.  However  c  commodities  with  no  close  substitutes  have  price  inelastic  demand because as the price increases, consumers continue purchasing that commodity since there no alternative commodities to turn to.   

Degree of necessity of the commodity; Demand is price inelastic for essential goods (necessities) because with increase in price of such commodities consumers continue buying almost the same amount since they cannot do without them. On the other hand demand for luxuries/non essential goods is price elastic because with an increase in price of such goods consumers reduce their drastically, since they can do without them.  

Level of durability/ Perishability of  the commodity; The demand for durable commodities is price inelastic demand because as their prices reduce consumer do not do not buy, this is because they can be used for a long time without replacement   e.g, television  sets,  refrigerators,  cookers  and  furniture.  On  the  other  hand,  the  demand  for  perishable commodities is price elastic, this is because with a fall in their prices more of them are bought  cannot be kept for a  long time hence need constant replacement e.g. food stuffs.

The proportion of  income spent  on  the  commodity/the  commodity  takes;  A commodity that takes a small proportion of the consumer’s income are price inelastic ,this is so because as their prices increase, the consumer continues buying them since they do not feel the pinch of the price increase. On the other hand the demand for commodities that take a big proportion of one’s income are price elastic, this is so because as their prices increase,  the  consumers  reduce  their  consumption  since  they  feel  the  pinch  of  the  price increase .

Level of addiction in the use of the commodity; Demand  for  the  commodities  consumed  out  of  a  habit  e.g. alcohol,  cigarettes  is  price inelastic this is so  because with an increase in the price of such a commodities consumers continue  buying almost  the  same  amount  of  the  commodity  since  it  is  not  easy break/abandon the habit once developed.  On the other hand the demand for commodities consumed not out of a habit are price elastic, this is so because   as their  price increase consumers  reduce  their  consumption  with  ease  since  they  have  no  strong  attachment  to them.

Level  of  income  of  the  consumer.;  The  demand  for  commodities  among  high  income earners is price inelastic, this is  so because with increase in the price of the commodity, such a consumer continues buying the same amount of the commodity, since he/she can afford  to  buy  the  commodity  at  whatever  price.  On  the  other  hand,  the  demand  for commodities among low income earners is price elastic, this is so because with the increase in  the  price  of  the  commodity,  such  a  consumer  reduces  the  amount  consumed  of  the commodity demanded since he/she cannot afford to buy at a high price.

The number of uses the commodity has. The demand for commodities with several uses e.g. electricity  for cooking, lighting, ironing etc  is price elastic, this is so because with an increase in price of the commodity the consumer reduces on some of the uses and remains with only those that are essential. On the other hand he demand for commodities with few uses is price inelastic, this is so because as their prices  increase the consumer continues buying them since they need them for those few uses.

Level of convenience of getting the commodity ;  The demand for commodities that are conveniently  acquired are price inelastic, this is because as their prices increase, consumers continue buying them since they the reach of the consumer. On the other hand the demand that  are  not  conveniently  acquired  are  price  elastic,  this  is  so  because  as  their  prices increase, consumers reduce their consumption since they  are  not easily accessible.

Time period(short run or long run); The demand for  a commodity is price inelastic in the short run, this is so because with increase in the price of the commodity, the consumer continues buying, since he/she cannot easily change the habit or find a cheaper substitute. On the other hand the demand for a commodity is price elastic in the long run, this is so because with increase in price of a commodity the consumer reduces the amount consumed of the commodity, since the time is long enough to change the habit and  find a cheaper substitute.

Speculation about price changes; The demand for a commodity is price inelastic when there  is  an  expectation  of further  increase  in  price  in  the  future,  this  is  so  because  with increase  in  the  price  of  the  commodity,  the consumer  continues  buying  so  as  to  avoid buying  it  in  future  at  a much  higher  price.  On  the  hand  the demand  for  a  commodity  is price elastic when there is an expectation of  a further reduction in price in the future, this is so because  with   a decrease in the price of the commodity the consumer reduces the amount bought, so as to buy more at a much lower price in the future.

Seasonal  changes;    The  demand  for  a  commodity  during  a  favourable  season  is  price inelastic,  this  is  so because  with  an  increase  in  price  of  a  commodity,  the  consumer continues buying such a commodity due to the apparent need for that commodity. On the other hand the demand for a commodity during unfavourable season is price elastic, this is so  because  with  a  reduction  in  the  price  of  the  commodity,  the  consumer  reduces  the amount consumed of a commodity due to the reduced apparent need for the commodity.

Possibility of postponement of demand for the commodity: The demand for goods, the use of which can be postponed is price  elastic, this is so  because as  their  prices  increase  consumers  reduce  their  consumption  since  their  use  is  not  very urgent. On the other hand demand for a good, the use of which cannot be postponed is price inelastic, this is because as their prices increase consumers continue buying them because their use is very urgent .

Level of awareness of availability of cheaper goods/ level of advertising.  The  demand  for  commodities  which  are highly  advertised  is  price  inelastic  this  is  so because  with  an  increase  in  price  of  a  commodity,  the consumers  continue  buying  the commodity  since  advertising  positively  influences  them  to  continue  buying  the commodity. On the other hand the demand for a commodity which is not is not intensively advertised is price elastic, this is so because with increase in the price of the commodity, the consumer reduces the amount consumed of the commodity, this is so because they are not positively influenced to continue buying the commodity  

Availability  of  complements.;  The  demand  for  goods  which  are  jointly  used  is  price inelastic, this is so because with increase in price of one of them, the consumer continues buying it because one cannot be used without the other  e.g. one who wants to continue using his/her car must continue buying the fuel even at an increased price.  On the other hand demand for commodities which are not jointly   used is price elastic, this is so because with an increase in price of the commodity the consumer reduces the quantity demanded of the commodity, this is so because one can be used without the other. 

 

Factors Responsible For Inelastic Demand for a Commodity: 

  • Presence of few substitutes.
  • Presence of complementary commodities
  • High degree of necessity.  
  • High degree of addiction.  
  • Existence of durable commodities.
  • Small proportion of income spent on a commodity.
  • High level of consumer’s income.
  • Fewer number of uses of a commodity.  
  • High level of convenience of getting a commodity.
  • Short-run period.
  • Expectation of future price increase.
  • Favourable seasonal demand.  
  • High level of advertising
  • Commodities whose use cannot be postponed to future use 

Factors Responsible for Elastic Demand for a Commodity: 

  • Presence of close (many) substitutes.  
  • Existence of independent commodities.
  • Presence of luxurious commodities.  
  • Presence of non-addictive commodities.  
  • Existence of perishable commodities 
  • Large proportion of income spent on a commodity
  • Low level of consumer’s income
  • Variety of uses of a commodity.  
  • Low level of convenience of getting a commodity
  • Long-run period.  
  • Expectation of future price fall  
  • Unfavourable seasonal demand.  
  • Low level of advertising.  
  • High degree of postponement of a commodity.  

 

Practical importance of Price Elasticity of Demand to the Government

It  guides  in  taxation  policy.  Government  earns  more  revenue  by  taxing  highly  those commodities  with  inelastic  demand  because  consumers  buy  at  any  price  for  example cigarettes,  beer  and  fuel  and  for  commodities  with  elastic  demand  a  low  tax  is  levied because imposing high taxes on them leads to a reduction in their demand.  

It  guides  in  subsidisation  policy.  Government  grants  subsidies  to  only  those  local industries whose commodities have elastic demand and the producer benefits in terms of cost reduction hence charging low prices.

It guides in nationalization policy. Commodities whose demand is inelastic such as clean and safe water, gas and electricity are provided by the state because consumers are likely to buy them at relatively high prices in case they are left in the hands of the private investors therefore government has to nationalize such enterprises.

It guides in determining incidence of a tax. Commodities whose demand is inelastic, the incidence of a tax successfully falls on a consumer through increased price by the producer whereas commodities whose demand is elastic, the incidence of a tax successfully falls on the producer because an increase in price of a commodity scares away the consumers, since it is hard for the producer to shift the tax burden to the consumer.

It guides on foreign exchange rate manipulation; This applies where there is a floating exchange rate system. In order to improve the balance of payment position of a country, the government allows the country’s currency to depreciate which discourages importation because they become more expensive thus reducing foreign exchange expenditure. On the other  hand  allowing  the  country’s  currency  to  depreciate  makes  exports  cheap,  which  attracts more buyers leading to increased foreign exchange earnings hence improving the balance of payment position of a country.

It  guides  on  devaluation  of  a  currency  of  a  country.  Devaluation  is  successful  when price  elasticity’s  of  demand  for  both  imports  and  exports  are  price  elastic.  This  is  so because  a  slight  decrease  in  the  prices  of  exports  leads  to  a  big  increase  in  quantity demanded of exports thus increased foreign earnings leading improvement in the balance of payment position. On the other hand a slight increase in the prices of imports leads to a big reduction in the quantity of imports, thus improving the balance of payments due to reduced import expenditure.

 

Practical importance of Price Elasticity of Demand to the Producer

It is used as a basis of price discrimination. Under monopoly carrying out discrimination is based on the price elasticity of demand in each market.  In  a market where demand is inelastic  the  producer  charges  a  high price,  this  is  so  because  consumers  with  inelastic demand can afford to buy the commodity at whatever price. On other hand where demand is elastic, a low price is charged this is so because consumers with elastic demand cannot afford to buy at a high price.

It guides in wage determination/It is helpful in determining wages of a particular type  of  labour.  If  the  demand  of labour  in  an  industry  is  price  elastic,  the  trade  union tactics/efforts to raise wages cannot be successful because employers can easily substitute labour, on the other hand if the demand of labour in an industry is price inelastic, the efforts of trade union to raise wages will succeed because employers can be convinced to raise wages of such workers, since employers cannot easily substitute labour.

It guides in pricing of commodities. The concept of price elasticity of demand helps the producers in pricing their output. If the demand for a product is elastic, the producer gains more profits by fixing a low price and therefore maximising sales.  In case the demand  is  inelastic,  the  producer  gains  more  profits  by  fixing  high  prices,  because increase in price does not affect quantity demanded. 

 

 Practical importance of Price Elasticity of Demand to a Consumer: 

It  guides  consumers  in  planning  their  expenditure. A  consumer  spends  more  on commodities whose demand is price inelastic because they take a high proportion of the consumer’s expenditure; on the other hand a consumer spends less on commodities whose demand is price elastic because they take a small proportion of the consumer’s expenditure.

 

INCOME ELASTICITY OF DEMAND:   

This refers to a measure of the degree of responsiveness of quantity demanded of a commodity to changes in the income of a consumer. 

Mathematically it is given by the following formula: 

Example

Assuming that a person’s salary increased from Shs 15,000 to Shs 20,000 and quantity demanded of a commodity decreased from 10 kg to 6 kg. Calculate income elasticity of demand.  

Interpretation of coefficients of income elasticity of demand

If the coefficient is negative, the nature of the commodity is inferior. This means that as the level of income increases the consumer buys less of the commodity. 

If the coefficient is positive, the nature of the commodity is a normal good. This means that as consumers income increases quantity demanded of increases and vice-versa. 

If the coefficient is zero, the nature of the commodity is an absolute necessity such as salt. This  means  that  changes in consumer’s  income  do  not  affect  quantity  demanded  of  the commodity at all. 

Income elastic This  is  when  the  income  elasticity  of  demand  is  greater  than  one  meaning  that  quantity demanded  changes  proportionately  more  than  change  in  income.  A  slight  change  in  the consumer’s income leads to a very large change in quantity demanded. 

Income inelastic This is when income elasticity of demand is less than one but greater than zero. This means that a large percentage change in income leads to a proportionately less percentage change in quantity demanded. 

 

Importance of income elasticity of demand

  1. It guides in taxation policies. For high income groups taxes tend to high whereas for low income groups taxes are low.
  2. It  helps  to  determine  the  nature  of  goods.  For  normal  goods  the  coefficient  is  positive,  for absolute necessity the coefficient is zero and for inferior goods the coefficient is negative.
  3. It helps to forecast future demand for commodities as level of income changes.      

 

CROSS ELASTICITY OF DEMAND: This is the measure of the degree of responsiveness of quantity  demanded  of  one  commodity  to  changes  in  price  of  other  commodities/  related commodities 

 Cross elasticity of demand is mathematically expressed as: 

Example

Given that the price of commodity Y increased from shs. 100 to shs. 150 and quantity demanded of a related commodity X increased from 50 kg to 90 kg. Calculate the cross elasticity of demand. 

Interpretation of coefficients of cross elasticity of demand  

  1. If  the  coefficient  is  positive,  the  two  commodities  are  substitutes  i.e.  an  increase  in  price  of commodity Y leads to an increase in quantity demanded of commodity X.
  2. If the coefficient is negative, the two commodities are complements i.e. an increase in price of commodity Y leads to a decrease in quantity demanded of commodity X
  3. If the coefficient is zero, the two commodities are independent (not related at all) i.e. quantity demanded of X is not affected by price changes of commodity Y  

 Importance of cross elasticity of demand:  

  1. Used to classify commodities. If the cross elasticity of demand is positive, the goods are substitutes  while  if    the cross  elasticity  of  demand  is  negative  then  the  goods  are complementary goods.
  2. Use in the classification of markets; If the cross elasticity of demand is infinite, the market is  perfectly  competitive, while  if  the  cross  elasticity  of  demand  is  zero  the  market  is oligopoly, yet where the cross elasticity is high (elastic) then the market is imperfect. 
  3. Used in the pricing policy. The cross elasticity of demand helps firms to decide whether to increase the price of the related goods or not.   

 

ELASTICITY OF SUPPLY

Elasticity  of  supply  is  the  measure  of  the  degree  of  responsiveness  of  quantity  supplied  of  a commodity to changes in factors that influence supply such as price of the commodity, prices of competitively supplied commodities, prices of jointly supplied commodities, the gestation period.   

PRICE ELASTICITY OF SUPPLY

Price elasticity of supply is the measure of the degree of responsiveness of quantity supplied of a commodity to changes in its own price.    

Price elasticity of supply is mathematically expressed as:  

Price elasticity of supply has a positive coefficient.  

 

Categories of Price Elasticity Of supply 

Fairly  elastic  supply.  Elastic  supply  is  one  where  a  very  small  percentage change  in  price  leads  to  a  big percentage  change  in  quantity  supplied  of  a commodity.  The  coefficient  is  greater  than  one  but  less  than infinity (PES>1<∞). 

Perfectly elastic supply. Perfectly elastic supply is one where at a prevailing price or above that    producers  are  willing  to  supply  more  all  they  can  and  none  at  all  below  that  price. The coefficient is equal to infinity (PES = ∞).  

Fairly inelastic supply. Inelastic supply is one where a very big percentage change in price leads to a small percentage change in quantity supplied of a commodity.  The coefficient is greater than zero but less than one (PES>0<1). 

Perfectly inelastic supply. Perfectly inelastic supply is one where price changes have no effect at all on quantity supplied of a commodity. This means that quantity supplied remains constant in spite the price changes. The coefficient is equal to zero (PES = 0). 

Unitary elasticity of supply. Unitary elasticity of supply is one where the percentage change in price is exactly equal to percentage change in quantity supplied of a commodity. The coefficient is equal to one (PES = 1). 

 

An illustration of perfectly inelastic, unit elasticity and perfectly elastic supply curve: 

 

Factors Influencing Price Elasticity of Supply: 

The cost of production . The supply of a commodity is price inelastic when the costs of production are high, this is so  because  with  increase  the  price  of  the  commodity,  producer  are  reluctant  to  increase supply, due to the low profit margin. On the other hand supply of a commodity is price elastic when the costs of production are low, this is so because with increase in the price of the commodity, producers quickly supply due to high profit margin.

Gestation period. The supply of a commodity with a short gestation period is price elastic, this is so because with increase in the price of such a commodity, producers in position to increase supply within a short period of time. On the other hand the supply of a commodity with a long gestation period is price inelastic, this is so because with increase in price of such a commodity, producers are not able to increase supply in a short period of time.

Level of technology. The supply of a commodity produced using advanced technology is price elastic; this is so because with increase in the price of such a commodity, the producers are to increase the supply of such a commodity due to the use of such modern technology. On the other hand the supply of a commodity  produced using poor technology is price inelastic, this is so because with increase in the price of such a commodity, the producers are not able to increase supply due to the inefficiency of such technology.

Perishability/Durability of a commodity: The supply of perishable commodities is price  inelastic , this is so because with increase in the price of such a commodity, the producers cannot increase supply once existing stock have been exhausted since such goods cannot be stored for  a long time. On the other hand the supply of durable commodities is  price elastic, this is so because with increase in the price of such goods, the producers able to supply by getting from the stores since the goods can be stored from the stores.

Time  period.  The  supply  of  a  commodity  is  price  inelastic  in  the  short  run.  This  is  so because with increase in the price of the commodity, the producers cannot easily increase the supply of the commodity, since the time is too short to increase the supply. On the hand the supply of a commodity is price elastic in the long run period, this is so because with increase in the price of the commodity, the producers can easily increase supply since the time is long enough to allow production and supply of more goods.

Natural factors especially in agricultural sector. The supply of a commodity is price elastic during favourable natural factors such as adequate rainfall, fertile soils; this is so because with an increase in price of a commodity, the producers increase production and supply of a commodity since the conditions are favourable for the activity. On other hand the supply of a commodity during unfavourable natural factors such as prolonged drought, infertile soils is price elastic, this is so because with increase in the price of the commodity  the producers are not able to increase production and supply of the commodity since the conditions are unfavourable for the activity.

Degree of freedom of entry of firms in production/ Ease of entry of new firms in the industry. The supply of a commodity  is price elastic when there is  freedom of entry of firms in an industry; this is so because with increase in the price of such a commodity it induces other firms to join production since there are no restrictions on entry. On the other hand the supply of a  commodity is  price inelastic when there is restricted entry into the industry; this is so because with increase in the price of a commodity is not easily increased since there are few producers due to restricted entry into the industry. 

Political climate. The supply of a commodity is price elastic when there is political stability this is so because with increase in the price of the commodity, the producers easily increase production and supply of a commodity, since such situations allow producers to produce more output as they live a settled life. On the other hand supply of a commodity is price inelastic; this is so because with an increase in the price of the commodity, the producers are not in position to increase supplies of the commodity since such situation do not allow production to easily take place as people do not live a settled life. 

Future price expectations. The supply of a commodity is price inelastic when there is an expectation of a further future price increase this is so because with an increase in the price of the commodity,  the  producers are reluctant to supply more of the commodity since they want to supply more in future at a much higher price. On the other hand the supply of the commodity is price elastic when there is  expectation of  a further future price reduction, this is so because with a decrease in the price of the commodity, the producers supply more of  the commodity due to fear  to sell their output at much lower price.

Availability of excess capacity: The supply of a commodity is price elastic when  the are firms are operating  excess capacity, this is so because with increase in the price of a commodity, the producers easily increase production and supply of the commodity since the  resources are not yet exhausted. On the other hand the supply of a commodity is price inelastic when the firms are operating at full capacity, this is so because with increase in the price of the commodity, the producers are not able to increase production and supply of the commodity.

Government policies of subsidization and taxation. The supply of the commodity is price elastic when government subsidizes producers this is so   because subsidies artificially reduce costs of production which encourages producers to produce and supply more of the commodity.  On the other hand the supply of the commodity is price inelastic when the government highly taxes the producers ,this is so because high taxes increases the costs of production which discourages producers thus reducing the supply of a given commodity.

 

Factors responsible for elastic supply of a commodity                                   

  • Low costs of production.  
  • Shorter gestation period.
  • Improved state of technology.  
  • Existence of durable commodities.  
  • Long-run period.
  • Favourable natural factors especially in agricultural sector.  
  • Freedom of entry of firms in production.  
  • Favourable political climate.  
  • Expectation of further future price fall.  
  • Presence of excess capacity.
  • Favourable government policy of subsidization.  

 

   Factors responsible for inelastic supply of a commodity 

  • High costs of production.. 
  • Longer gestation period.  
  • Low level of technology.
  • Presence of perishable commodities.
  • Short-run period.
  • Unfavourable natural factors especially in agricultural sector.
  • Restricted entry of firms in production.
  • Unfavourable political climate.
  • Expectation of further future price rise.
  • Existence of full utilization of available resource.
  • Unfavourable government policy of taxation.  

 

IMPORTANCE OF PRICE ELASTICITY OF SUPPLY: 

Used  in  the  devaluation policy. The  supply  of  exports  should  be  price  elastic  such  that  producers of exports should be able to increase production and supply more when there is increase in demand for exports.

Used  in  government  in  formulating  taxation  policy.  More  tax  revenue  is  be  got  by  the government taxing goods that have got inelastic supply, this is so because imposition of taxes on such goods does not affect their supply greatly. 

Used   to determine the incidence of a tax. A producer pays more of a tax when elasticity of supply is inelastic and pays less when the price elasticity of supply is elastic.

Used to determine the wage rate. Labour which has an inelastic supply earn a high wage because it is not easy to get such labour and labour with an elastic supply earns a low wage because it is easily acquired  

Discussion

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