CHAPTER 2B
RESOURCE ALLOCATION: ELASTICITIES OF DEMAND AND SUPPLY

ELASTICITY

measure used to show the degree of responsiveness of quantity demanded or quantity supplied of a good or service to a change in one of the determinants of demand and supply

Price elasticity of demand (PED)

Price elasticity of supply (PES)

Price Elasticity of demand (PED)

the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus

1 < | PED | < infinity:
Demand for a good is price elastic when change in price of a
good leads to proportionately larger change in quantity demanded


0 < | PED | < infinity:
Demand for a good is price inelastic when a change in price of a good leads to a proportionately smaller change in quantity demanded

Factors affecting PED

PED = Percentage change in Quantity demand / Percentage change in price of the good

a. Availability and closeness of Substitutes:
Greater availability, consumers can switch to substitutes more easily when price increase, greater PED --> more price elastic

b. Degree of necessity
Greater necessity, lower PED --> price inelastic

c. Proportion of income spent on product
Greater proportion of income spent, greater PED --> price elastic

d. Time period
Longer time, greater PED --> price elastic


Reasons:
(a) habits of consumers change
(b) longer term, more substitutes developed

Price Elasticity of Supply (PES)

the degree of responsiveness of the quantity supplied of a good to changes in its price, ceteris paribus

Factors Affecting PES

PES = Percentage change in quantity supplied /
Percentage change in price of the good

1. PES > 1:
price of a good leads to a proportionately larger change in quantity supplied --> price elastic


2. PES < 1:
price of a good leads to a proportionately smaller change in quantity supplied --> price inelastic


3. PES =1:
price of a good leads to an equal proportionate change in quantity supplied --> unitary price elasticity

a. Time


i. Momentary period (very short run)
producers unable to respond to change in price --> PES = 0


ii. Short Run
production is restricted by at least one fixed factor of production
--> quantity supplied < proportionate
--> price inelastic


iii. Long Run
more factors available --> quantity supplied > proportionate --> price elastic

b. Existence of spare capacity
more spare capacity available, quantity supplied > proportionate
--> price elastic

c. Availability and durability of stocks
greater no. of goods durable, quantity supplied > proportionate
--> price elastic

d. Length of production period
Longer time --> quantity supplied < proportionate --> price inelastic
Shorter time --> quantity supplied > proportionate --> price elastic

e. Factor mobility (labour)
higher the factor mobility, more price elastic

Application of PED

TOTAL REVENUE

ii. Demand for the product is price inelastic
Loss of revenue due to fall in price is greater than the gain in revenue due to the increase in quantity demanded
--> TR decreases

i. Demand of Product is relatively price elastic:
Loss of revenue due to fall in price is smaller than the gain the revenue due to the increase in quantity demanded --> TR increases

Limitations of elasticity concepts

a. Assumptions of ceteris paribus
all other factors remain unchanged


i. Costs held constant


ii. Other non-price determinants are not constant in the real world

b. Reliability and Accuracy of Elasticity data
data may not be reliable/accurate. If PED wrong, pricing strategy wrong, total revenue may decrease

c. Interactions between demand and supply
In reality, there could be other changes in supply that would result in changes to the price of the product.