Elasticity of Supply

Micro Economics

Elasticity of SupplyA measure of the responsiveness of the quantity supplied to a price change.

The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same.

Elasticity of SupplyCalculating the Elasticity of Supply

formula: Percentage change in quantity

supplied Percentage change in price

Price Elasticity of Demand Total Revenue and Elasticity

The total revenue from the sale of good or service equals the price of the good multiplied by the quantity sold. (P x Q)

When the price changes, total revenue also changes.

But a rise in price doesn’t always increase total revenue.

Price Elasticity of DemandThe change in total revenue due to a change in price depends on the elasticity of demand: If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases. If demand is inelastic, a 1 percent price cut decreases the quantity sold by more than 1 percent, and total revenues decreases. If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged.

Price Elasticity of Demand

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity sold remain the same). If a price cut increases total revenue, demand is

elastic. If a price cut decreases total revenue, demand is

inelastic. If a price cut leaves total revenue unchanged, demand is unit elastic.

Price Elasticity of Demand

Your Expenditure and Your Elasticity If your demand is elastic, a 1 percent price cut

increases the quantity you buy by more than 1 percent and your expenditure on the item increases.

If your demand is inelastic, a 1 percent price cut increases the quantity you buy by less than 1 percent and your expenditure on the item decreases.

If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent and your expenditure on the item does not change.

Price Elasticity of DemandThe Factors That Influence the Elasticity of Demand The elasticity of demand for a good

depends on:The closeness of substitutesThe proportion of income spent on the

goodThe time elapsed since a price change

Price Elasticity of Demand Closeness of Substitutes The closer the substitutes for a good or

service, the more elastic are the demand for it. Necessities, such as food or housing, generally have inelastic demand. Luxuries, such as exotic vacations,

generally have elastic demand.

Price Elasticity of Demand

Proportion of Income Spent on the Good

The greater the proportion of income consumers spent on a good, the larger is its elasticity of demand.

Time Elapsed Since Price Change The more time consumers have to adjust to

a price change, or the longer that a good can be stored without losing its value, the more elastic is the demand for that good.

More Elasticities of Demand Cross Elasticity of Demand

The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the price of a substitute or a complement, other things remaining the same.

The formula for calculating the cross elasticity is:

Percentage change in quantity demandedPercentage change in price of substitute or

complement

Independent Goods A Zero or near Zero cross elasticity

suggests that the two products are unrelated or independent goods.

Example: We would not expect a change in the price of butter to have any impact on the purchases of film.

Elasticity of Supply Calculating the Elasticity of Supply

The elasticity of supply is calculated by using the formula:

Percentage change in quantity supplied Percentage change in price

Calculate elasticity of Supply

Price per bunch of five daffodils

Qs supplied per month

$1 10000

$2 12000

answer Es= 0.2

Do the calculation Here is supply

schedules for natural rubber and man made rubber

Calculate price elasticity of supply for natural rubber and man made rubber

Price per lb Qs of natural rubber per month

$0.80p 1000$1.00 1100Price per lb Qs of man

made rubber per month

$0.80p 2000$1.00 2800

Elasticity of Supply

Elasticity and Total Revenue

When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues.

When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.

Type of demand Value of Ed

Change in quantity versus change in price

Effect of an increase in price on total revenue

Effect of a decrease in price on total revenue

Elastic Greater than 1.0

Larger percentage change in quantity

Total revenue decreases

Total revenue increases

Inelastic Less than 1.0 Smaller percentage change in quantity

Total revenue increases

Total revenue decreases

Unitary elastic

Equal to 1.0 Same percentage change in quantity and price

Total revenue does not change

Total revenue does not change

TR P Q

ElasticityPrice

Quantity Demanded (000s)

D

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

£5

100

Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.This value is represented by the grey shaded rectangle.

Total Revenue

ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

£5

100

£3

140

Total Revenue

ElasticityPrice (£)

Quantity Demanded

10

D

5

5

6

% Δ Price = -50%% Δ Quantity Demanded = +20%Ped = -0.4 (Inelastic)Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

ElasticityPrice (£)

Quantity Demanded

D

10

5 20

Producer decides to reduce price to increase sales

7

% Δ in Price = - 30%% Δ in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

Elasticity If demand is price

elastic: Increasing price

would reduce TR (%Δ Qd > % Δ P)

Reducing price would increase TR (%Δ Qd > % Δ P)

If demand is price inelastic:

Increasing price would increase TR (%Δ Qd < % Δ P)

Reducing price would reduce TR (%Δ Qd < % Δ P)

Elasticity

Income Elasticity of Demand:

A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity For example: Yed = - 0.6: Good is an inferior good but inelastic – a rise in

income of 3% would lead to demand falling by 1.8%

Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%

Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%

Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%

How will the following changes in price affect total revenue _TR increases, decreases or remains unchanged.

a. Price falls and demand is inelasticb. Price rises and demand is elasticc. Price rises and supply is elasticd. Price rises and supply is inelastice. Price rises and demand is inelasticf. Price falls and demand is elasticg. Price falls and demand is of unit

elasticity

Answers; TR will

a. decreasesb. decreasesc. Increasesd. Increasese. Increasesf. Increasesg. remains same

What are the major determinants of price elasticity of demand?Use these determinants in judging whether

demand for each of the following products is elastics or inelastic:

a) Orangesb) Cigarettesc) Winston cigarettesd) Gasolinee) Butterf) Salt

g. Automobilesh. Football gamesi. Diamond braceletj. This text book

Answers!a. elasticb. inelasticc. elasticd. inelastice. elasticf. inelasticg. elastich. elastici. elasticj. inelastic