introduction
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Elasticity & it’s Effects
Introduction of Elasticity
The concept of elasticity is intended to measure the degree of responsiveness of a buyer or seller to a change in a key determinant, in particular price. The degree of responsiveness of the quantity demanded to a price change is called the price elasticity of demand. If the price change is that of another good then the study deals with cross elasticity of demand.
In economics, elasticity is the measurement of how responsive an economic variable is to a change in another. For example:
"If I lower the price of my product, how much more will I sell?" "If I raise the price of one good, how will that affect sales of this
other good?" "If we learn that a resource is becoming scarce, will people
scramble to acquire it?"
An elastic variable (or elasticity value greater than 1) is one which responds more than proportionally to changes in other variables. In contrast, an inelastic variable (or elasticity value less than 1) is one which changes less than proportionally in response to changes in other variables?
Elasticity can be quantified as the ratio of the percentage change in one variable to the percentage change in another variable, when the latter variable has a causal influence on the former. A more precise definition is given in terms of differential calculus. It is a tool for measuring the responsiveness of one variable to changes in another, causative variable. Elasticity has the advantage of being a unit less ratio, independent of the type of quantities being varied. Frequently used elasticity’s include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between factors of production and elasticity of inter temporal substitution.
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Elasticity & it’s Effects
Concept of Elasticity
Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus.
In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis.
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Elasticity & it’s Effects
History of Elasticity
The first professional review of the history of elasticity theory was given by French elasticity theorist Adhémar Jean Claude Barré the Saint-Venant can be stated as:
"... The difference between the effects of two different but statically equivalent loads becomes very small at sufficiently large distances from load."
This theory was given in (1864).The original statement was published in French by Saint-Venant in (1855).
Although this informal statement of the principle is well known among structural and mechanical engineers, more recent mathematical literature gives a rigorous interpretation in the context of partial differential equations.
Another exception is the History of the theory of Elasticity and of the Strength of Materials from Galilei to Lord Kelvin (1886-1893) by Isaac Todhunter and Karl Pearson, which presents on 2200 pages.
During the nineteenth century, Mechanics was mainly considered to be a part of Applied Mathematics. A significant change occurred at the beginning of the twentieth century when Continuum Mechanics acquired special significance. In the middle of that century, Stephen Timoshenko published the History of Strength of Materials with a brief Account of the History of Theory of Elasticity and Theory of Structures (1953).
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Elasticity & it’s Effects
Definition of Elasticity
The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price).
It’s also called price demand elasticity.
A measure of a sensitivity variable’s to change in another variable. In economics, elasticity refers the degree to which individuals (consumers/producers) change their demand/amount supplied in response to price or income changes.
Calculated as:
Elasticity is used to assess the change in consumer demand as a result of a change in the good's price. When the value is greater than 1, this suggests that the demand for the good/service is affected by the price,
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whereas a value that is less than 1 suggest that the demand is insensitive to price.
Businesses often strive to sell/market products or services that are or seem inelastic in demand because doing so can mean that few customers will be lost as a result of price increases.
Elasticity measures the relationship between a good and its price based on consumer demand, consumer income, and its available supply.
E.g. How it works/Example:
1).If the quantity demanded changes a lot when prices change a little, a product is said to be Elasticity. This often is the case for products or services for which there are many alternatives, or for which consumers are relatively price sensitive. For example, if the price of Cola A doubles, the quantity demanded for Cola A will fall when consumers switch to less-expensive Cola B.
2). When there is a small change in demand when prices change a lot, the product is said to be inelastic. The most famous example of relatively inelastic demand is that for gasoline. As the price of gasoline increases, the quantity demanded doesn't decrease all that much. This is because there are very few good substitutes for gasoline and consumers are still willing to buy it even at relatively high prices.
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Elasticity & it’s Effects
Types of Elasticity
1.) Elasticity of Demand
The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price).Also called price demand elasticity.
Demand Elasticity Determinants
The determinants of demand elasticity are
The time framework (market period, short run or long run):- The availability of substitutes.- The proportion the item represents in total income.- The perception of the item as necessity or luxury.
Different types of Elasticity of Demand
After knowing what is demand and what is law of demand, we can now come to elasticity of demand. Law of demand will tell you the direction i.e. it tells you which way the demand goes when the price changes. But the elasticity of demand tells you how much the demand will change with the change in price to demand to the change in any factor.
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Elasticity & it’s Effects
Different types of Elasticity of Demand:
1. Price Elasticity of Demand2. Income Elasticity of Demand3. Cross Elasticity of Demand4. Advertisement Elasticity of Demand
1. Price Elasticity of Demand:
We will discuss how sensitive the change in demand is to the change in price. The measurement of this sensitivity in terms of percentage is called price Elasticity of Demand. According to Marshall, Price Elasticity of Demand is the degree of responsiveness of demand to the change in price of that commodity.
An important aspect of a product's demand curve is how much the quantity demanded changes when the price changes. The economic measure of this response is the price elasticity of demand.
Price elasticity of demand is calculated by dividing the proportionate change in quantity demanded by the proportionate change in price. Proportionate (or percentage) changes are used so that the elasticity is a unit-less value and does not depend on the types of measures used (e.g. kilograms, pounds, etc).
As an example, if a 2% increase in price resulted in a 1% decrease in quantity demanded, the price elasticity of demand would be equal to approximately 0.5. It is not exactly 0.5 because of the specific definition for elasticity uses the average of the initial and final values when calculating percentage change. When the elasticity is calculated over a certain arc or section of the demand curve, it is referred to as the arc elasticity and is defined as the magnitude (absolute value) of the following:
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Elasticity & it’s Effects
[(Q 2−Q 1)/((Q1+Q 2)/2)]/ [(P 2−P 1)/ ((P 1+P 2)/2)]
Where,
Q1 = Initial quantity Q2 = Final quantity P1 = Initial price P2 = Final price
The average values for quantity and price are used so that the elasticity will be the same whether calculated going from lower price to higher price or from higher price to lower price. For example, going from $8 to $10 is a 25% increase in price, but going from $10 to $8 is only a 20% decrease in price. This asymmetry is eliminated by using the average price as the basis for the percentage change in both cases.
For slightly easier calculations, the formula for arc elasticity can be rewritten as:
( Q2 - Q1 ) ( P2 + P1 )
( Q2 + Q1 ) ( P2 - P1 )
To better understand the price elasticity of demand, it is worthwhile to consider different ranges of values.
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Elasticity & it’s Effects
i.) Elasticity > 1
In this case, the change in quantity demanded is proportionately larger than the change in price. This means that an increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue. In the extreme case of near infinite elasticity, the demand curve would be nearly horizontal, meaning than the quantity demanded is extremely sensitive to changes in price. The case of infinite elasticity is described as being perfectly elastic and is illustrated below:
From this demand curve it is easy to visualize how an extremely small change in price would result in an infinitely large shift in quantity demanded.
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ii.) Elasticity < 1
In this case, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic.
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iii.) Elasticity = 1
This case is referred to as unitary elasticity. The change in quantity demanded is in the same proportion as the change in price. A change in price in either direction therefore would result in no change in revenue.
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2. Income elasticity of demand:
In economics, the income elasticity of demand measures the responsiveness of the quantity demanded of a good to the change in the income of the people demanding the good. It is calculated as the ratio of the percent change in quantity demanded to the percent change in income. For example, if, in response to a 10% increase in income, the quantity of a good demanded increased by 20%, the income elasticity of demand would be 20%/10% = 2.
3. Cross elasticity of demand:
In economics, the cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demand of a good to a change in the price of another good.
It is measured as the percentage change in quantity demanded for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the quantity of new cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of demand would be -20%/10% = -2.
4. Advertisement Elasticity of Demand:
The degree of responsiveness of quantity demanded to the change in the advertisement expense of expenditure.
Ea= Change in quantity demanded x original advertisement expenses change in advertisement expenses original quantity demanded.
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2.) Elasticity of Supply
A measure of how much the quantity supply of a good responds to a change in a price of that good, computed as the percentage in quantity supplied divided by the percentage change in price.
The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa.
Supply elasticity is the degree of responsiveness of the quantity supplied to a change in price. It is calculated as
Es = % change in quantity / % change in price.
Supply Elasticity Determinants
The major determinants of supply elasticity are- the time framework (market period, short run or long run),- the ability to shift resources.
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i.) Elasticity > 1
The % change in quantity > % change in price. Es>1.From the diagram below we see a small change in price brings about a large change in the quantity supplied.
ii.) Elasticity < 1
It is the reverse of elastic Es<1The % change in quantity < % change in price.From the diagram below we see a large change in price brings about a small change in the quantity supplied.
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iii.) Elasticity = 1
The % change in quantity = % change in price Es=1From the diagram below we see a change in price brings about an exact change in the quantity supplied.A 2% change in price brings about a 2% change in quantity supplied.
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Elasticity & it’s Effects
ELASTICITY MEASUREMENT
If elasticity were measured by absolute quantities, then it would be affected by the units of measure used for both price and quantity. To avoid this difficulty, elasticity is a ratio of relative changes in quantity and price:
Ed = (dQ/Q) / (dP/P)
Or
Ed = % change in quantity / % change in price.
MIDPOINT ELASTICITY
The calculation of elasticity using the formula of change in relative quantity over change in relative price results in different values depending on whether the starting point of the calculation is the highest or lowest price. To avoid this difficulty, both price and quantity are averaged: this is the equivalent of taking the elasticity at the midpoint of the price-quantity range.
Ed = [(Q2-Q1)/ ((Q1+Q2)/2)] / [(P2-P1)/ ((P1+P2)/2)]
OR
Ed= (Q2-Q1)/ (Q1+Q2) × (P1+P2)/ (P2-P1)
It should be noted that price elasticity of demand is always negativeand absolute values are often quoted without indicating the negative sign.
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TOTAL REVENUE AND ELASTICITY
If demand is elastic, then price and total revenue are inversely related; that is, if price is increased, total revenue decreases. If demand is inelastic, price and total revenue are directly related; that is, if price is increased, then total revenue increases as well.
SUMPTUARY TAX AND ELASTICITY
The purpose of a sumptuary tax is to change the pattern of consumption in a society. Such a sales tax will be effective only if the demand and supply are elastic. Indeed, if both or either are highly inelastic, no matter how large the tax is, the quantity will not change.
TAX REVENUE AND ELASTICITY
If the purpose of a sales tax is to raise revenue for the government, such tax will be effective only if demand and supply are inelastic. Indeed, if both or either are elastic - which they usually are in the long run - the decrease in quantity purchased will cause the additional revenue from the tax to be minimal or even negative.
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TAX INCIDENCE AND ELASTICITY
Technically a sales tax is paid by the consumer; the seller only collects the tax on behalf of the taxing authority. A further analysis of the incidence of a sales tax (i.e. the analysis of who really bears the burden of the tax) reveals that the burden of the tax is shared. The price increase resulting from the sales tax reduces the quantity traded and forces the seller to lower the selling price.
1) TAX INCIDENCE AND ELASTIC DEMAND
If the demand is highly elastic (that is, customers are able to switch), the supplier will be forced to lower selling prices considerably to continue on selling some of his/her products. Thus, if demand is elastic while supply is inelastic the burden of the tax is shifted almost in its entirety to the supplier.
2) TAX INCIDENCE AND ELASTICI SUPPLY
When supply is elastic, an increase in sales taxes will result in a large increment in the price paid by consumers and the tax burden being largely paid by consumers. When supply is inelastic, an increase in sales taxes will result in a price reduction by sellers, and the tax burden is largely paid by sellers.
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Effect on Consumer and Producer
1. Consumer surplus
When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.
• Consumer surplus is a measure of the welfare that people gain from consuming goods and services.• Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).• Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.
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2. Producer surplus
Producer surplus is the additional private benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for. In other words they received a reward that more than covers their costs of production.
The producer surplus derived by all firms in the market is the area from the supply curve to the price line, EPB.
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References
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Books:
1. Principle of Economics
2. Introduction to Economics
Websites:
1. www.blackwell.com 2. www.netmba.com 3. http://www.businessdictionary.com/definition/elasticity-of-demand.html#ixzz3SS5lp12a
4. http://aboutcareerchoices.blogspot.com/2008/01/explain-different-types-of-elasticity.html
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