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2.4 Elasticity of Demand and Supply

(A) Price Elasticity

i) Elasticity of Demand: Elasticity of demand can be classified into two major divisions: one the highly elastic, unitary elastic and the highly inelastic type and two, the extreme cases of the perfectly elastic and the perfectly inelastic type.

a) Highly elastic, Unitary elastic and highly inelastic: The laws of demand and supply are no doubt an important part of economic analysis. But the knowledge about demand and supply relations serves only a limited purpose. This is in view of the fact that both demand and supply laws are applicable to all kinds of goods. However, an actual rise or fall in the quantity demanded or supplied with a small variation in the price may considerably differ for different goods such as food, automobiles, film shows, garments, hardware materials, machines, land etc. In other words it is important to know the extent of rise or fall in the demand with a given change in the price for each individual good. This is exactly the purpose served by the concept of price elasticity of demand; this concept is advanced and subtle in nature. It was first developed by Alfred Marshall; he has defined elasticity as follows:

Elasticity of demand is the degree of responsiveness with which quantity demanded changes for a given change in price.

In other words it is a proportional change in the quantity demanded to a proportional change in price.

Price Elasticity of demand is then the ratio of the proportional change in the quantity demanded to the proportional change in price.

Proportional change in quantity can be expressed as        where q1 is the initial and q2 is the new quantity demanded.

Proportional change in price is similarly   where P1 is initial and P2 is the new price.

Elasticity ratio e is therefore,    

If symbols q and P are used for small variations in quantity and price respectively then,

Note that Dq / Dp is in the limit derivative or marginal change and p/q is the reciprocal of average change, therefore

Letís illustrate this. In our demand schedule example above, when price changes from 2 to 3 units, the quantity demanded changes from 4 to 1 units. Substituting these values we have:

Note that the elasticity ratio 3/2 is more than one and has a negative sign. Both these are important features. Numerical values explain the extent or degree of change in demand while the sign of the ratio explains the direction of change. Since the law of demand is based on the inverse relation between price and quantity, the elasticity of demand is always stated with a negative sign.

The numerical value of elasticity can be equal to 1 (that is called Ďunití) more than one or less than one. In case of unit elastic demand (e = 1) both price and quantity (demanded) changes occur in the same proportion. If the value of elasticity exceeds one (e > 1) then the percentage or proportional change in quantity demanded is greater than that in price and the good is said to be price elastic or highly responsive to a change in price. If the value of elasticity is less than one (e < 1) then the proportional change in quantity is smaller than that in price and the demand for the good is said to be price inelastic or not very responsive to a change in price. The information about the value of elasticity therefore serves an important purpose in classification of various goods as elastic or inelastic in demand. This helps in several practical and policy applications such as taxation, foreign trade, monopoly, price determination etc.

There are four methods of measurement of elasticity of demand. These are percentage, proportion, outlay and geometric or point elasticity methods. The one mentioned last (point elasticity method) is the most accurate and can be explained conveniently with a given demand curve:

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Index

2. 1 Fundamental Concepts
2. 2 Demand Schedule, Function and Law
2. 3 Supply Schedule, Function and Law
2. 4 Elasticity of Demand and Supply
2. 5 The Concept of Equilibrium

Chapter 3

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