ELASTICITY OF DEMAND by Srikant Devaraj

Supply and Demand:

Supply and demand form the backbone of economics and govern the laws of the economic market. The inter relationship between them have long defined the allocation of resources in the market. The quantity of demand and supply relate to the responsiveness of the product in the market and in turn define its requirement. (Investopedia, 2003) This change of demand/supply of product leads to the concept of Elasticity. I would like to begin this paper by giving an example of the relationship between demand, supply and price.

Consider a new video game in the market. Based on the company’s previous research, consumers would not buy games higher than for $300 only 30 were released because the opportunity cost is too high for suppliers to produce more. If, however, the 30 games are demanded by 50 people, the price will subsequently rise because, according to the demand relationship. As the demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied since the supply relationship shows that the higher the price, the higher the quantity supplied.


However, if there are 30 video games console’s produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover consoles might drop as the producers attempt to sell the remaining. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD was too high.


Elasticity:

The Economics glossary defines elasticity as:
"Elasticity is a measure of responsiveness to change. The responsiveness of behavior measured by variable Z to a change in environment variable Y is the change in Z observed in response to a change in Y. Specifically, this approximation is common:
Elasticity = (percentage change in Z) / (percentage change in Y)
The smaller the percentage change in Y is practical, the better the measure is and the closer it is to the intended theoretically perfect measure." (Economics, 2009)

To put it in simple words elasticity is the degree of change in supply and demand curve with respect to price. The degree of change varies with the product/service concerned. However, for commodities that are necessities price changes do not have much effect since consumers would continue buying them irrespective of the increase in price. And similarly commodities that are not much of a requirement will deter more consumers in case of a price increase.

Price Elasticity of Demand:

Where the Law of demand states that the decrease in price increases the demand of the product, the price elasticity of demand determines how much of the quantity demanded responds to change in price, i.e., it’s the proportionate change in demand given a change in price. (Christensen, 2003)

Determinants of price elasticity of demand
The price elasticity of demand depends on many economic, social and physiological factors, however some of the general rules include: (Bamford and Munday, 2002)
Substitute availability: There is a simple relationship here, greater the substitute greater is the elasticity. For example if we consider butter and margarine, an increase in the price of margarine while the butter remains same causes the sale of margarine to reduce drastically since its substitutable. Whereas in case of eggs where there is no substitute its less elastic.
Necessarily Vs Luxury: Necessities tend to have a constant demand curve while luxury goods tend to fluctuate. For example in case of increase in college tuition would not cause students to stop classes in the middle of the semester, however when the real estate market faces a price shoot up the number of buyers definitely dwindle.
Market definitions: Elasticity of demand also depends on how we define market boundaries. Narrowly defined markets are more elastic than broadly defined ones. For example food in general is broad and exhibits a constant demand, while if we narrow down to cookies, there are many substitutes and depicts an inelastic relationship.
Income: Products requiring a larger portion of the consumer’s income tend to be more elastic.
Permanent or temporary price change: A one day sale would have different response than an individual price decrease of the same magnitude.
Time Factor: Goods and services tend to have a more elastic effect over a longer period of time.

Calculating the price elasticity of demand

Since price elasticity of demand is change in price for quantity demanded, mathematically it amounts to:
Price elasticity of demand = Percentage change in quantity demanded /Percentage change in price
For example, a 10% increase in the price of a tread mill causes the amount of the equipment bought to fall by 20 %. So the price elasticity of demand is
Price elasticity of demand = -20 % / 10% = - 2

Demand is said to be inelastic when he absolute value of the own price elasticity is lesser than 1, i.e, percentage change in quantity decreases when there is a change in price. In certain situations, the demand remains inelastic, inspite of pieces being higher. This is infact true for a number of medicaions that are available to treat certain conditions, where there is no subsititute. Demand remains constant in spite of high prices. Also, take the case of fuel consumption, where only few substitutes exist. During 2006, when the fuel prices were at its maximum, the demand for gasoline was affected only slighly. Although there were very few alternatives like hybrid cars, they still continued to purchase gasoline and the demand was indeed considered inelastic. Another typical example would be water, where there is no substitute. (Christensen, 2003)


Demand is said to be unitary elastic when the absolute value of the own price elasticity is equal to 1. (Baye, 2009)
Below figure represents graphical representation of three types of elasticity.
1_sri.jpg


The rule of thumb is that the price elasticity for most products is near to 1.0. For most consumer goods and services price elasticity is in between 0.5 to 1.5. The table 1 below shows estimated price elasticity’s of demand for a variety of consumer goods and services: (Anderson, 1997)









Estimated Price Elasticity’s of
Demand for Various Goods and Services
Source: (Anderson, 1997)



Goods



Estimated Elasticity of Demand





Inelastic

Salt
0.1
Matches
0.1
Toothpicks
0.1
Airline travel, short-run
0.1
Gasoline, short-run
0.2
Gasoline, long-run
0.7
Residential natural gas, short-run
0.1
Residential natural gas, long-run
0.5
Coffee
0.25
Fish (cod) consumed at home
0.5
Tobacco products, short-run
0.45
Legal services, short-run
0.4
Physician services
0.6
Taxi, short-run
0.6
Automobiles, long-run
0.2


Approximately Unitary Elasticity

Movies
0.9
Housing, owner occupied, long-run
1.2
Shellfish, consumed at home
0.9
Oysters, consumed at home
1.1
Private education
1.1
Tires, short-run
0.9
Tires, long-run
1.2
Radio and television receivers
1.2


Elastic

Restaurant meals
2.3
Foreign travel, long-run
4.0
Airline travel, long-run
2.4
Fresh green peas
2.8
Automobiles, short-run
1.2 - 1.5
Chevrolet automobiles
4.0
Fresh tomatoes
4.6

Marginal revenue – Relationship with elasticity of demand

In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring. Marginal revenue (MR) is the change in total revenue per unit change in output. Since MR measures the rate of change in total revenue as quantity changes, MR is the slope of the total revenue (TR) curve
.
The Total Revenue Test states that if demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total revenue. And if demand is inelastic, an increase (decrease) in price will lead to an increase (decrease) in total revenue. Total revenue is maximized at the point where demand is unitary elastic. (Baye, 2009)

The figure below represents the relationship between Marginal revenue and total revenue with the elasticity of demand. The green curve indicates Total revenue, Yellow line indicates Marginal revenue and Red line indicates demand curve.







2_sri.jpg

(Source: Truett and Truett, 2006 )

From the above graph we can conclude that the Marginal revenue is positive only when demand elasticity is greater than unity, i.e., a price fall causes proportionately larger increase in quantity demanded. It also shows that when price falls, the total revenue increases and marginal revenue is positive. Hence Marginal curve lies above the horizontal axis. Similarly, the Marginal revenue is negative whenever elasticity of demand is lesser than unity, i.e., a price fall causes proportionately smaller increase in quantity demanded. It also shows that when price falls, the total revenue falls and marginal revenue becomes negative. This marginal curve lies below the horizontal axis. (Truett and Truett, 2006)


Moving from left to right on the bottom graph indicates what happens to total revenue as price is lowered and the quantity sold increases. At lower quantities (higher prices) demand is elastic. Quantity increases are relatively greater than price decreases and total revenue increases as more units are sold. This means a company facing an elastic demand can increase revenue by decreasing price.


When demand becomes inelastic, quantity increases are now relatively less than price decreases, and total revenue falls. This means a company could increase total revenue by increasing price and selling fewer units. This could mean a very high profit. Important questions to be answered concern how competitors react to these higher prices, can the company produce lower quantities at reasonably low costs, exactly how much profit will the company make, and how will the government react to these higher profits. When demand is elastic, price and total revenue move in the opposite direction. When demand is inelastic, price and total revenue move in the same direction.
(Truett and Truett, 2006)

The following table shows the consolidation of results obtained from the above graph:






Marginal Revenue
Total Revenue
Price Elasticity of Demand
MR > 0
TR increases as Quantity increases
Elastic
E > 1

MR = 0
TR is maximized
Unit Elastic
E = 1

MR < 0
TR decreases as Quantity increases
Inelastic
E < 1

A firm maximizes its profits at the point where marginal revenue is equal to marginal cost. Since marginal cost is predictably positive, marginal revenue should be positive too. Therefore marginal revenue cannot be positive unless and until the elasticity of demand is numerically greater than 1. (Spraos, 1956) I would cite the fuel costs set by OPEC as an example. When the demand of fuel increases, OPEC tries to increase their production to meet the demand and set their prices higher. When the demand of fuel decreases, they try to reduce production, cut their supplies so that there will be increase in demand for the fuel. Therefore in both the cases, they earn revenues by changing the production rate.

Elasticity of Supply

Elasticity of supply is the ratio of relative change of the quantity supplied to the relative change in the supply price. In other words, it is a measure of how much the quantity supplied of a good responds to a change in the price of that good. This is important for the suppliers as they indicate how much production will increase or decrease with a given price change. The price elasticity of supply is used to see how sensitive the supply of a good is to a price change. The higher the price elasticity, the more sensitive producers and sellers are to price changes. High price elasticity suggests that when the price of a good goes up, sellers will supply a great deal less of the good and when the price of that good goes down, sellers will supply a great deal more. Low price elasticity implies just the opposite, that changes in price have little influence on supply. (Bittermann, 1934)

Determinants of the Price Elasticity of Supply
They are
a) Flexibility of sellers: goods that are somewhat fixed in supply have inelastic supplies.
b) Time horizon: supply is usually more inelastic in the short run than in the long run.
c) Production possibilities: Goods that can be produced at a constant (or very gently rising) opportunity cost have an elastic supply. Goods that can be produced in only a fixed quantity have a perfectly inelastic supply.
d) Storage possibilities: The supply of a storable good is highly elastic. The cost of storage is the main influence on the elasticity of supply of a storable good. (Bittermann, 1934)
Supply is said to be elastic (inelastic) if the elasticity exceeds (is less than) 1. The more elastic supply is, the more will a change in price increase production. Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. (Bade and Parkin, 2002)

Perfectly Elastic Supply
An almost zero percentage change in price brings a very large percentage change in the quantity supplied.
3_sri.jpg

A small rise in the price decreases the quantity supplied by a very large amount, i.e., supply is perfectly elastic.

Elastic Supply

The percentage change in the quantity supplied exceeds the percentage change in price.

4.jpg

A 10% increase in the price of a book, increases the quantity supplied by 20%, i.e., the supply of books is elastic.

Unit Elastic Supply
The percentage change in the quantity supplied equals the percentage change in price.


5.jpg


A 10% increase in the price of fish, increases the quantity supplied of fish by 10%, i.e., the supply of fish is unit elastic.

Inelastic Supply
The percentage change in the quantity supplied is less than the percentage change in price.

6.jpg

A 20% increase in the price of a hotel room, increases the quantity supplied of rooms by 10%, i.e., the supply of hotel rooms is inelastic.

Perfectly Inelastic Supply

The percentage change inthe quantity supplied is zero when the price changes.

7_sri.jpg



A small rise in the price of a beachfront lot, increases the quantity supplied by 0%, i.e., the supply of beachfront lots are perfectly inelastic. (Bade and Parkin, 2002)

Another application for elasticity of supply is the gold. Price of gold is volatile, sometimes shooting upwards one moment and dramatically decreasing the next. This happens because of shifts in demand and highly inelastic supply. Gold production is expensive and time consuming to process.

Cross Price Elasticity

Cross elasticity of demand is the % change in quantity demanded divided by the % change in the price of a substitute or complement. It measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant (Baye, 2009).

Cross elasticity is positive for goods that are substitutes.
Cross elasticity of demand is positive if the sales of product X move in the same direction as a change in the price of product Y. Larger the positive cross-elasticity coefficient, greater the substitutability between the two products. For example, when the price of hot dogs increases, the quantity of hamburgers demanded increases.

Cross price elasticity is negative for goods that are complements. When c
ross elasticity is negative: increase in price of product X decreases the demand for product Y. Larger the negative cross-elasticity coefficient, greater the complimentarily between the two products. For example, when the price of hot dogs increases, quantity of hot dog rolls demanded decreases.

A product's substitutability, measured by the cross-elasticity coefficient, is important in businesses and government because the demand for their products is directly affected by the price of other products. The figure below shows the cross price elasticity of demand between Pizza’s, soda and burgers. (Bade and Parkin, 2002)


8.jpg

Pizzas and burgers are substitutes, therefore Cross elasticity is positive.
Pizzas and soda are complements therefore Cross elasticity is negative.

Some of the cross price elasticity of goods is mentioned below:


Item
Market
Elasticity
Consumer products



clothing/food
U.S.
0.1
gasoline (competing stn)
Boston, MA
1.2
Utilities



electricity/gas (residential)
Quebec
0.1
electricity/oil (residential)
Quebec
0
bus/subway
London
0.25


Another application for cross price elasticity is the market for carbonated soft drinks industry. The rivals coke and pepsi are typical examples. The sales of Coke will fall if the price of Pepsi falls because some Coke drinkers will switch from Coke to Pepsi. The own and cross price elasticities for regular carbonated soft drinks is given in below table: (Cotterill, 1994)


9.jpg


Significant complements rather than substitute relationships is reflected in the above table. Sprite, a clear soda, for example, has a negative (complementary) cross price elasticity of (–0 .090) in the Coke demand equation and Coke is a complement in the Sprite equation. Since these brands are both produced by the Coca Cola Company the results do provide some evidence on the extent to which companies position and market products as complements rather than substitutes. Mountain Dew, a Pepsico brand, however has a positive (substitute) cross price elasticity in the Pepsi demand equation.


Complementary demand relationships were not expected among these competing regular soft drink products. When Coke, for example, lowers its price, shoppers are attracted and pickup some Sprite as a complementary product to provide “variety” or a clear soda for the non-coke crowd. Other strong complementary relationships exist for the following two pairs: Seven-Up and private label, and Mountain Dew and Dr. Pepper. (Cotterill, 1994)


Income Elasticity

Income elasticity of demand is the % change in quantity demanded divided by the % change in income. Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant. (Baye, 2009)

Income elasticity is positive for Normal (Superior) Goods such as steak and vacations - more is purchased as income increases. A positive income-elasticity coefficient symbolizes a normal good; income and quantity demanded move in same direction

Income elasticity is negative for Inferior Goods such as bread and hamburger - less is purchased as income increases. A negative income-elasticity coefficient represents an inferior good (Ex. retread tires, cabbage, used clothing). A negative coefficient means that the income and quantity demanded move in opposite directions. i.e., as the income increases, the demand for the good decreases meaning it is inferior.

The below figure shows the demand curves for all the three types of income elasticity. (Bade and Parkin, 2002)

10.jpg



The below table indicates the income elasticity for various products.

Item
Market
Elasticity
Consumer products


cigarettes
U.S.
0.1
liquor
U.S.
0.2
food
U.S.
0.8
clothing
U.S.
1
newspapers
U.S.
0.9
Utilities


electricity (residential)
Quebec
0.1
telephone service
Spain
0.5

The demand for necessities tends to be relatively less income elastic than the demand for discretionary items. For example the demand for clothing is more sensitive to income than demand for food.
The below table reflects the budget shares and income elasticites of various consumption categories across the world. (Regmi et al., 2006)


11.jpg



Based on the above table, low-income countries spend a greater portion (47 percent) of their total expenditures on food compared with richer countries, which on average spend 13 percent of their total budget on food. In general, lower income countries spend a greater proportion of their budget on necessities such as food, while richer countries spend a greater proportion on luxuries. With income elasticity below one, food, beverages and tobacco, and clothing and footwear appear to be necessities in all countries, while education, gross rent, fuel and power, house operations, medical care, recreation, transport and other groups are all luxuries. (Regmi et al., 2006)



Coverage from Science of Success:


Koch’s Market-Based Management system acts as a stepping stone between how individual performance can be improved and how liberty can free societies to accomplish more. It is based on five dimensions: vision, virtue and talents, knowledge processes, decision rights, and incentives. (Koch, 2007)

Vision is about finding when and how an organization can create the greatest long-term value. It uses experimentation to develop value delivered for customers based on what the finest opportunities are and what the organization can most successfully accomplish.

Virtues and talents ensure that people with the right values, skills, and capabilities are hired, retained, and developed. In short, it attracts and retains people who want to follow the right principles with suitable talents for the tasks.

Knowledge processes involve creating, acquiring, sharing, and applying relevant knowledge, and measuring and tracking profitability. In short, it analytically adds to, disseminates, and applies knowledge related to profitability.

Decision rights ensure that the right people are in the right roles with the right authorities to make decisions and holding them responsible. It encourages people to become better decision makers after they have developed their skills and to be accountable for the decisions they make.

Finally, incentives reward employees as much as possible by the long-term value they have helped deliver for the organization. (Koch, 2007)


MULTIPLE CHOICE QUESTIONS:


1. In measuring the sensitivity of demand, the
a. price and income elasticities refer to movements along the demand curve; other elasticities refer to shifts of the entire demand curve
b. price and cross-price elasticities analyze movements along the demand curve; other elasticities refer to shifts of the entire demand curve
c. income and cross-price elasticities refer to movements along the demand curve; price elasticity refers to shifts of the entire demand curve
d. price elasticity refers to movements along the demand curve; income and cross-price elasticities refer to shifts of the entire demand curve

ANSWER: D - The price elasticity usually considers the movement along the curve. Cross-price and Income elasticity considers the shift of entire demand curves.

2. The value of price elasticity of demand:
a. Depends on the units that are used to measure quantities
b. Has the same value as the slope of the demand curve
c. Depends on the units that are used to measure prices
d. Do not depend on the units in which quantity and price are measured.

ANSWER: D - The units of measurement of price and quantity are independent of the value of price elasticity.

3. If the income elasticity of demand is 1, then
a. A 5 % increase in income will induce a 1% increase in purchases of good
b. A 5 % decrease in income will induce a 5% decrease in purchases of good
c. A 5 % increase in income will induce a 5% decrease in purchases of good
d. A 5 % increase in income will induce a 5% increase in purchases of good

ANSWER: B - Income elasticity = % change in quantity demanded / % change in income = -5% / -5% = 1

4. Currently you purchase 4 packages of hot dogs a month. You will graduate from Ball State University in May and you will start a new job in June. You have no plans to purchase hot dogs in June. For you, hot dogs are
a. A substitute good.
b. A normal good.
c. An inferior good.
d. A law-of-demand good.

ANSWER: C - When income increases, less of hot dogs will purchased.

5. For a good that is a necessity,
a. Quantity demanded tends to respond significantly to a change in price.
b. Demand tends to be inelastic.
c. The law of demand often does not apply.
d. All of the above are correct.

ANSWER: B - Necessity's will have constant demand even when there is an increase in price.


REFERENCES:

Anderson, P.L., McLellan, R, Overton, J.P., & Wolfram, G. (1997, November). Estimated Price Elasticities of Demand for Various. Mackinac Center Report, November, 67.

Bade, R., & Parkin, M. (2002). Foundations of Microeconomics. Retrieved March 20, 2009, from Elasticities of demand and Supply Web site: http://www.unf.edu/~traynham/ch05lecture.pdf

Bamford, C.G., & Munday, S.C.R (2002). Markets – Studies in Economics and Business. Heinemann Educational Publishers,[27-30].

Baye, M. R. (2009). Managerial Economics and Business Strategy, 6th Edition. St. Louis: McGraw-Hill Irwin.

Bittermann, H.J (1934).Elasticity of Supply. The American Economic review. 24(3), [417-429].

Christensen, T.E. (2003). Wisegeek. Retrieved March 20, 2009, from Price elasticity of demand Web site: http://www.wisegeek.com/what-is-price-elasticity-of-demand.htm

Cotterill, R.W (1994).Scanner Data: New Opportunities for Deman and Competitive Strategy Analysis. Agricultural and Resource Economics Review. 23(2), 138.

Economics, (2009). About.com. Retrieved March 20, 2009, from Definition of Elasticity Web site: http://economics.about.com/cs/economicsglossary/g/elasticity.htm

Investopedia, (2003). Investopedia. Retrieved March 20, 2009, from Economics basics - Demand and Supply Web site: http://www.investopedia.com/university/economics/economics3.asp

Koch, C.G. (2007). The science of success: How market-based management built the world's largest private company. John Wiley & Sons.

Regmi, A., Deepak, M.S., Seale, J.L., & Bernstein, J (2006). Cross-Country Analysis of Food Consumption Patterns. Applied Economics, 38(13), 16.

Spraos, J (1956).Imperfect Competition and the Elasticity of Demand for Imports. The Economic Journal. 66(261), [171-173].

Truett, L.J., & Truett, D.B. (2006). Managerial Economics - 8th edition.John Wiley & Sons.