# Elasticity of demand

Document Sample

Assignment No.1

Micro Economics

Topic: Importance of elasticity of demand & supply
And Factors Effecting on it

Submitted By
Tehseen Javed
Roll No: 2789
Class MBA 9E

Submitted To
Sir. Abdul Rehman

Punjab College of Information Technology
Elasticity of Demand

By demand we mean, the quantity of any commodity which a consumer wants to buy
and has purchase power. The quantity demand of a commodity is a function of price
of that commodity. It is started that “other things remaining same the quantity
demanded depends upon price and there exists and inverse relationship between
price and quantity demand”
According to Alfred Marshall, “other things being equal with fail in price, the demand
of the commodity is extended and with a rise in price, demand is contracted”

%Qd
Ed 
%P
%change in quantity demanded
Ed 
%change in price

Importance of Elasticity of Demand

   If the business is producing a price elastic good, a small percentage change in
price leads to a large percentage change in quantity demanded. Lowering the
price will have the effect of increasing total revenue and raising the price will
decrease total revenue, e.g., if the price of Mars Bars increased by 25%
ceteris paribus, we would expect their sales to fall dramatically as consumers
shift to other chocolate bars. This would have the effect of reducing their total
revenue.

   If the business is producing on the unitary price elasticity section of the
demand curve, small changes in price do not change total revenue as a
percentage change in price will be exactly offset by an inverse change in
quantity.

   If the business is producing price goods, a small percentage change in price
leads to a smaller percentage change in quantity demanded. This will have
the effect of increasing total revenue when the price is increased and
decreasing total revenue when the price falls. For example if a firm invented a
miracle cure for the common cold and decided upon a price of 50p a pack.
The firm sold 10 million packs in the first year of sales. Next year they decide
to raise prices by 25% and sales fall to 9 million (10% fall), the level of sales
have dropped, but the total revenue has increased

   It is important to note that the revenue maximizing level of production occurs
when elasticity is unitary, but this isn't necessarily the level where profit is
maximized. We don't know the firm's costs at different levels of output.
Furthermore elasticity is notoriously difficult to calculate and errors in the
elasticity figures could lead to incorrect pricing decisions.

   There are two graphs in Figure each showing a different possible demand
curve for oil in the world. We want to show why it is important to know which
of these two demand curves is correct, or at least which one gives a better
description of economic behavior in the oil market. Each graph has the price
of oil on the vertical axis (in dollars per barrel) and the quantity of oil
demanded on the horizontal axis (in millions of barrels of oil a day).Both of
the demand curves pass through the same point A, where the price of oils
\$20 per barrel and the quantity demanded is 60 million barrels per day. But
observe that the two different curves show different degrees of sensitivity of
the quantity demanded to the price. In the top graph, where the demand
curve is relatively flat, the quantity demanded of oil is very sensitive to the
price; in other words, the demand curve has a high elasticity. For example,
consider a change from point A to point .When the price rises by \$2, from \$20
to \$22, or by 10 percent (\$2/\$20 .10, or10 percent), the quantity demanded
falls by 12 million, from 60 million to 48 million barrels a day, or by 20
percent (12/60 .20 or 20 percent).On the other hand, in the bottom graph,
the quantity demanded is not very sensitive to the price; in other words, the
demand curve has a low elasticity. It is relatively steep. When the price rises
by \$2, or 10 percent, from point A to point C, the quantity demanded falls by
3 million barrels, or only 5 percent. Thus, the sensitivity of the quantity to the
price, or the size of the elasticity, is what distinguishes these two graphs.
   An attractive feature of the price elasticity of demand is that it does not
depend on the units of measurement of the quantity demanded—whether
barrels of oil or pounds of peanuts. It is a unit-free measure because it uses
percentage changes in price and quantity demanded. Thus, it provides a way
to compare the price sensitivity of the demand for many different goods. It
even allows us to compare the price sensitivity of less expensive goods—like
rice—with that of more expensive goods like steak. For example, suppose that
when the price of rice rises from 50 cents to 60 cents per pound, the quantity
demanded falls from 20 tons to 19 tons: That is a decline of 1ton for a 10
cent price increase. In contrast, suppose that when the price of steak rises by
\$1, from \$5 to \$6 per pound, the quantity demanded falls by 1 ton, from 20
tons to 19 tons of steak. That would be a decline of 1 ton for a 1 dollar price
increase. Using these numbers, the price sensitivity of the demand for steak
and the demand for rice might appear to be very different: 10 cents to get a
ton of reduced purchases versus \$1 to get a ton of reduced purchases. Yet
the elasticity’s are the same. The percentage change in price is 20 percent in
each case (\$1/\$5 \$.10/\$.50 .20, or 20 percent), and the percentage change
in quantity is 5 percent in each case: 1 ton of rice/20 tons of rice 1 ton of
steak/20 tons of steak .05, or 5 percent. Hence, the elasticity is 5/20 1/4 in
both cases.

Factors Effecting The Elasticity of Demand

Good with close substitutes tend to have elastic demand curves. The demand for
good ''A'' is ''price sensitive'' to changes in the price of good ''B'', because they both
satisfy the same want. The demand for one brand of butter will vary, if another
brand is put on ''special'' at your local supermarket.
''Necessities'' tend to have inelastic demand curves. If households see a good as
essential to daily living, demand for the good will be ''price insensitive''. For example,
if the price of milk rose by 50 cents a liter, demand for milk would not change
greatly. All households want milk.
Luxuries on the other hand tend to have elastic demand curves. If soft drinks are put
on ''special'' at your local supermarket, and their price is lowered, demand for them
will rise markedly. Part of this ''necessities'' versus ''luxuries'' distinction is based on
the cost of the item. Many necessities are inexpensive: they have low prices - a loaf
of bread, a liter of milk, a box of matches, all only cost a very small part of your
available disposable income. An increase in the price of a liter of milk of 50 cents is
still ''small change'' for many consumers, and they will continue to demand milk at
the same levels as they did before the price rise. Luxuries on the other hand can be
very expensive and cost a large part of your available disposable income. You may
decide not to buy that French champagne to celebrate a birthday, if the price rises
from \$30 to \$32. The price of \$30 is already a large enough disincentive.
Elasticity of Supply
To what extend quantity supply     Q S decrease   as a increase in price of a produce
while other things remaining the same
If you produce sales in high price you will increase the price

dQ Q
qS        
dP P
Importance of Elasticity of Supply

   Now let us look at the importance of knowing the size of the supply elasticity
even if it is not at one of these two extremes. Figure shows two different
supply curves for coffee. The horizontal axis shows the quantity of coffee
supplied around the world in billions of pounds; the vertical axis shows the
price in dollars per pound of coffee. For the supply curve in the top graph, the
quantity supplied is very sensitive to the price; the price elasticity of supply is
high. For the supply curve in the bottom graph, the price elasticity of supply
is much lower.

The price elasticity of supply is important for finding out the response of price
to shifts in demand. This is shown in Figure where the demand for coffee
declines, perhaps because of concerns about the effect of the caffeine in
coffee or because of a decrease in the price of caffeine-free substitutes for
coffee. In any case, if the price elasticity of supply is high, as in the top
graph, the price does not change as much as when the price elasticity of
supply is low, as in the bottom graph. With a high price elasticity, a small
change in price is enough to get firms to bring the quantity supplied down to
the lower quantity demanded.
   Elasticity of supply is influenced by a number of factors. These include: length
of the production period.

In the late 1990's, demand for Australia wines overseas has reached all time
records. Vines take three years to grow to a point where they yield adequate
amounts of fruit. Increases in demand for Australian wine has seen prices rise
(from Po to P1), and returns to existing grape growers are excellent. Those
who wish to buy grapes face a market where supply can only increase
marginally (from Qo to Q1), in the short term

   However, many new stands of vines are being planted, and in a few years,
returns to growers may stabilize, as supply increases. Prices will fall from P1
to P2 as the supply of grapes increases from Q1 to Q2.

.
Factors Effecting Elasticity of Supply
Supply curves have ''elasticity''. Just as demand curves do. The major factors
affecting the response of firms to changes in price are expectations of future
prices and time

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 views: 74 posted: 7/22/2011 language: English pages: 7