Introduction to Economics Chapter Two Demand, Supply and Elasticity Chapter Two 2. Theory of Demand and Supply 2.1 Introduction We began the study of economics by stressing the importance of scarcity in determining society's choice. Recall from chapter one that Economics is concerned with problem of scarcity. When there is free exchange (no government control and other barriers), prices will allocate scarce goods and services. Therefore, one of the major objectives of economics is to analyze the factors that determine the prices and quantities of commodities sold. The determinants of price and quantity sold (purchased) for analytical purpose are usually separated into two categories: factors affecting demand for a good and factors affecting supply of a good. The purpose of this chapter is to explain what demand and supply are and show how they determine price and quantity sold in markets. Moreover, concepts such as market equilibrium, elasticity, etc. are introduced. 2.2. The Theory of Demand 2.2.1. Definition of Key Concepts Demand is a willingness and ability of a consumer to purchase goods and services at specific price within a set of possible prices at a given period of time. Law of demand: This is the principle of demand, which states that, other things being constant, price of a commodity and it quantity demanded are inversely related i.e., as price of a commodity increases (decreases) quantity demanded for that commodity decreases (increases), ceteris paribus. Quantity demanded (Qd) of a commodity is the amounts of the commodity purchased at a given price level. The inverse relationship between the quantity demand and price of a commodity can be shown by a demand schedule and a demand curve. Demand Schedule is a table which shows how much of a good individuals are willing and able to buy at different price levels during a given period of time (week, month etc). Table 2.1: Hypothetical Demand Schedule for Teff. Price of teff (in Birr) 100 150 200 250 300 Qd for teff (in quintals) 40 35 25 15 10 Department of Economics, DDU 1 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity At each price level consumers buy definite quantity of teff. As price of teff increases from 100 Birr to 300 Birr, quantity demanded for the teff decreases from 40 quintals to 10 quintals. This demand schedule can also be depicted graphically as a demand curve for teff as follows. Price of teff teffteff 300 250 200 150 100 0 10 15 25 35 40 Quantity of teff Fig. 2.1: Demand curve for teff Demand curve of a commodity is a curve, which shows the relationship between the quantity demanded of the commodity at different price levels. In drawing the demand curve we singled out price of a commodity as the most important factor affecting the quantity demanded of the commodity and ignored the influences of other factors (hold all other influences constant). 2.2.2. Determinants of Demand The demand curve shows how a change in commodity's own price will affect the quantity demanded, but what determine the shape and the position of the curve itself? The shape and position of the demand curve depends on the following major determinants. That is to say, the following variables are also important determinants of quantity demanded of a commodity. However, we treat them separately from own price of a commodity because unlike change in own price level, change in these variables has quite different effect on the position of the demand curve itself. All the following variables cause demand curve to change its position and we call them shift variables of demand curve. As one of the following determinants changes assuming other things being constant demand curve shifts either to the right or to the left. A right ward (left ward) shift of the demand curve indicates an increase (a decrease) in demand. A. Tastes and Preferences of the Consumers Department of Economics, DDU 2 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity Individuals' preferences and tastes for particular commodity differ according to the satisfaction they get from the commodity. When people change their mind about taste and preference for a commodity demand for the commodity also changes. For example if consumers have favorable (unfavorable) taste and preference for a commodity the demand for commodity increases (decreases), other things being constant. Tastes and preferences of the individuals towards the consumption of egg increases if it is announced that consumption of egg is helpful in curing lung Cancer. For example, advertisement on different goods and services changes tastes and preferences of consumers and accordingly the demand for these goods and services changes. The following demand curve depicts the effect of a favorable tastes and preferences of a consumer on raincoat during rainy season. Price of Raincoat An increase in Demand A decrA eadecrease se in demin andemand d (a left (a waleft rd sward hift) shift) Quantity of raincoat Fig. 2.2: An individual demand for raincoat B. The Income of Consumers Other things being constant, as income of the consumers' increases (decreases) demand for normal goods increases (decreases), but demand for inferior goods decreases (increases). C. Prices of Related Goods If two goods are related, then the change in price of one good affects demand for the other. The related goods are either" substitute or "complementary" to each other in consumption. When price of its substitute good (Injera) increases (decreases), demand for the commodity (Bread) increases (decreases), ceteris paribus. As price of its complementary good (Fuel) increases (decreases) demand for that commodity (Car) decreases (increases), ceteris paribus. Department of Economics, DDU 3 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity D. Number of Consumers An increase in a number of consumers causes an increase in demand for commodities given that consumers have ability to pay for. For example, Addis Ababa with the total population of 3 million people buys commodities 3 times than the population of Nazareth with 1 million people. 2.2.3. Change in Quantity Demanded and Change in Demand The law of demand states that, ceteris paribus, price and quantity demanded of a commodity are inversely related. The demand curve is derived under the assumption of Ceteris Paribus i.e., other determinants of demand except own price are held constant. Thus, the demand curve shows how quantity demanded of a commodity varies when the price of the commodity changes. In this case we observe change in quantity demanded simply because of change in the price of a commodity, and the demand curve remained unchanged (not shifted). Thus, if we vary only price of a commodity and hold other determinants of demand (income, taste and preference, prices of related goods, expectation, number of consumers) constant, the demand curve does not shift. In this case as price varies we are moving along the same demand curve and we call this movement change in quantity demanded. The following graph shows change in quantity demanded from Q1 to Q2 or from Q2 to Q1 due to change in price of the commodity from P1 to P2 or from P2 to P1 respectively, ceteris paribus. Price A P1 Fig. 2.4: Change in quantity demanded (movement B along the same demand) P2 P3 C 0 Q1 Q2 Q3 Quantity If the price of a commodity (own price) remains constant and one or more of those other factors affecting demand (e.g., income, taste and preference, prices of other goods, Department of Economics, DDU 4 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity expectation and number of consumers) change, then the demand curve shifts from its position either to the right or to the left. Thus, when the demand curve changes its position we call it change in demand (shift in demand). Price D1 D0 D2 Fig. 2.5: Change in demand (shift in demand curve) P0 D1 D0 D2 0 Quantities When demand curve shifts from D0 to D2 we say increase in demand, i.e., shift of the demand curve to the right. When demand curve shifts from D0 to D1 (shift of demand curve to the left) we say decrease in demand. Increase in demand (shift from D0 to D2) is caused due to: increase in consumers' income for normal goods, favorable taste and preference for a commodity, expectation of higher price in the future, increase in the price of substitute goods, decrease in price of complementary goods and others, ceteris paribus the reverse is also true. Therefore, when we say increase (decrease) in demand we mean shift of the demand curve to the right (left). When we say increase (decrease) in quantity demanded we mean downward (upward) movement along the same demand curve. Note that an increase (decrease) in demand also implies purchasing of more (less) of goods at each price level. Thus, change in demand necessarily implies change in quantity demanded, but change in quantity demanded does not necessarily imply change in demand. Change in own price causes movement along the same demand curve without causing shift of the demand curve while change in other factors affecting demand cause shift in the demand curve. 2.2.4. Individual and Market Demand Curve Department of Economics, DDU 5 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity Individual demand curve is defined as amount of goods that a single consumer is willing and able to buy at different price levels over certain time period. Market Demand Curve is the total amount of goods that all consumers are willing and able to buy at each price level over certain time period. Table 2.2: Demand for wheat by three individual consumers over the last five months Price per Quintal (1) 300 260 220 180 140 100 60 Abebe's Demand (2) 0 2 4 6 8 10 12 Bekele's Demand (3) 3 6 9 12 15 18 21 Almaz's Demand (4) 5 10 15 20 25 30 35 Total (market) Demand 5 = 2+3+4 8 18 28 38 48 58 68 From this table we can see that market demand is the horizontal summation of the demand of those three consumers, which can be shown as individuals and market demand curve as follows. 300 260 + = 220 180 140 100 60 0 2 4 6 8 10 12 3 6 9 12 15 18 21 3 8 13 18 23 28 33 ig. 2.6: Individual and Market Demand Curves: Quantity of wheat 2.3. The Theory of Supply 2.3.1. Definitions Supply refers to the willingness and ability of producers to produce goods and services and make available for sale in the market at a given price level within a set of possible prices over certain period of time (e.g., week, month, year, etc). Department of Economics, DDU 6 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity Law of Supply states that other things being equal the quantity supplied of a commodity varies directly with the price of that commodity i.e. quantity supplied increases (decreases) as price of the commodity increases (decreases), ceteris paribus. Supply Schedule is a table which shows how much of a good individuals are willing and able to produce and make available for sale in the market at different price levels during a given period of time (week, month etc) Quantity Supplied is the amount of commodity that producer supplies to the market at a given price level. The direct (positive) relationship between price of a commodity and quantity supplied can be shown using either the supply schedule or the supply curve. Table 2.3 An individual supply schedule of coffee Price of coffee Quantity supplied (Birr) for coffee ( k. g) 70 700 60 600 50 500 40 400 30 300 20 200 10 100 Supply curve of a commodity is a curve, which shows the relationship between the quantities supplied of the commodity at different price levels. In drawing the supply curve we singled out price of a commodity as the most important factor affecting the quantity supplied of the commodity and ignored the influences of other factors (hold all other influences constant). S Price 70 60 50 40 30 20 10 0 100 200 300 400 500 600 700 Fig. 2.7: The Supply Curve Quantity As price of a commodity increases from 10 Birr to 70 Birr then quantity supplied increases from 100 to 700. Supply curve is derived under the assumption that other factors that can Department of Economics, DDU 7 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity affect quantity supplied are hold constant and only price of a commodity is allowed to vary. Quantity supplied of a commodity and its price is positively related i.e. as price increases quantity supply also increases. 2.3.2. Determinants of Supply Firms are interested in supplying of commodities in order to get profit. Thus, they supply more goods when price is high relative to cost of production and supply less when production cost is high relative to price. Price of a commodity is not the only determinant of quantity supplied of the commodity. There are a number of other factors. These are: A. Prices of Production Substitutes Production substitutes are goods, which a producer tends to substitute for one another when their price changes. If price of a good increases other things remain, constant, producers decrease the production of its substitute because production of the good is more profitable than production of its substitute. For example, if price of wheat increases in the market in relation to price of teff a farmer allocates large part of its land to wheat production instead of teff production. B. Prices of factor inputs Other things being constant, an increase (decrease) in the price of factors of production causes an increase (decrease) in cost of production. As cost of production increases (decreases) profit - margin decreases (increases) and therefore amount supplied to the market decreases (increases). Thus, increase (decrease) in price of factor inputs causes quantity supplied to fall (rise) of course under the assumption of other things being constant. Price of Commodity S2 S0 S1 A decrease in supply An increase in supply Quantity of a commodity Fig, 2.8 Shift of supply curve Department of Economics, DDU 8 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity C. Technological State of production The development of the new method of production or the invention of efficient machines may make possible a big expansion of output at a lower cost and so causes supply to increase. i.e. improvement in technology causes supply to increase and absolute technology causes supply to decrease. D. Number of Producers As number of firms producing a good increase, more and more goods will be supplied. 2.3.3. Change in Quantity Supplied and Change in Supply Change in quantity supplied refers to the movement along the some supply curve and it is caused by a change in commodity's price. In this case only price of a commodity is allowed to vary and other determinants of supply (e.g. Price of production substitute, prices of factor inputs, technological state, taxes and subsidies, no of producer, expectation of producers and weather etc,) are held constant. Price P3 S P2 P1 Fig. 2.9 Change in quantity supplied B (movement along the same supply curve) A Quantity 0 Q1 Q 2 Q3 As price increases from P1 to P2, quantity supplied also increases from Q1 to Q2, i.e., we call this increase in quantity supplied and as price decreases from p3 to p2 quantity supplied also decreases from Q3 to Q2. Change in supply refers to the shift of the supply curve. If we fix price of a commodity (own price) constant and vary any of those other factors affecting supply (e.g. Prices of production substitute and inputs, technological state, tax and subsidy, no of producers, producers' expectation and weather) then the supply curve changes its position, i.e., the supply curve shifts. Department of Economics, DDU 9 2014 Introduction to Economics Chapter Two Price Decrease in supply S1 S0 Demand, Supply and Elasticity S2 Increase in supply Po 0 Q1 Q0 Q2 Quantity Fig. 2.10: Change in Supply (Shift in the supply curve) If the supply curve shifts from So to S2 (shift of the curve to the right), we call it increase in supply. If the supply curve shifts from So to S1 (shift of the curve to the left), we call it a decrease in supply. Increase in supply, i.e., shift of the supply curve to the right is caused by the following factors: decrease in price of production substitute, decrease in prices of inputs, improvement in technology, increase in subsidy, decrease in tax, increase in number of producers, expectation of lower price in the future, good weather and others, ceteris paribus. The supply curve shifts to the left (decrease in supply) when the above factors change in opposite direction. NB. As supply curve shifts, quantity supplied also changes therefore change in supply necessarily implies change in quantity supplied. However, change in quantity supplied does not necessarily imply change in supply, because change in quantity supplied can be observed by moving along the same supply curve (without shift in supply curve). 2.3.4. Individual and Market Supply Curve Individual Supply Curve shows us the quantity that a single producer is willing and able to supply at each price level over certain period of time. Department of Economics, DDU 10 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity Table 2.4: A hypothetical supply schedule for the production of wheat by three individual producers over the last seven months Price of wheat (Birr) (1) 300 260 220 180 140 100 60 Kebede's supply of wheat (k.g) (2) 7 6 5 4 3 2 1 Balcha's supply of wheat (k.g) (3) 26 22 18 14 10 6 2 Birke's supply of wheat (k.g) (4) 35 30 25 20 15 10 5 Market supply of wheat (k.g) [5 = 2 + 3 + 4] 68 58 48 38 28 18 8 Exercise: Draw supply curves for the above supply schedules Market Supply Curve shows the total amount of particular commodity supplied by all producers at each price level, i.e., market supply curve is the horizontal summation of individuals. 2.4. Market Equilibrium Market can be considered as a mechanism or structure that facilitates exchange of goods and services among different economic units (e.g., firm, government, etc). Market does not necessarily refer to certain geographical area. It can exist wherever there is a contact between buyers and sellers without any spatial dimension attached to it. At that equilibrium, price and quantity remain. If some changes occur to shift either the supply curve or the demand curve, then the market equilibrium point also changes. Now the question is, what determines the price level on which both consumers and producers agree on, i.e., the equilibrium? The operation of the forces of supply and demand provides answer to this question. At any price level above the equilibrium price, quantity supplied is greater than quantity demanded. At that price level producers plan to supply more and more of the goods in order to get more profit. However, consumers plan to buy less and less as goods are too costly to them. Therefore, there will be an excess supply (surplus). In order to get rid of this excess supply there will be completion among producers to decrease price. This decrease in price encourages consumers to demand more and more of the goods. Department of Economics, DDU 11 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity Thus, producers continue to decrease their prices and consumers continue to buy more until the excess supply is eliminated or until the equilibrium point is reached at point E. At any price below the equilibrium price level, quantity demanded is greater than quantity supplied. At that price level, producers plan to supply less and less of the goods. However, consumers plan to buy more and more as they feel goods are relatively cheap. Thus, there is an excess demand (shortage of goods) and this creates competition among consumers to get these scarce goods by increasing price. This increase in price encourages producers to supply more and more. Thus, consumers continue to bid up price and producers continue to supply more and more until the excess demand is eliminated or the equilibrium price is reached again at point E. Graphically the market equilibrium (i.e., equilibrium price which is 180 birr and equilibrium quantity which is 38 quintals) can b shown as follows: Excess supply or shortage of demand Price G Fig. 2.13 Market equilibrium E 180 Excess demand or F shortage of supply D Quantity 38 At point E supply and demand curve intersect each other and therefore quantity supplied is equal to quantity demanded hence market equilibrium is attained at point E. 2.5. Effects of Change in Demand or Supply on the Market Equilibrium Strictly speaking market equilibrium is achieved under the assumption of perfectly competitive market, in which all factors affecting supply and demand except the price of a commodity are assumed to be constant. When one of the factors varies and others held constant, then the market equilibrium point also changes. This situation can be shown by the following graph. Department of Economics, DDU 12 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity 1. Effects of Change in Demand when Supply Remains Unchanged D0 D1 S Price P1 e1 e0 P0 Quantit Fig. 2.14 Effects of an increase in Demand when Supply Remains Unchanged Q1 Q0 An increase in demand (shift of the demand curve from D0 to D1), supplies being unchanged, causes equilibrium point to change from e0 to e1. In this case the new equilibrium point (point e1) is attained both at a higher price and quantity than the initial equilibrium (point e0). A decrease in demand (shift of the demand curve from D1 to D0) and supply remains constant causes attainment of the equilibrium at a lower point. i.e., equilibrium point decrease from point e1 to e and therefore equilibrium quantity decreases from Q1 to Q0 and equilibrium price decreases from P1 to P0. 2. Effects of Change in Supply when Demand Remains Unchanged D0 S0 S1 Price P0 e P1 e1 D0 0 Q0 Q1 Quantity Fig. 2.15 Effects of an increase in supply when demand remains unchanged An increase in supply (shift of supply curve from S0 to S1) assuming demand not to change causes equilibrium point to change from point e to e1. As a result equilibrium price decreases from P0 to P1 and equilibrium quantity sold or bought increases from Q0 to Q1, i.e., the new equilibrium is attained at a lower price but higher quantity than before and vice versa. Department of Economics, DDU 13 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity 3. Effect of simultaneous change in DD and SS on equilibrium price and quantity If both demand and supply increase simultaneously, then the equilibrium quantity increases but equilibrium price may increase, decrease or remain unchanged depending on the relative magnitude of the percentage change in demand and supply. There are three cases. (1) If demand increases by more proportion than the supply, the new equilibrium (e1) is attained at both higher equilibrium price and quantity than before. Thus, the new equilibrium quantity (Q1) is greater than the previous equilibrium quantity (Q0) and the new equilibrium price (P1) is also greater than the previous equilibrium price (P0). D1 S0 S1 D0 Price P1 e1 P0 eo Q0 Q1 Quantity Fig. 2.17 Effects of increase in demand by more proportion than supply increase. (2) If supply increases by more proportion than demand, then the new equilibrium (e1) is attained at a higher equilibrium quantity (Q1) than previous quantity (Q0) but at a lower equilibrium price (P1) than the previous price (P0). S0 D0 D1 S1 Price P0 e0 P1 e1 Quantity Q0 Q1 Fig. 2.18 Effects of increase in supply by more proportion than demand increase. Department of Economics, DDU 14 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity (3) If both demand and supply increases by an equal proportion the new equilibrium quantity is attained at a higher level then the initial equilibrium quantity. But equilibrium price remains unchanged. Price D0 P0 D1 e0 S0 S1 E1 Q0 Q1 Quantity Fig. 2.19 Effects of increase in supply and demand by equal proportion. So far we discussed the relationship between price and quantity demanded in terms of demand schedule and demand curve. As well, we have seen the relationship between price of a commodity and quantity supplied in terms of supply schedule and supply curve. Our demand and supply curves helped us in explaining basic concepts in demand and supply analysis such as market equilibrium, change in demand, change in quantity demand, change in supply, change in quantity supply, etc. The supply schedule (curve) or demand schedule (curve) can also be represented by supply equation or demand equation respectively and can be used to explain those basic demand and supply concepts we mentioned above. E.g. if the demand and supply curve equation of a commodity are given by: 𝑄 𝑑 = 250 - 50P and 𝑄 𝑠 = 25 + 25P, respectively, where 𝑄 𝑑 , 𝑄 𝑠 and P are quantity demanded, quantity supplied and price respectively. The equilibrium price and quantity will be: 𝑄 𝑑 = Qs at market equilibrium, so 250 - 50P = 25 + 25P 250 - 25 = 25P + 50P 225 = 75P P=3 𝑄 𝑑 = 250 - 50(3) = 100 = 𝑄 𝑠 Thus, equilibrium price and quantity is 3 and 100 units respectively. Department of Economics, DDU 15 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity 2.6. Elasticities The concept of elasticity is widely used in Economics. By elasticity we mean the responsiveness of dependent variable when the independent variables changes by 1 percent. Business -people who use economics in decision making is interested in knowing the responsiveness of the dependent variable (say quantity demanded or quantity supplied) to the change in any one of the independent variable (say price). In economics, elasticities that are quite important for the decision making of both consumers and producers are Elasticity of demand and Elasticity of supply 2.6.1 Elasticity of Demand Elasticity of demand is defined as a measure of the degree of responsiveness of quantity demanded (consumers) to the change of determinants of demand. There are three major types of elasticity of demand: Price elasticity of demand Income elasticity of demand Cross-price elasticity of demand 2.6.1.1. Price Elasticity of Demand Price elasticity of demand (𝑒𝑑𝑝 ) is also "called elasticity of demand". It is a concept that measures by how much percent will quantity demanded changes when its price changes by certain percent, i.e., edP Percentage change in quantity demanded = Percentage change in price %Δ 𝑄 𝑄2−𝑄 1 𝑋100 𝑄1 𝑃2−𝑃 1 𝑋100 𝑃1 = = %Δ 𝑃 ∆𝑄 𝑑 𝑃 = 𝑋 𝑑 ∆𝑃 𝑄 Even though calculation of price - elasticity of demand yields negative value because of the inverse relationship between quantity demanded and price, for convenience we consider a positive value in terms of its "absolute value". The Five Categories of Price Elasticity of Demand Depending on its magnitude, elasticity of demand can be categorized as follows: 1. Perfectly inelastic demand:: in this case coefficient price elasticity of demand (𝑒𝑑𝑝 ) is zero, i.e., if demand for the commodity is perfectly inelastic, change in price of the commodity does not affect quantity demanded and the demand curve is vertical. Department of Economics, DDU 16 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity 2. Inelastic Demand:: in this case percentage change in quantity demanded is less than percentage change in price. eg . a change of price by 10%, which caused quantity, demanded to change only by 5%. Here the value of demand elasticity lies between 0 and 1, i.e. 0 < 𝑒𝑑𝑝 < 1. Graphically it can be shown as follows. 3. Elastic Demand:: When percentage change in quantity demand is greater than percentage change in price, it is said to be elastic demand. eg change in quantity demand by 10% which was caused by 5% change in price. 4. Unitary Price Elasticity:: here percentage change in price is equal to percentage in quantity demanded. e.g. As demand changes by 10% price also changes by 10%. 5. Perfectly Elastic demand:: The percentage change in price is zero but percentage change in quantity demanded is high. Here elasticity of demand is infinite, 𝑒𝑑𝑝 = Linear demand curve and price elasticity of demand Graphically, elasticity of demand for a straight-line demand curve can be shown as follows: 𝑒𝑑𝑝 = Price D 𝑒𝑑𝑝 >1 𝑒𝑑𝑝 =1 M 𝑒𝑑𝑝 =0 𝑒𝑑𝑝 <1 0 Quantity Fig.2.20 Demand curve showing price elasticity Point M is the midpoint of straight-line demand curve. Above the mid point M to the left of M demand is elastic (i.e., 𝑒𝑑𝑝 > 1). At the midpoint demand is unitary elastic with 𝑒𝑑𝑝 = 1. Below the midpoint to the left of M demand is in elastic with 𝑒𝑑𝑝 <1. ∆𝑄𝑑 𝑑 Arc Price elasticity (𝑒𝑥𝑦 )= ∆𝑃 𝑃 +𝑃 𝑋 𝑑2 1𝑑 𝑄 +𝑄 2 1 Factors Affecting Price Elasticity of Demand Elasticity of demand depends on a number of things. Some of them are: a. Availability and Number of Substitute:: - if a commodity has many substitutes, a change in price of one substitute will affect quantity demanded of the other substitute highly. The larger Department of Economics, DDU 17 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity the number of good substitute products available, the grater the elasticity of demand i.e., a commodity with many substitutes has larger price elasticity (purposes) b. Number of Alternative Uses of a Commodity:: If a commodity has many alternative uses it has high price elasticity of demand, i.e., the higher is the number of alternative uses of a commodity, the higher is its price elasticity. c. The Nature of a Commodity (i.e. whether it is luxury or necessity) If a commodity is a necessity-good, then its, 𝑒𝑑𝑝 is low (inelastic demand) because whatever price level is, consumers buy almost fixed quantity of this good. If a commodity is nonessential or luxury then it has high price elasticity, because for this commodity a consumer has an alternative to postpone consumption if price increases, as it is not so essential for daily activity. d. Other factors such as size of percentage share of commodity's expenditure in total expenditure of a consumer, time horizon of consumption, durability of a good, etc can also affect price elasticity of demand (how? Explain it by yourself). 2.6.1.2 Income Elasticity of Demand Income elasticity of demand measures percentage change in quantity demanded due to certain percentage change in income of the consumer (Y). Percentage change in quantity demanded edy = Percentage change in income %Δ𝑄 𝑄2−𝑄 1 𝑋100 𝑄1 𝑌2−𝑌 1 𝑋100 𝑌1 ∆𝑄 𝑑 𝑌 = 𝑋 𝑑 ∆𝑌 𝑄 = = %Δ𝑌 If income elasticity of demand for certain good is positive, then the good is said to be normal good. If income elasticity of a commodity is negative, then the good is inferior good. ∆𝑄 𝑑 Arc Income Elasticity (edxy ) = ∆𝑌 𝑌 +𝑌 𝑋 𝑑2 1𝑑 𝑄 +𝑄 2 1 2.6.1.3 Cross Price Elasticity of Demand Cross price elasticity is used to measure the percentage change in quantity demanded of a commodity, (say X) due to percentage change in price of the other commodity, (say Y). Percentage change in quantity demandedof good X edxy = Percentage change in price of good y %Δ𝑄 𝑥 𝑄𝑥 2 −𝑄1 𝑋100 𝑥 𝑄1 𝑦 𝑦 𝑃2 −𝑃1 𝑦 𝑋100 𝑃1 = = %Δ𝑌 ∆𝑄 𝑑 𝑃𝑦 𝑦 𝑥 = 𝑥 𝑋 𝑦𝑑 ∆𝑃 𝑄 Where Qdx is change in quantity demand of good x, ∆𝑃𝑦 Is change in price of good y Department of Economics, DDU 18 2014 Introduction to Economics Chapter Two Demand, Supply and Elasticity 𝑑 𝑒𝑥𝑦 is point cross price elasticity If goods are related in consumption they are either a substitute or a complementary to each other. Cross price elasticity can be positive, negative or zero. For a substitute goods cross price elasticity is positive. For complementary goods cross price elasticity is negative. If goods have no relation their cross price elasticity of demand is zero. Table 2.5 Demand schedule for good X and Y Points A B C Px 2 4 5 Py 3 5 6 Qx 18 12 10 Qy 13 9 4 𝑑 Cross - elasticity of demand for commodity X i.e. 𝑒𝑥𝑦 as we move from A to B is given by ∆𝑄𝑥𝑑 edxy = ∆𝑃𝑦 ∆𝑄𝑥𝑑 edxy = ∆𝑃𝑦 𝑃𝑦 𝑋 𝑦𝑑= 𝑄 12− 12−18 𝑃𝑦 18− 18−12 𝑥 𝑋 𝑦𝑑= 𝑄 𝑥 5−3 3−5 3 −6 3 𝑋 = 𝑋 = 18 2 18 5 −6 5 𝑋 = 𝑋 = 12 2 12 −1 2 −5 4 for movement from A to B for movement from B to A 2 1 ∆Qd x Py +Py 𝑑 Arc cross - price elasticity (𝑒𝑥𝑦 ) = ∆Py Q2x +Q1x . 2.6.2 Elasticity of Supply (Reading Assignment) 2.7. Application of Elasticity The concept of demand elasticity is useful for business-people. If a producer wants to sell more of his commodity by reducing price then the demand curve for his product must have elastic demand. If demand for the product is elastic, an increase in price results decrease in revenue as small percentage change in price causes large decrease in quantity sold. If a producer faces an inelastic demand curve for his product he can increase his revenue by increasing price because under this case large percentage increase in price causes little percentage decrease in quantity demanded. If a producer faces inelastic demand curve, then it cannot increase its revenue by decreasing price. If demand is unitary, change in price does not affect total revenue. In this case there is no need of decreasing or increasing price, as it does not affect total revenue of the producer. Department of Economics, DDU 19 2014