APPLICATION OF DEMAND AND SUPPLY THEORY: ELASTICITY

INTRODUCTION
Elasticity extends our understanding of markets by letting us know the degree to which changes
in prices and incomes affect supply and demand. Sometimes the responses are substantial, other
times minimal or even nonexistent.
But by knowing what to expect, businesses and the government can do a better job in deciding
what to produce, how much to charge, and, even, what items to tax.

Understanding Elasticity
Elasticity in general terms is concerned with the degree/extent of responsiveness or
sensitivity of one variable to changes in another.
It is a means of measuring how quantity demanded or quantity supplied of a product react to
changes in price and other determinants.
Interpretation of elasticity:
Absolute value of 1 or more implies elastic, -0.9 to 0.9, inelastic.i.e, below 1 in absolute
values, we refer it as inelastic.
Categories of elasticity:
Elasticity of demand:-price elasticity of demand, Income Elasticity of demand, cross-price
Elasticity of demand.
Elasticity of supply:-price elasticity of supply, cross-price elasticity of supply, Elasticity of
Factor Substitution (the responsiveness of the quantity of factors of production such as labor
and capital used in the production process to changes in their relative prices. If factors of
production can be easily substituted for one another, the elasticity of factor substitution is
high; if substitution is difficult, the elasticity is low.
ELASITICITY OF DEMAND

Elasticity of demand measures the responsiveness of quantity demanded of a commodity to a

change in one of the factors influencing demand. The main measures of elasticity of demand
are:
a) Price elasticity of demand
b) Income elasticity of demand
c) Cross price elasticity of demand

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A) PRICE ELASITICITY OF DEMAND

The price elasticity of demand measures the responsiveness of quantity demanded of a

commodity to a change in its price. It is the percentage change in quantity demanded
resulting from one percentage change in the price of the commodity.
%Q
p 
%P
For example, if a firm increases the price of its product by 2% and quantity demanded
subsequently decreases by 3%. The price elasticity would be
 3%
p   1.5
2%
p
is negative because of the law of demand which states that price and quantity demanded
are inversely related. Thus when the price change is positive, the change in quantity
demanded is negative and vice versa.

Point and Arc Elasticities

These are two approaches to computing price elasticities. Arc Elasticity is appropriate for
analyzing the impact of discrete (i.e. measurable) changes in price. The point Elasticity can
be used to evaluate the effect of small price changes.

Point Price Elasticity

The point Elasticity of demand is the elasticity at a given point on the demand curve. It is
given by the following formula.
%Q Q / Q Q P
p    
%P P / P P Q
Therefore the formula for point price elasticity of demand can be rewritten as
dQ P
p  
dP Q
Note that along linear demand curve with a function of:
Qd  a  bP
dQd
 b
where -b is the slope or i.e. dP
Therefore price elasticity of demand equals

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 dQ P P
p    b
dP Q Q
Example:
Suppose that the estimated linear demand function for pork is:
Q = 286 -20p
where Q is the quantity of pork demanded in million kg per year and p is the price of pork in
$ per year. Given that, at equilibrium; p = $3.30 and Q = 220, then the elasticity of demand
for pork is
dQ P  3.30 
p    20   0.3
dP Q  220 
Interpretation: one percentage point increase in the price of pork results in a 0.3% point
decrease in its quantity demanded.

Arc Price Elasticity of Demand

Arc elasticity of demand is elasticity between two points on demand curve. This method

simply averages the two prices and the two quantities as the reference points for computing

the percentages. Arc price elasticity is defined as

Q P2  P1  / 2 Q2  Q1 P2  P1
p    
P Q2  Q1  / 2 P2  P1 Q2  Q1

where the subscripts 1 and 2 respectively, refer to the original and to the new values, of price

and quantity or vice versa.

Example
The demand of a commodity decreases from 2000 to 1500 units when the price changed from
$8 to $10 per unit. Calculate arc price elasticity of demand.

Answer:
1500  2000  10  8 
p     1.29
10  8  1500  2000 

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Measures of elasticity and shapes of demand curves

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Note: in Figures (c), (d) and (e), when we say that the price elasticity of demand exceeds one,
less than one or equals one, we refer to the absolute value only (i.e. ignored the negative
sign).

Price elasticity of demand along a linear demand curve

Elasticity of demand is different at every point along a downward sloping linear demand
curve; but constant along horizontal and vertical linear demand curves. Along a downward-
sloping linear demand curve the elasticity of demand is a more negative number the higher
the price is.
Graphically,

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Effect of price elasticity of demand on firm revenue

Any shock that changes the equilibrium price will affect a firm’s revenue. Whether revenue
increases or decreases when the equilibrium price changes, will depend on price elasticity of
demand. Specifically,
a) With demand is elastic, a higher price reduces revenue
b) With demand is inelastic, a higher price increases revenue

Determinants of Price Elasticity of Demand (PED)

1. Availability of very close substitutes. The more closer a good is substitutable to
another the more elastic is its demand.
An example is the demand for cigarettes: this demand is inelastic because such
substitutes that exist (like cigars, pipes, chewing tobacco, other drugs, nicotine patches
and chewing gum) are not very close in terms of their perceived functions and attributes.
However, a single brand of cigarettes may have elastic demand, depending on brand
loyalty.
2. Proportion of income spent on the product. The higher this is, the more elastic the
demand, other things remaining equal. This is because the income effect of the price

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 change is greater. Thus the demand for sugar will tend to be inelastic while the demand
for cars will be more elastic.
3. Time frame. Demand tends to be more elastic in the longrun, because it may take time
for consumers to switch/adjust to different products.
4. Habit: Some goods are consumed because of habit e.g. advice/ smoking; in this case
we find that price changes leave quantity demanded more or less unaffected. In this
case their demand is said to inelastic. Habits are easier to change over a longer time
period.
5. Nature of a commodity-Demand for luxury goods (e.g. refrigerator, TV etc) is more
elastic because their consumption can be dispersed with or postponed when their prices
rise. On the other hand, consumption of necessities (e.g. foodstuffs), essential for life,
cannot be postponed and so their demand is inelastic.
6. Range of uses of a commodity- The wider the range of uses of a product, the higher
the elasticity of demand. As the price of a multi-use commodity decreases, people
extend their consumption to its other uses, thereby increasing the demand. For instance,
milk can be taken as it is, it may be converted into cheese, ghee and butter. The demand
for milk will therefore be highly elastic.

Importance of price elasticity of demand

1) When the Government imposes a tax on a commodity, its price will tend to rise. But a
product is very elastic in demand, it’s demand will considerably fall when the price has risen.
Hence Government will not get larger revenue from this tax, since consumers will have
considerably reduced their demand for it.
Note: sometimes, although government may levy taxes on those goods whose demand is less
elastic, these goods are mostly necessities, and government may perhaps exempt them on
humanitarian grounds
2) Price setting by businessmen: The will be able to increase their sales by lowering price,
if demand is elastic; and increase the price if demand is inelastic.
3) Price setting by discriminating monopolist. This type of monopolist charges different
prices to different consumers on the basis of their demand curves (elasticity of demand). The
monopolist therefore needs to understand how each customer-type responds to price changes
(i.e. their elasticity) before setting the right price for each.

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B) INCOME ELASTICITY OF DEMAND

This is the responsiveness of quantity demanded to change in income.

In percentage terms it can be expressed as:

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝜀𝑌 = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

Symbolically

𝜕𝑄 𝑌
𝜀𝑌 = 𝜕𝑌 ∙ 𝑄

Where
𝜕𝑄 is change in quantity demanded.
Q is original quantity demanded.
𝜕𝑌 is change in income
Y is original income.
Income elasticity of demand for most commodities is positive, indicating higher purchases at
higher income
C) CROSS ELASTICITY OF DEMAND

The demand for one product can be influenced by price of another. For example, the demand
for beef depends on the demand for pork, mutton and fish etc. if the price of beef rises while
prices of substitutes (pork, mutton and fish) remains unchanged, consumers will substitute
beef with the cheaper product.
Cross price elasticity of demand is the percentage change in quantity demanded of good one
good due to change in the price of good another good. It measures the degree of
responsiveness of demand for one product to changes of the price of its substitutes or
complementary goods.
For instance, cross price elasticity of demand for tea (T) will be expressed as the percentage
change in its quantity demanded with respect to the percent change in price of its substitute
coffee (C).
Point cross elasticity is calculated by the formula:
𝜕𝑄𝑇 𝑃𝐶
𝜀𝑇,𝐶 = ∙
𝜕𝑃𝐶 𝑄𝑇
Where
𝑃𝐶 is price of coffee

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𝑄𝑇 is quantity of tea.

Cross elasticity of demand can either be positive or negative.

A high positive cross elasticity means that the commodities are close substitutes.
A negative cross elasticity means that the goods are complementary in the market, thus a
decrease in the price of one stimulates the sale of the other.
A cross elasticity of zero means that the goods are independent of each other in the market.
Example 1

In a certain region the price of beef increased from Ksh 100 to Ksh150 per Kg, leading to a
decrease in quantity demanded of beef from 60 to 40 Kg per month while the quantity
demanded for mutton increased from 200 to 250 Kg. Calculate the cross price elasticity of
demand for mutton.
Solution:

250  200  100 

 mb     0.5
150  100  200 

Example 2:

Given the following demand function for commodity Y:

𝑄𝑌 = 2000 − 0.4 𝑃𝑌 + 2.2𝑃𝑊 +0.0037 I

Such that: PY (Price of good Y) = $20, PW (price of good W) = 10$, and I (Income)

=$10,000.

a) Compute different elasticities of demand and interpret your answers

b) With reasons, state the relationship between the commodities Y and W

ELASTICITY OF SUPPLY
The price elasticity of supply measures the responsiveness of quantity supplied of a commodity
to a change in one of the factors influencing demand.

Point Price Elasticity

Price elasticity of supply is the percentage change in the quantity supplied (Q) due to a given
percentage change in the price (P). The point Elasticity of supply is the elasticity at a given
point on the supply curve. It is given by the formula.

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 %Q Q / Q Q P
s    
%P P / P P Q
Therefore the formula for point price elasticity of supply can be rewritten as
dQ P
s  
dP Q

Arc Price Elasticity of Supply

Arc elasticity of supply is elasticity between two points on supply curve. Arc price elasticity
of supply is defined as
Q P2  P1  / 2 Q2  Q1 P2  P
s    
P Q2  Q1  / 2 P2  P1 Q2  Q1

Determinants of elasticity of supply

1. Availability of factors of production (Inputs)
When factors of production are available, supply will be highly elastic and vice versa.
Suppliers will be able to meet demand in good times.
2. Excess capacity of unsold stock (Buffer-stock)
If there exist a lot of stock, incase prices increase, supplier would be able to respond very fast
by increasing supply. In such a case supply is said to be highly elastic.
3. Time factor
This refers to the time it takes to produce and supply a product in the market. In the short run,
supply of most items that take a long time to produce is inelastic. But, in the long run supply
is elastic.
4. Nature of a commodity
Durable/ stockable commodities such as clothes etc. have greater elasticity of supply than
perishable goods such as milk. This is so because, incase the price of perishable items is low,
producers will still be forced to supply the items because they cannot be stored for future sale
when the prices would increase.

Usefulness of the concept of elasticity

1. Useful in taxation.

If it is the aim of the government to raise revenue it has to put into consideration elasticities of
the commodities to be taxed, especially price elasticity of demand.

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In order to raise revenue the government has to impose heavy taxes on goods which have
inelastic demand e.g. cigarettes and beer. This is because after taxes are imposed on such goods
consumers will continue to demand the goods in large quantities as before and therefore the
government is able to collect more revenue.
On top of this, the burden of taxes on goods which have inelastic demand falls more on
consumers because sellers are able to pass a greater part of the tax to the consumers through
high prices. This leaves the production of such goods more or less un-affected thus making it
possible for the government to raise enough revenue.
This is shown in the diagram below.

The original equilibrium price before the imposition of tax was 𝑃0 and the new equilibrium
price after tax is 𝑃1 .
Distance AC on the diagram represents the tax imposed on the good.
AB of the tax is met by the consumers.
It can be seen from the diagram that the quantity in the market fell by a small proportion 𝑄0 𝑄1
It can thus be said that when a commodity has inelastic demand it pays the government to tax
that commodity heavily because the greatest part of the tax is met by consumers, thus leaving
the production of that good more or less unaffected, hence enabling the government to collect
more revenue from that good.

2. Elasticity is important in international trade

Before a country devalues her currency so as to encourage export and discourage imports, it
has to put into consideration the elasticity of demand and supply for her export and imports.

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For devaluation to succeed, exports must be highly elastic so that after devaluation, greater
quantities can be sold in the foreign market. Similarly, the export must have elastic supply in
order to meet increased demand in foreign markets.
On the import side, imports must have elastic demand so that after devaluation greater
quantities of imports can be abandoned.
We can therefore say that before any country devalues her currency, it is important to consider
elasticity of demand and supply for export and imports.

3. Elasticity shows the degree to which goods are related.

High cross elasticity between two commodities shows that the two commodities are very
related.
This is a useful concept especially for formulating pricing strategies. Such elasticity is
especially important in studying how unfair competition of dumped goods affects performance
of domestic industries. This would thus enable the government know how much import duty
to impose on such goods as to protect local industries from collapsing.

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