Elasticity of Demand and Supply

Elasticity of Demand:

The term Elasticity of Demand refers to the degree of co-relation between price and demand. It is the measure of responsiveness to the change in price.  

Types of Elasticity:

The quantity demanded of a commodity may change as a result of change in its determinants like price, income of the consumer, and price of related goods.

There are three types of elasticity:

1. Price Elasticity
2. Income Elasticity
3. Cross Elasticity

1. Price Elasticity of Demand –

It refers to the responsiveness of quantity demanded of a commodity to a change in its price given the consumer income, his taste and price of all other goods. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price.

Ed =%ΔQd / %ΔP

Categories of Price Elasticity of Demand:

Elasticity of Demand can be divided into 5 categories: -

1. Perfectly Elastic
2. Elastic
3. Unitary
4. Inelastic
5. Perfectly Inelastic

a. Perfectly Elastic demand [Ed = ∞] -

Perfectly elastic demand describes a situation where any price increase, even a tiny one, leads to a complete drop in quantity demanded to zero. This occurs when there are numerous perfect substitutes available, and consumers will switch to a different product immediately if the price of one good increases. The demand curve for a perfectly elastic demand is a horizontal line.

b. Elastic Demand [Ed > 1] –

Elastic demand refers to a situation where the quantity demanded of a product or service changes significantly in response to a change in its price. In simpler terms, if a small price change leads to a large change in the amount people buy, the demand is considered elastic.

c. Unitary Elastic Demand [Ed = 1] –

Also known as unitary elasticity, it occurs when a change in price leads to an equal proportional change in the quantity demanded. In simpler terms, if the price of a product changes by a certain percentage, the quantity demanded of that product will change by the same percentage, resulting in a constant total revenue. 

d. Inelastic Demand [Ed < 1] –

Inelastic demand means that a change in price has a relatively small effect on the quantity of a good or service demanded. Consumers will purchase the good or service regardless of whether the price is low or high. Such examples of products that have inelastic demand are life-saving medications such as insulin.

e. Perfectly Inelastic Demand [Ed = 0] –

Perfectly inelastic demand is a situation where the quantity demanded of a good or service remains constant, regardless of changes in its price. This means that consumers will purchase the same amount of the product, whether the price is high or low. A perfectly inelastic demand curve is represented by a vertical line on a graph, or parallel to y – axis.

2. Income Elasticity of Demand –

It shows the degree of responsiveness of quantity demanded of goods to a change in income of the consumer.

Income Elasticity =

Proportionate Change in Purchase of a Commodity / Proportionate change in Income

3. Cross Elasticity –

Generally, most of the commodities have substitutes or complimentary goods. The demand for the good is not only the function of the price but other things like income of the consumer, price of substitutes and complimentary goods. The cross elasticity of demand can be extended to a situation where two commodities are related to each other. It is the ratio of percentage change in demand of one good to the percentage change in price of the other good.

Cross Elasticity =

% change in demand for commodity X / % change in price of commodity Y

Elasticity of Supply:

The price elasticity of supply measures how much the quantity supplied changes when the price of a product changes. It helps understand how the supply of a product is affected by price fluctuations in the market. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

Es = %ΔQs / %ΔP

Categories of Elasticity of Supply:

Elasticity of Supply can be divided into 5 categories: -

1. Perfectly Elastic
2. Relatively Elastic
3. Unitary Elastic
4. Relatively Inelastic
5. Perfectly Inelastic

1. Perfectly Elastic Supply [Es = ∞] –

A commodity becomes perfectly elastic when its elasticity of supply is infinite. This means that even for a slight increase in price, the supply becomes infinite. For a perfectly elastic supply, the percentage change in the price is zero for any change in the quantity supplied.

2. Relatively Elastic Supply [Es > 1] –

When the percentage change in the supply is greater than the percentage change in price, then the commodity has the price elasticity of supply greater than 1.

3. Unitary Elastic Supply [Es = 1] –

A product is said to have a unit elastic supply when the change in its quantity supplied is proportionate or equal to the change in its price. The elasticity of supply, in this case, is equal to 1.

4. Relatively Inelastic Supply [Es < 1] –

When the supply of a product changes less than its price, we can say that the supply is relatively inelastic. In this situation, the price elasticity of supply is less than 1.

5. Perfectly Inelastic Supply [Es = 0] –

Product supply is said to be perfectly inelastic when the percentage change in the quantity supplied is zero irrespective of the change in its price.

It is important to note that the elasticity of supply is always a positive number. This is because the law of supply says that the quantity supplied is always directly related to changes in the price of a product. In other words, when the market price of a product increases, its supply either increases or stays the same.

Application of Demand and Supply – Tax Floor and Ceilings

Price Ceiling –

The maximum price fixed by government beyond which producers cannot charge. Such ceilings are imposed on necessary consumer goods during emergency period like war, in order to prevent them from rising during critical period.

Price Floor –

Unlike price ceiling, price floor is generally introduced to protect interest of the sellers. Generally, the price floor sets the price above the equilibrium price. It has been seen that such tool is used for agricultural goods to support farmers. In case of floor pricing, the price is fixed higher than the equilibrium price, which results in Supply of the good being higher than the demand. This situation results in surplus, where crops produced by farmers are more than demanded by buyers at that price.

For a price floor to be effective, it must be set above the equilibrium price. If it’s not above equilibrium, then the market won’t sell below equilibrium and the price floor will be irrelevant.