Fundamentals of Business

Elasticity

An important concept in understanding supply and demand theory is elasticity. It refers to how supply and demand changes in response to various stimuli. One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity because it calculates the elasticity over a range of values.

It is a measure of relative changes. Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

Example calculation.
We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price. That is,   quantity% /   price% suppose, the price of bread moves from £1.00 to £1.05, and the quantity supplied goes from 100 loaves to 102 loaves, the slope is 2/0.05 or 40 loaves per pound. Since the elasticity depends on the percentages, the quantity of loaves increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4.
NOTE:
Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity, because the denominator will be exactly the same regardless.

If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices change a lot, it is said to be inelastic.
Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the quantity demanded of the other will increase.
For example, in response to an increase in the price of fuel, the demand for new cars that are fuel efficient (hybrids) for will also rise.
In the case of perfect substitutes, the cross elasticity of demand is equal to infinity.
Where the two goods are independent, the cross elasticity of demand will be zero: as the price of one good change, there will be no change in quantity demanded of the other good.
In case of perfect independence, the cross elasticity of demand is zero. When two goods are dependent, that is compliments, the cross elasticity of demand is negative.
As the price price of one goes up, the demand for the other will fall.

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand.

When demand D1 is in effect, the price will be P1. When D2 is occurring, the price will be P. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price. It is sometimes the case that a supply curve is vertical: that is the quantity supplied is fixed, no matter what the market price.

For example,
if South Africa vs. England, Rugby World cup finals 2007 match is next week in Paris, increasing the number of seats in the Stade de France stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of the people who value the tickets less sell them to people who are willing to pay more (i.e., scalp the tickets), then the effective price will rise to the equilibrium price.