Elasticities of Demand and Supply | Microeconomics

We know that the quantity demanded of a commodity rises when its price falls. The converse is also true. This is the essence of the law of demand. However, the law of demand just indicates the direction of change in the quantity demanded of a commodity when its price changes, all other variables affecting demand remaining the same.

But, in case of certain commodities like salt or rice we do not find much change in demand when price changes.

On the other hand, a small change (fall) in the price of readymade garments or motor cars leads to more than proportionate change (rise) in demand. This is why Alfred Marshall introduced the concept of elasticity in 1890 to measure the magnitude of the quantity demanded of a commodity to a certain percentage change in its price or the income of the buyers or in the prices of related goods (substitutes or complements).

Elasticity is a measure of market sensitivity of demand. It is defined as the degree of responsiveness of the quantity demanded of a commodity to a change in any of the determinants of demand. Since there are three major determinants of demand for a commodity as we know elasticity of demand is of three main types, viz., price elasticity, income elasticity and cross elasticity.

Price Elasticity of Demand:

Price elasticity of demand is defined as the degree of responsiveness of the quantity demanded of a commodity to a certain percentage change in its own price, ceteris paribus.

It is expressed as: 

Here dP/dQ is the slope of the demand curve which is the ratio of two absolute changes — absolute change in price divided by absolute change in quantity. But elasticity is a measure of percentage change. The reciprocal of the slope of the demand curve (dQ/dP) has to be multiplied by the original price-quantity ratio to find out the value of e_p which is called the coefficient of the price elasticity of demand. It is always a pure number because it is the ratio of two percentage changes.

Mathematically speaking e_p is always a negative number because the slope of the demand curve is negative. However, we often take an absolute value of e_p for analytical purposes. The important point to note is that if e_p is greater than 1, demand is said to be price elastic. But if e_p is less than 1 demand is inelastic. And if e_p is exactly equal to 1 demand is said to be unitary price elastic.

In two special situations it is possible to measure e_p from the slope of the demand curve alone, viz:

(i) The case of completely elastic demand curve (a horizontal straight line) and

(ii) The case of completely inelastic demand curve (a vertical straight line).

See Fig. 2.13.

For a horizontal demand curve, dQ/dP is infinite. Since a very small change in price leads to a very large change in demand, the elasticity of demand is infinite. For a vertical demand curve, dQ/dP is zero. Because the quantity demanded is the same at all possible prices, the elasticity of demand is zero.

If e_p = 1 the demand curve will be a rectangular hyperbola. However, if the demand curve is a straight line e will fall. In fact, we get different values of e_p at different points on a straight line demand curve and the same value of e_p at all points on a rectangular hyperbola demand curve.

Price elasticity of demand depends on a number of factors. The most important determinant of price elasticity is the number and closeness of substitutes available. It depends on how we define a commodity. If we define a commodity broadly we do not find close substitutes. For example, let us take the case of chocolates.

The demand for chocolates is not much elastic because chocolates do not have many substitutes. But if we define a commodity narrowly we find close substitutes and demand is fairly elastic. For example, there are many varieties of chocolates. Thus if the price of a particular variety of chocolate such as Cadbury chocolate increases consumers will buy less of it and more of other chocolates such as Amul chocolates.

Thus the demand for Cadbury chocolates is more elastic than demand for chocolates in general. The same reason explains why the demand for cigarettes is more inelastic than the demand for a particular variety of cigarette. Likewise the demand for Chinese food is more elastic than the demand for food in general.

Price Elasticity of Supply:

Price elasticity of supply is the percentage change in quantity supplied of a commodity resulting from a 1-percentage increase in price. The coefficient of price elasticity of supply is normally positive. In an extreme situation it can be zero (the case of completely inelastic supply). But it cannot be negative. The reason is that there is a direct (positive) relation between the price of a commodity and the quantity offered for sale.

It is very easy to measure price elasticity of supply. If the supply curve intersects the vertical axis supply is price elastic. If it intersects the horizontal axis supply is price inelastic. If the supply curve is a straight line through the origin supply is unitary price elastic. The last point may be proved very easily.

If the supply curve is a straight line through the origin the equation of the supply curve can be expressed as:

Here b is the slope of the supply curve and e_s is the coefficient of the price elasticity of supply.

At present it suffices to note that like the demand curve the supply curve may also be horizontal, indicating infinite price elasticity of supply or vertical implying infinitely inelastic supply.

Another point to note is that price elasticity of supply depends on various factors. Perhaps the most important factor is time. Supply is more elastic in the long run than in the short run. A simple example will make the point clear. Suppose the demand for candle lights increases in Kolkata due to an increase in the incidence of power failure.

Initially, as price rises, more candle lights will be supplied from existing stocks or by increasing the capacity utilisation of the existing plants. However, if the incidence of power failure continues or if the power situation worsens more candle lights will be in demand. Such demand cannot be met in the short run if there is no existing stock or if the factories are running to full capacity.

However, as price rises due to high demand new factories will be set up in the long run to increase the production capacity in the industry. In the long run more candle lights will be supplied not only by existing firms but also by new firms which join the industry. As a result supply will be more elastic than it was in the short run.