Supply and Demand

Price Elasticity of Demand

The demand of a commodity can be classified as being inelastic, elastic or unitary elastic in response to changes in price. Demand is inelastic when price increase leads to less than the equal decrease in demand.

However, elastic demand refers to a situation where percentage increase in price results to a more than equal percentage decrease in demand. Lastly, unitary elasticity is a situation where the percentage increase in price and percentage decrease in demand is equal.

Cross elasticity of Demand

Cross elasticity of demand measures the degree of dependency between demand of one commodity and price of another commodity.

For complementary goods demand of one commodity depends on the price of the other commodity. Subsequently, cross elasticity of demand for complementary goods is less than zero. For substitutes, cross elasticity of demand is positive given that increase in price of one commodity increases demand of the other commodity.

Income Elasticity of Demand

Income elasticity of demand is the sensitivity of demand to changes in average levels of income in a country. Demand of inferior goods is elastic as far as income is concerned because people switch to other goods when their income changes. Since people increase the quantity of normal goods, they purchase when their income increases, income elasticity of demand for normal goods is greater than zero.

Relationship between Elasticity and Substitutes

Substitutes provide consumers with more options to choose from when deciding what to buy. Assume that Coke and Pepsi are perfect substitutes and that price per unit of both commodities is equal. Increase in the price of Coke will make it more expensive than Pepsi.

Consumers being aware of the presence of Pepsi will decrease their demand for Coke and increase demand for Pepsi. As a result, the demand for a given commodity is more elastic when substitutes are easily available.

The proportion of Earnings Spent on Goods and Elasticity

Other factors held constant, demand for commodities that take a higher percentage of income is elastic. Take for example house rent and tea leaves. Equal percentage increase in prices of tea leaves and house rent will cause a different reaction from consumers.

Since the proportion of income spent on tea leaves is small, the increase in expenditure on tea leaves due to the increase in prices will be small. Therefore, the decrease in demand will be lesser. Similarly, an increase in the expenditure on rent will be significant. As a result, many people will want to move to cheaper houses to reduce expenses.

The reaction of Customers to Huge Changes in Price

People do not instantly alter their demand because of very many reasons. Time may be a limiting factor preventing consumers from getting information about available options.

Consequently, people tend not to change their demand in response to income or price changes in the short-run. Nevertheless, as time elapses, people become aware of substitutes available thus reducing demand for a commodity whose price is high. As a result, elasticity of demand increases in the long-run.

Effects of Elasticity on Total Revenue

When price ranges between 40 and 80, demand is elastic. This is because any increase in price causes higher than the equal decrease in quantity demanded thus reducing total revenue.

When the price is between 40 and 50, the increase in price is equal to a decrease in demand thus leaving total revenue unchanged. Consequently, price is unitary elastic in this case. On the other hand, when price ranges between 0 and 40 units demand is inelastic. The price increase does not cause a substantial decrease in demand thus leading to an increase in total revenue.