DISTINCTION BETWEEN POINT ELASTICITY AND ARC ELASTICITY OF DEMAND.

The two are different ways of computing elasticity of demand.

1. Point elasticity
Point elasticity is the proportionate change in quantity demanded resulting from a
proportionate change in price at a particular point along the demand curve.

When calculating point elasticity, it is assumed that the slope of the demand function
is known.

From the formula for elasticity,

Q p
 pp = 
p Q

Q
As noted earlier is the reciprocal of the slope of the demand function.
p

Given a demand function Q = b0 − b1 p.

Q
is found by getting first derivative of Q with respect to p
p

p
Thus point of elasticity  pp = −b1 
Q

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Example

Demand schedule

Price Quantity

0 40
1 35
2 30
3 25
4 20
5 15
6 10
7 5
8 0

Price

a
6
p − 8
slope = =
4 b Q 40

D
Quantity
0 10 20 40

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Arc Elasticity

Arc elasticity is a measure of the average elasticity; i.e. the elasticity at the mid point of the chord that
connects 2 points (A and B) along the demand curve defined by the initial and the new price levels.

Price

A
p1

B
p2 D

Quantity
0 Q1 Q2

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Using example in above demand schedule.

Assume initial price p1 = 5 , which then increases to p1 = 6

p1 Q1
5 15

p2 Q2
6 10

Q = Q2 − Q1 = 10 − 15 = −5
p = p 2 − p1 = 6 − 5 = 1

p1 + p 2 = 11
Q1 + Q2 = 25

− 5  11  1
 Ep =    = −2
1  25  5

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Income Elasticity of Demand

This can be defined as the responsiveness of quantity demanded to change in income in % term
it can be defined as:

% change in quantity demanded

EY =
% change in Income

Q Y
So that E I = 
Y Q

Where

Q is change in quantity demanded.

Q is original quantity demanded.

Y is change in income

Y is original income.

Arc income elasticity of demand can be calculated as:

Q (Y1 + Y2 )
EY = 
Y (Q1 + Q2 )

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▪ Income elasticity of demand for most commodities is positive, indicating higher purchases
at higher income. Income elasticity for a few commodities is known as inferior goods.
▪ Degree of income elasticity varies in accordance with the nature of commodities consumers
consume in general. Where the commodity id a basic necessity, the demand is not very
responsive to change in income. Basic necessities like food are usually bought in fairly
constant amount and on regular basis. In this case EY  1
▪ However, in the case of luxuries, the demand is very responsive to change in income. Sales
of such goods increase rapidly with increase in income. In this case EY  1

Cross elasticity of Demand

▪ The demand for one product can be influenced by the demand. For example, the demand
for beef product 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.
▪ In some cases, an increase in price of one product can lead to a reduction in demand for
other products. This is true of complementary products e.g. electricity and electronic
gadget, petrol to automobile etc. in this case the products are considered to be
complementary or used together rather the substitutes.
▪ Therefore, cross elasticity is the percentage change in quantity demanded of good x due to
1 % change in the price of good Y 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 elasticity of demand for tea (T) is the percentage change in its quantity
demanded with respect to one (1) percent change in price of its substitute coffee (C).

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 Point cross elasticity is calculated by the formula

QT pc
Et ,c = 
pc QT

Where

pC is price of coffee

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 cross substitutes. If price of butter
increases, the price of its substitutes (margarine) held constant, the quantity demanded of
margarines would increase.
▪ 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.

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Numerical example

QY = 5000 − 0.5 pY − 2.3 pW + 0.2 p X + 0.000001 p Z + 0.0037 I

Compute different price elasticity and state the relationships between the commodities Y, W, X and Z.

Solution

Take first derivative of commodity Y with respect to all other products.

QY
= −2.3
pW QY
= 0.2
QY p X
= 0.000001
p Z

pW p X pZ
We know with certainty that the ratios , and are all positive.
QY QY QY
Q y pw p
EY ,W =  = −2.3 w From this example it is clear that good y and w are complementary
p w Qy Qy

Q y px p
goods since E y , w is negative. E y , x =  = 0.2 x
p x Qy Qy

E y , x , is positive implying that x and y are substitutes. Good z and y are independent

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 DETERMINANTS OF PRICE-ELASTICITY OF DEMAND

The following are the main determinants of price elasticity of demand.

▪ Availability of close substitutes to the commodity.

▪ Nature of a commodity
▪ Proportion of income which consumers spend on a particular commodity.
▪ Range of uses of a commodity.
▪ Habits
1. Availabity of close substitutes-The higher the degree of the closeness of the substitutes, the
greater the elasticity of demand of the good or service. For instance, coffee and tea may be
considered as close substitute for each other. Therefore, 1 percent increase in price of say
coffee, would lead to more than proportionate increase in quantity demanded of coffee.
2. 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.
3. Proportion of income which consumes spend on a particular commodity-If
proportion of income spent on a commodity is large, its demand will be more elastic, and
vice versa. A classic example of such commodities is salt, which claims a very small
proportion of income whereas clothes, and other durable consumer goods claim a large
proportion of income.
4. 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.

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5. Habit: some goods are consumed because of habit e.g. 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.

Elasticity of supply.

▪ This is the percentage change in the quantity supplied of a commodity resulting from a 1%
change in price.
▪ Elasticity of supply is usually positive because a higher price gives producers an incentive
to increase output.
▪ Like elasticity of demand, elasticity of supply can also be referred with respect to such
variables as interest rates, wage rates, price of raw materials and other intermediate goods
etc.
▪ Symbolically, elasticity of supply ( E sp ) can be expressed as follows.

Qs p
E sp = 
p Q

▪ When a small change in price bring about a very big change in quantity supplied, then we
say that quantity supplied is elastic. On the other hand, if a big change in price brings about
a small change in quantity supplied, then we say that supply is inelastic.

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Determinants of elasticity of supply

1. Availability of factors of productivity

this can be looked at as the ease with which factors of production could be shifted from
one use to another. It can also be looked at as the number of available resources. When
factors of production are available, supply will highly be 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 inelastic.

4. Nature of a commodity
durable/ stockable commodities as clothes etc. have greater elasticity of supply than
perishable goods as milk. This is so because, incase the price of perishable items is low,
producers will still be forced to supply the items. Because it cannot be stored for future
sale when the prices would increase.

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 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.

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.

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 Price
D0
S1
S0

p1 C
p0 E
B
v1 S1
A
S0 D0
Quantity
0 Q1 Q0

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 Q1Q0

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.

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2. 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.

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. 3) Elasticity also tells us 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.

Summary

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