Microeconomics: Elasticity Concept of Supply and Demand

INTRODUCTORY MICROECONOMICS

CONTENTS

MICROENOMICS (Words: 2,744)

1. ELASTICITY CONCEPT OF DEMAND & SUPPLY

Elasticity lets us know a lot of things about our demand and supply. Besides that, elasticity of demand lets us know what number of additional units of an item will be sold when the value is cut (or what number of fewer units will be sold when the value is increased). The degree to which a demand or supply curve’s responds to a change in value is the curve elasticity (Heakal, R., 2003). Reem Heakal (2003) expressed that items that are necessities are more incentive to price changes since purchasers might keep purchasing these items despite the increments of price. On the other hand, a price increase of a good or service that is recognized to a lesser degree need will stop more consumers since the chance expense of purchasing the item will get to be excessively high (Quant Lego, 2013).

Elasticity is a concept of responsiveness of one or more economic variables to changes in an alternate set of one or more variables (Quant Lego, 2013). The way of this responsiveness and the genuine value of elasticity convey useful knowledge and information to comprehend the way of relationship among economic variables and take decisions to influence one economic variable under one’s control to acquire a desired outcome about the quality of the other economic variable (Quant Lego, 2013).

A good or service is acknowledged to be highly elastic if a slight change in value prompts to a sharp change in the amount demanded or supplied. Normally these sorts of items are promptly accessible in the business and an individual may not so much require them in his or her everyday life. O the other hand, an inelastic good or service is one in which changes in value witness just modest changes in the amount demanded or supplied, if any whatsoever (Quant Lego, 2013). These products have a tendency to be things that are to a greater extent a need to the consumer in his or her everyday life.

The elasticity of the supply or demand curves can be determined using the equation below:

Elasticity = (% change in quantity / % change in price)

According to Heakal, R. (2003), if elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

The demand curve is a negative slope as shown in Figure 1, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic (Heakal, R., 2003).

Figure 1Graph of elastic demand

(Source: http://www.investopedia.com/university/economics/economics4.asp)

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price as shown in Figure 2 (Heakal, R., 2003).

Figure 2Graph of Inelastic demand

(Source: http://www.investopedia.com/university/economics/economics4.asp)

Elasticity of supply works similarly. According to Heakal, R. (2003), if a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Hence, elasticity in this case would be greater than or equal to one as shown in Figure 3.

Figure 3 Graph of elastic supply

(Source: http://www.investopedia.com/university/economics/economics4.asp)

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one as shown in Figure 4 (Heakal, R., 2003).

Figure 4Graph of inelastic supply

(Source: http://www.investopedia.com/university/economics/economics4.asp)

Elasticity, defined as a ratio of proportional or per cent changes, is necessarily dimensionless — meaning that it is independent of units of measurement (Hodrick, L. S. (1999). For example, the value of the price elasticity of demand for gasoline would be the same whether prices were measured in dollars or francs, or quantities in tonnes or gallons. This unit-independence is the main reason why elasticity is so popular a measure of the responsiveness of economic behaviour (Hairies, L., 2005).

2. PRICE ELASTICITY OF DEMAND AND SUPPLY

Hence, elasticity is a measure of exactly how much the amount demanded will be influenced by a change in value wage or change in price of related goods (Heakal, R., 2003). There are four sorts of elasticity, there are; price elasticity of demand, income elasticity of demand, cross price elasticity of demand and price elasticity of supply (Gachette, B., 2007).

2.1 Price Elasticity of demand

Price elasticity of demand analyses the responsiveness of consumer demand to a change in price which is significant to know since then we know if it’s more beneficial to increase or decrease cost.

In addition, price elasticity of demand help figure demand and help the firms choose about pricing in distinctive business portions. Monopolistic price discrimination might be practiced if the demand elasticity of distinctive business sector fragments is known/ assessed. Price elasticity of demand and supply helps to focus the feasible offering of the occurrence of a tax or a change in the tax rate (Das, S., 2005). Buoyancy in tax venues might be judged on the basis of income and price elasticity. This information is very useful for the economists included in providing estimates of tax revenue and proposes new taxes or changes in tax rates in the government (Das, S., 2005).

2.2 Income elasticity of demand

Income elasticity of demand is the responsiveness of consumer demand to a change in wage this helps economists with classifying goods as substandard (the higher the income the lower the consumption) or normal (the higher the income the higher the consumption) (Das, S., 2005).

Income elasticity of demand helps extend the interest for goods that a nation might require as the economy develops to higher and higher per capita wage levels. Demand for certain essential components of food are relatively inelastic after a certain level of income is reached. Thus, demand for cereals (for example, oats) is inelastic once the population has crossed the poverty line. But the demand for grains may at present increment through the demand for meat (as animals have to be reared on fodder grains). Such information helps long-term national planning.

2.3 Cross price elasticity of demand

Cross price elasticity of demand is the responsiveness of consumer demand to a change in a competitors price this helps economists in comprehension if goods are complements (demand for one leads to demand for another) or substitutes (demand for one means less demand for another) (Das, S., 2005).

Cross price elasticity also help pricing and marketing strategies keeping in view the effect of changes in cost of substitutes, complementary items and competing items in the same want fulfilling category. Publicizing using elasticity is essential to decide about advertising outlays and alternative advertising campaigns of organizations.

2.4 Price elasticity of supply

Finally price elasticity of supply is the responsiveness regarding supply with a change in price which helps economists comprehend suppliers capacity to increase stocks for example agricultural goods producers have a low price elasticity of supply because if demand suddenly increases they have limited capacity to increase supply because of the long time it takes to produce this supply (Das, S., 2005).

3. DIFFERENCE BETWEEN CONSUMER SURPLUS & PRODUCER SURPLUS

Customer and Producer surplus are two huge parts of matters of trade and profit particularly concerning marketing and pricing (Michigan State University, 2001). Customer Surplus is the cost above business sector value that you might be ready to pay or expressed diversely it is the maximum price that you might pay for a thing – the genuine price for that thing. Producer Surplus is basically the contrast between what a producers is willing and able to supply or offer an item for and what they get for it (Whfreeman, 2005).

Simple example about consumer surplus, such as I-phone, let’s say that you willing to pay a maximum of RM2,500 but when you get to the store you discovered that the I-phone only cost you RM2,000 in which case you bought it and received a consumer surplus of RM 500; RM2,500 – RM2,000 = RM 500. Another example for producer surplus, take a company like Apple, let’s say that they would be willing to sell I-Pod for RM 200 and that is the absolute lowest they would willing to sell for but they manage to sell them for a price of RM 300 in this case the producer surplus is RM 100; RM 300 – RM 200 = RM100.

When you observed those figures carefully, you’ll see that a basic economic principle in that the higher a product is priced the higher the producer surplus will be but the lower consumer surplus will, eventually if the seller keeps raising its prices then the consumer surplus will become 0 at the point the consumer will not want to purchase that product anymore (Whfreeman, 2005). Therefore, there are certain factors that need to be comprehended deeply in order to understand more about this consumer and producer surplus.

Firstly is the law of demand. The law of demand stated that consumers will buy more of something (for example, sugar) when the price is falls or cheaper. Secondly is the law of supply. The law of supply stated that the higher the price of a product the more of it sellers are willing to supply. The premise of this comes essentially from producer surplus. Higher product price increases producer surplus thus they are willing to sell more of it because of the positive surplus (Michigan State University, 2001).

The concepts of producer and consumer surplus help economists make welfare (normative) judgement about different methods of producing and distributing goods (Khan Academy, 2014). The differences between consumer and producer surplus are consumer surplus measures the gains to consumers from trade, whereas producer surplus measures the gains to producers from trade. Both consumer and producer surplus can measure a nation’s prosperity more accurately than GDP (gross domestic product). These concepts can help us to understand why markets are an efficient way to organize trade.

Figure 5Graph of total surplus of Consumer and producer (e.g. books)

(Source: Gachette, B. (2007) Principles of Microeconomics.)

Based on the Graph of total surplus of consumer and producer as shown in Figure 5, both consumers and producers are better off because there is a market in this good, there are gains from trade. These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient.

Consumer surplus is the difference between the value to buyers of a level of consumption of a good and the amount the buyers must pay to get that amount. Consumer surplus is the welfare consumers get from the good. Consumer surplus can be estimated from the demand curve for a good (Pepperdine University, 2010). The term producer’s surplus first shown up in A. Marshall’s Principle [11, p. 811, f.2], taking shape as the area between the competitive equilibrium price and the supply curve, a curve that slopes upwards as a result of placing the firms in order of diminishing efficiency as shown on figure 5. Marshall seems to stretch out the terms in order to comprehend all the surpluses a man determines as producer, including a “worker’s surplus” arising from the sale of his personal services and a “saver’s surplus” arising from the services of his capita (Mishan, E. J., 1968).

4. EFFECTS OF ELASTICITY ON CONSUMER SURPLUS & PRODUCER SURPLUS

In economics, elasticity is the ratio of the proportional change in one variable with respect to proportional change in another variable (Gachette, B., 2007). Price elasticity, for example, is the sensitivity of quantity demanded or supplied to changes in prices. Elasticity is usually expressed as a negative number but shown as a positive percentage value. One typical application of the concept of elasticity is to consider what happens to consumer demand for a good (for example, apples) when prices increase. According to Gachette, B. (2007), as the price of a good rises, consumers will usually demand a lower quantity of that good, perhaps by consuming less, substituting other goods, and so on. The greater the extent to which demand falls as price rises, the greater the price elasticity of demand. However, there may be some goods that consumers require, cannot consume less of, and cannot find substitutes for even if prices rise (for example, certain prescription drugs). Another example is oil and its derivatives such as gasoline. For such goods, the price elasticity of demand might be considered inelastic.

Furthermore, elasticity will normally be different in the short term and the long term (Das, S., 2005). For example, for many goods the supply can be increased over time by locating alternative sources, investing in an expansion of production capacity, or developing competitive products which can substitute. One might therefore expect that the price elasticity of supply will be greater in the long term than the short term for such a good, that is, that supply can adjust to price changes to a greater degree over a longer time (Pepperdine University, 2010).

This applies to the demand side as well. For example, if the price of petrol rises, consumers will find ways to conserve their use of the resource. However, some of these ways, like finding a more fuel-efficient car, take longer period of time. Thus, consumers may be less able to adapt to price shocks in the short term than in the long term (Hairies, L., 2005).

However, there would be another effect of consumer surplus when the producer takes advantage of consumer surplus such as setting prices. In an organization (producers/ sellers) can identify groups of consumer within their market who are willing and able to pay different prices for the same product, then producers/sellers might engage in price discrimination. The price that the consumer willing to pay, thereby turning consumer surplus into extra revenue. This often happen in local fitness gym either in your area or other places whereby different fitness gym offers different prices with the same products.

Another good example that can be seen the effect of consumer and producer surplus is the Airlines companies itself, such as Air Asia Airlines. Air Asia Airlines using their famous tagline “Now everyone can fly” is one of the cheapest and affordable prices Airlines in Asia. By extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. If you noticed that, often the price of tickets flights is cheaper when you book the flight earlier either weeks or months in advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow at the same time making sure that each seat are being filled. The nearer the time to take off, the higher the price of the tickets flights. Thus, if a businessman is desperately to fly from Kota Kinabalu, Sabah to Kuala Lumpur, Peninsular Malaysia within 24 hour time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher. Therefore, this is one of the way Airlines such as Air Asia Airlines exploit their monopoly position by raising the prices in markets where demand is inelastic, at the same time extracting consumer surplus from buyers and increasing profit margin.

5. SUMMARY

In conclusion, elasticity is an important concept in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, distribution of wealth and different types of goods as they relate to the theory of consumer choice and. Elasticity is also significant in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus. Furthermore, the concept of elasticity has an extraordinarily wide range of applications in economics. In particular, an understanding of elasticity is useful to understand the dynamic response of supply and demand in a market, in order to achieve an intended result or avoid unintended results. For example, a business considering a price increase might find that doing so lowers profits if demand is highly elastic, as sales would fall sharply. Similarly, a business considering a price cut might find that it does not increase sales, if demand for the product is price inelastic. Therefore, an economic signal is any piece of information that helps people makes better economic decisions.

6.REFERENCES

Das, S. (2005) The Concept of Elasticity in Economics. Available at: http://www.montgomerycollege.edu/~sdas/elasticity/broaderusage.htm (Accessed 20 February 2014).

Gachette, B. (2007) Principles of Microeconomics. Available at: http://www.aiu.edu/publications/student/english/Principles%20of%20Microeconomics.html (Accessed 21 February 2014)

Haines, L. (2005) Elasticity is Back: Oil and Gas Investor.

Heakal, R. (2003). Economics Basics: Elasticity. Investopedia Available at: http://www.investopedia.com/university/economics/economics4.asp (Accessed 21 February 2014).

Hodrick, L. S. (1999) Does Price Elasticity Affect Corporate Financial Decisions? Journal of Financial Economics.

Mishan, E. J. (1968). What is Producer Surplus? The American Economic Review, Vol. 58, No. 5.

Khan Academy (2014) Consumer & Producer Surplus. Available at: https://www.khanacademy.org/economics-finance-domain/microeconomics/consumer-producer-surplus (Accessed 20 February 2014).

Michigan State University (2001) Consumer and Producer Surplus. Available at: https://www.msu.edu/course/ec/201/brown/pim/pdffiles98/csps98.pdf (Accessed 21 February 2014).

Pepperdine University (2010) Chapter 4: Surplus and Efficiency. Available at: http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Ch4.ppt (Accessed 20 February 2014).

Quant Lego (2013) Economics Basics: A Tutorial. Building Blocks For Financial Quant Skills. Available at: http://www.quantlego.com/knowledge/economics-basics-tutorial/5/ (Accessed 21 February 2014).

Whfreeman (2005) Chapter 6: Consumer and Producer Surplus. Available at: http://www.whfreeman.com/college/pdfs/krugman_canadian/CH06.pdf (Accessed 21 February 2014).