Question

4- After you graduate from university, you find a job in a company that produces good X. You are working in a competitive market. Your boss asks you to compute the price elasticity of demand, income elasticity of demand, cross-price elasticity of demand, and the price elasticity of supply. The question is: how your boss will benefit from computing each of these elasticities. Explain in detail with an example for each case.

Answer 1

Elasticity of demand

Elasticity refers to the degree of responsiveness of demand with respect to price.

1. Price elasticity of demand

It refers to the ratio of percentage change in quantity demanded to percentage change in price. Or degree of responsiveness of demand with price.

ep =

Where ep = price elasticity of demand

Delta Q = change in quantity demanded

Delta P= change in price

P= initial price

Q= initial quantity

Eg: let us assume that the price of commodity X is100 and the quantity demanded is 30. If the price falls from 100 to 50 ,the quantity demanded increases from 30 to 60 . The price elasticity of Demand can be calculated as

Ep= 30/50*100/30

ep=2

Here price elasticity is greater than 1 which means quantity demanded changes by a large portion than price.

2. Income elasticity of demand

It means the ratio of percentage change in quantity demanded to percentage change in income

Ey = Delta Q/DeltaY * Y/Q

where Delta Q and Delta Y are changes in quantity demanded and income respectively. Y and Q are the initial income and quantity demanded.

Eg: suppose weekly  income of a person increases from 2000 to 4000. he consumes 10 units of apple in the initial income Rs 2000. Now he demands 30 units. Income elasticity of demand is given below

Ey = 20/2000*2000/10

Ey = 2

Income elasticity is greater than 1. That means demand is highly responsive to income

3. Cross elasticity of demand

It is the ratio of the proportionate change in quantity of X to a proportionate change in the price of a related commodity Y

Ec = Delta Qx/ Delta Py * Py/Qx

Where,

Py = the original price of good Y.

Qx = the initial quantity of good X

Delta Py = change in price of good Y

Delta Qx = change in quantity X

Eg: Assume the price of good Y is 30 . The quantity demanded of good X is 100 . The price of good Y falls to 20. So that the quantity demanded of X increases to 200. Cross elasticity of demand is given below

Ec = 100/10* 30/100 =3

This is applicable in the case of Close substitute goods.if the price of tea increases , the quantity demand for coffee will also increase. Because they are substitute goods. If any change in the price of perfect complements will affect the demand of it's complementary good. Example car and petrol, Inc and pen, bread and butter etc.

4. Price elasticity of supply

It refers to the degree of responsiveness of supply with respect to price. In other words the rate at which supply changes as price changes.

Es = Delta Q / Delta P * P/Q

Here,

Delta Q is the change in quantity supplied

Delta P is the change in the price level

P is the initial price

Q is the initial quantity supply

Example: let us suppose a producer is willing to supply 100 quintals of wheat at the price of Rs 2000 Per quintal, if the price increases to RSVP 2500 per quintal, producer will be willing to supply 150 quintals of wheat. Elasticity of supply can be calculated as

Es = 50/500* 2000/100

Es = 2

Here a graduate working in a competitive market. As we all know the ultimate aim of a firm or producer is to maximize his profit. They are highly competitive in nature . So that they always try to maximise their revenue and minimise cost. Here boss wanted to compute price, income, cross elasticities of demand and price elasticity of supply. He tries to analyse how these important factors like price, income, price of related  commodities affect the elasticity of their products demand. ( if e =0 ,quantity demanded does not change as price changes. If e =1 quantity demanded changes in the same proportion as changes in price. If 'e' is greater than 1 quantity demanded changes larger proportion than change in price and if 'e' is less than 1, quantity demand changes by a smaller proportion than the change in price). And at the same time he wants to analyse the realtionship between the price and quantity supplied... He can make profit through these elasiticities. Because he will fix the price on the basis of the elasticity of demand. And if their products have collide substitutes, they can drive out their rivals through reduction in their price without reducing their profit..