The concept of elasticity of Demand

A very important concept in understanding supply and demand theory is elasticity. In this context, it refers to how supply and demand respond to various factors. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity, which calculates the elasticity over a range of values, in contrast with point elasticity, which uses differential calculus to determine the elasticity at a specific point). It is a measure of relative changes.

Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

Calculation of the elasticity has an the advantage over the slope of the curve in being independent of (arbitrary) units, such as gallons vs.
quarts, say for the response of quantity demanded of milk to a change in price. Another distinguishing feature of elasticity that it is more than just the slope of the function. For example, a line with a constant slope will have different elasticity at various points.

One way of calculating elasticity is the percentage change in quantity
over the associated percentage change in price. For example, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered.

One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%?

If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve. At all price levels, more luxury cars would be demanded.

Another elasticity sometimes considered is the cross elasticity of
demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods.

Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in
demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0.

When demand D₁ is in effect, the price will be P₁. When D₂ is occurring, the price will be P₂. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

It is sometimes the case that a supply curve is vertical: that is the quantity supplied is fixed, no matter what the market price. For example, the amount of land in the world can be considered fixed. In this case, no matter how much someone would be willing to pay for a piece of land, the extra cannot be created.

Also, even if no one wanted all the land, it still would exist. If land is considered in this way, then it warrants a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change). On the other hand, the supply of useful land can be increased in response to demand — by irrigation. And land that otherwise would be below sea level can be kept dry by a system of dikes, which might also be regarded as a response to demand. So even in this case, the vertical line is a bit of a simplification.

Supply-side economics argues that the aggregate supply function – the total supply function of the entire economy of a country – is relatively vertical. Thus, supply-siders argue against government stimulation of demand, which would only lead to inflation with a vertical supply curve.

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