🟠 Topic 3: Elasticity of Demand and Supply

📖 Explanation (1000+ Words)

📌 Introduction

One of the most important concepts in microeconomics is elasticity, which measures how responsive demand or supply is to changes in price, income, or other factors. Understanding elasticity helps economists and policymakers predict how markets react to changes, and assists businesses in pricing strategies.

🔹 What is Elasticity?

💡 Elasticity refers to the degree to which the quantity demanded or supplied responds to changes in one of its determinants, such as price, income, or the price of related goods.

Elasticity answers questions like:
✔️ How much will demand for smartphones fall if their price increases by 10%?
✔️ Will a reduction in petrol prices increase its consumption significantly?

🔹 Types of Elasticity of Demand

1️⃣ Price Elasticity of Demand (PED)

• Definition: Measures the responsiveness of quantity demanded to changes in price.
• Formula:

PED=%Change in Quantity Demanded%Change in Price\text{PED} = \frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Price}}

• 💡 If PED > 1, demand is elastic (responsive).
• 💡 If PED < 1, demand is inelastic (unresponsive).
• 💡 If PED = 1, demand is unitary elastic.

Factors Affecting PED

• Availability of substitutes 🥤: More substitutes = Higher elasticity.
• Necessity vs luxury 🏥: Necessities = Inelastic; Luxuries = Elastic.
• Time period ⏳: Short term = Inelastic; Long term = Elastic.
• Proportion of income spent 💰: Higher proportion = More elastic.

2️⃣ Income Elasticity of Demand (YED)

• Definition: Measures the responsiveness of demand to changes in income.
• Formula:

YED=%Change in Quantity Demanded%Change in Income\text{YED} = \frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Income}}

• Normal goods: YED > 0 (Demand rises with income).
• Inferior goods: YED < 0 (Demand falls as income rises).

3️⃣ Cross Elasticity of Demand (XED)

• Definition: Measures the responsiveness of demand for one good to changes in the price of another good.
• Formula:

XED=%Change in Demand for Good X%Change in Price of Good Y\text{XED} = \frac{\% \text{Change in Demand for Good X}}{\% \text{Change in Price of Good Y}}

• Substitute goods: XED > 0 (Tea & Coffee ☕).
• Complementary goods: XED < 0 (Car & Petrol 🚗⛽).

🔹 Types of Elasticity of Supply

1️⃣ Price Elasticity of Supply (PES)

• Definition: Measures the responsiveness of quantity supplied to changes in price.
• Formula:

PES=%Change in Quantity Supplied%Change in Price\text{PES} = \frac{\% \text{Change in Quantity Supplied}}{\% \text{Change in Price}}

• If PES > 1, supply is elastic.
• If PES < 1, supply is inelastic.

Factors Affecting PES

• Time to adjust production 🏭: Longer time = More elastic supply.
• Availability of resources ⛏️: Scarce inputs = Inelastic supply.
• Spare production capacity ⚙️: More spare capacity = More elastic supply.
• Ease of factor mobility 🚚: Easily movable factors = More elastic supply.

📊 Importance of Elasticity

🔥 Real-life Examples

📌 Petrol in India: Petrol has inelastic demand, so even large price hikes cause only small reductions in demand.
📌 Luxury Cars: Demand for luxury cars like Mercedes is elastic, as buyers can defer purchase if prices rise 🚗.
📌 Seasonal Vegetables: Supply of seasonal vegetables is elastic in long term but inelastic in short term due to crop cycles 🌽.

🔄 Relationship Between Elasticity & Revenue

• Elastic Demand: Price rise leads to fall in total revenue.
• Inelastic Demand: Price rise leads to increase in total revenue.

This helps businesses decide whether to raise or lower prices for maximizing revenue.

🔔 MCQs  

1️⃣ Consider the following statements about Price Elasticity of Demand (PED):

1. If PED > 1, demand is elastic.
2. If PED < 1, demand is inelastic.
3. PED for luxury goods is generally less than 1.
4. Availability of close substitutes makes demand more elastic.

Which of the above statements are correct?

✅ Options:
(a) 1, 2 and 4 only
(b) 1 and 3 only
(c) 2, 3 and 4 only
(d) 1, 2, 3 and 4

2️⃣ Which of the following factors affect Price Elasticity of Supply (PES)?

1. Availability of raw materials
2. Time period for adjustment
3. Consumer preferences
4. Production capacity

✅ Options:
(a) 1, 2 and 4 only
(b) 1 and 3 only
(c) 2 and 4 only
(d) 1, 2, 3 and 4

3️⃣ Which of the following goods is most likely to have inelastic demand?

✅ Options:
(a) Air conditioners
(b) Essential medicines
(c) Smartphones
(d) Designer clothes

4️⃣ Consider the following statements regarding Income Elasticity of Demand (YED):

1. Normal goods have positive YED.
2. Inferior goods have negative YED.
3. Luxury goods have YED < 1.
4. YED is unaffected by income changes in the long run.

Which of the above statements are correct?

✅ Options:
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1, 2 and 3 only
(d) 1, 2, 3 and 4

5️⃣ Cross Elasticity of Demand (XED) is positive for which type of goods?

✅ Options:
(a) Complements
(b) Substitutes
(c) Necessities
(d) Inferior goods