AGRICULTURAL ECONOMICS

Elasticities of supply and demand

 Price elasticity of demand (ep)
According to the law of demand a negative
relationship exists between the price and the
quantity demanded. Price elasticity provides an
indication of how sensitive or responsive
the quantity demanded is for a change in the
price. If the quantity demanded by consumers
responds strongly to a change in the price, the
demand is said to be "elastic", while the concept
"inelastic" is used when the quantity demanded
is not very responsive to a change in the price.
 Price elasticity of demand (ep)
Elasticity is a measure of the sensitivity or
responsiveness between two variables that are
related. This indicates that a cause and effect
reaction exists between the two variables. A
change in X causes a change in Y and elasticity
provides a measurement of how strong this effect
is. Examples of elasticity in economics are price
elasticity of demand and supply, income elasticity
of demand, cross elasticity and interest elasticity
of investment.
 Price elasticity of demand (ep)
Price elasticity (ep) of demand is
measured as follows:

Price elasticity (ep) is measured by dividing

the percentage change in quantity
demanded through the percentage change in
the price of the product.
 Price elasticity of demand (ep)
The percentage change in quantity demanded is
equal to the change in quantity demanded,
divided by quantity demanded times 100.
The percentage change in the price is equal to the
change in price divided by price times 100.
The price elasticity is therefore equal to the
change in the quantity demanded divided by
quantity demanded times 100 divided by the
change in the price divided by price times 100.
 Price elasticity of demand (ep)
Percentage change in quantity =
Final Qty Initial Qty/Initial Qty *100
Percentage change in price =
Final Price Initial Price/Initial Price *100
 Price elasticity of demand (ep)
It provides a relative measure of elasticity. The
elasticity coefficient is a number and a
distinction is made between ep <1 ; ep =1;
ep >1 ; and the theoretical cases of ep = 0 and
ep = infinite.
 Price inelastic demand (ep < 1)
If the price elasticity of a product is smaller that
one, the demand is said to be inelastic.
In the case of an inelastic demand, the
percentage change in the quantity demanded
is smaller than the percentage change in the
price.
The following examples illustrate this:
Assume that the quantity demanded decreases
from 100 to 90 when the price increases from R8
to R10.
 Price inelastic demand (ep < 1)
The percentage change in the quantity
demanded is equal to 10,52% while the
percentage change in the price is equal to
22,2% .
The price elasticity is therefore equal to
 Price inelastic demand (ep < 1)
Price elasticity is important for firms since it
has an important impact on the total revenue
firms receive from the sales of their products.
If a firm produces a price inelastic product,
that is ep < 1, an increase in the price will
cause an increase in the total revenue of the
firm.
 Price elastic demand (ep > 1)
If the price elasticity of a product is larger than
one, the demand is said to be elastic.
In the case of an elastic demand, the percentage
change in the quantity demanded is larger than
the percentage change in the price.
The following example illustrates this:
Assume that the quantity demanded decreases
from 100 to 70 when the price increases from R8
to R10.
 Price elastic demand (ep > 1)
The percentage change in the quantity
demanded is equal to 46,15% while the
percentage change in the price is equal to
22,2%.
The price elasticity is therefore equal to
 Price elastic demand (ep > 1)
Price elasticity is important for firms since it
has an important impact on the total revenue
firms receive from the sales of their products.
If a firm produces a price elastic product, that
is ep > 1, an increase in the price will cause a
decrease in the total revenue of the firm.
 Price elasticity of demand (ep) and
total revenue (TR)
Price elasticity is important for firms since it has an important
impact on the total revenue firms receive from the sales of their
products
The total revenue (TR) of a firm is a function of the price the firm
get for its product and the quantity sold. Therefore, total revenue
can be described as:
TR = Price x Quantity
=PxQ
If the quantity demanded by consumers responds strongly to a
change in the price, the demand is said to be "elastic". In this case
the price elasticity is larger than 1 and consequently total revenue
decreases as the price increases.
If price elasticity is smaller than one demand is said to be
"inelastic". In this case total revenue increases when the price
rises.
 Factors affecting Price elasticity of
demand
These are determinants of the
sensitivity/responsiveness of quantity demanded
to price changes
1. The presence of substitutes
2. The cost of the good relative to household
income
3. The essential or non-essential nature of
commodity
4. Habits
5. Loyalty
 Factors affecting Price elasticity of
demand
The presence of substitutes
Goods with readily available substitutes buyers
would switch to alternative whose price has not
increased and are now cheaper. Demand of
such goods are highly price-elastic
Goods with no effective substitutes if price
increases, the quantity bought would only
decrease by a small amount. Such goods are
relatively unresponsive to price changes, hence
their demand in price-inelastic
 Factors affecting Price elasticity of
demand
The presence of substitutes
 Factors affecting Price elasticity of
demand
The cost of the good relative to household income
Households spend very little on salt. If the price
of salt doubles, housewives would still buy the
same amount of salt because the impact of the
increase on total spending in insignificant.
A student using a car, would cut down on non-
essential travelling if the cost of fuel increases.
This is because fuel expenses are considerably
high in proportion to the total spending money.
 Factors affecting Price elasticity of
demand
The essential or non-essential nature of commodity
There are commodities that people cannot live
without the essentials like water, food, shelter
and clothing. If the price of these go up, the
quantity demanded hardly change.
The quantity demanded of luxuary goods (non-
essential) would be highly responsive to price
changes as consumers can live without them
 Factors affecting Price elasticity of
demand
Habits
Well established habits make consumers
insensitive to price changes. Governments
take advantage of this by imposing tax on
tobacco. Tax on cigarettes increase price, but
the decrease in quantities bought in minimal
(inelastic). This means the revenue from
cigarette sales increases.
 Factors affecting Price elasticity of
demand
Loyalty
Consumers that are loyal to certain brands of
goods would hardly switch to alternatives if
price increases.
 Perfectly elastic Demand
A perfectly elastic demand indicates that if
there is a slight increase in the price the
quantity demanded will drop to zero. In this
case consumers are not willing to pay more
than the ruling price and even an increase of a
few cents will decrease the quantity
demanded to zero. A perfectly elastic demand
curve has an elasticity coefficient of infinity
and is depicted by a horizontal line.
Perfectly elastic Demand
 Perfectly inelastic Demand
A perfectly inelastic demand indicates that the
quantity demanded remains unchanged
irrespective of a change in the price of the
product. A perfectly inelastic demand has an
elasticity coefficient of zero and is depicted by
a vertical line.
Perfectly inelastic Demand
 Price elasticity of demand (ep) and
total revenue (TR)
True or false questions
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Elasticity is simply a measure of the responsiveness or sensitivity of a dependent
variable (eg the number of motor accidents) to changes in an independent
variable (eg the average following distances maintained by motorists).
True
False
Price elasticity of demand is a measure of the responsiveness of quantity
demanded to changes in price.
True
False
Price elasticity of demand varies from point to point along a linear normal demand
curve.
True
False
 Income elasticity of Demand
If households get an increase in income they
will increase the quantity of goods and
services they buy. However, they will not
increase expenditure on all commodities
equally.
Very little extra bread will be bought but a lot
more bottles of wine may be bought. The
responsiveness of demand for commodities as
a result of income change is measured by
Income elasticity of Demand
 Income elasticity of Demand
Income elasticity of Demand =
% change in quantity demanded x 100
% change in household income
Graphically, the response of demand to
income is shown by a shift in demand curve
 Income elasticity of Demand
The graphs show that wine is more responsive
(elastic) to increase in income than bread
 Income elasticity of Demand
According to Engels law, the proportion of
personal expenditure devoted to necessities
decrease as income rises
 Significance of Income elasticity of
demand
Government policy to increase minimum wage
rates can be used to stimulate industry
production through increasing consumer
expenditure.
Consumers will respond differently for each
category of goods. Agricultural goods will be
relatively inelastic compared to services industry,
since agricultural goods are typically necessities
(food, clothes)
The agricultural industry does not benefit much
from policies that increase household income as
compared to other industries
 Cross elasticity of Demand
The cross elasticity of demand measures the responsiveness of the
quantity demanded of a particular good to changes in the price of a
related good.
It is measured as the percentage change in demand for one good in
response to a percentage change in price of the other good.
For example, if a 10% increase in the price of CD players, the
quantity of new CDs demanded decreased by 20%, the cross
elasticity of demand would be -20%/10% = -2. In this example the
two goods, CD players and CDs are complements - that is, one is
used with the other. In these cases the cross elasticity of demand is
negative (complements).
If the two goods are substitutes the cross elasticity of demand is
positive. In other word if the price of one goes up the quantity
demanded of the other will increase (substitutes).
 Cross elasticity of Demand
The cross elasticity of demand=
% change in quantity demanded of good Y x 100
% change in price of good X

Where X and Y are related goods