Price is dependent on the interaction between demand and supply components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price. This section of the Agriculture Marketing Manual explains price in a competitive market. When imperfect competition exists, such as with a monopoly or single selling firm, price outcomes may not follow the same general rules. Equilibrium priceWhen a product exchange occurs, the agreed upon price is called an equilibrium price, or a market clearing price. Graphically, this price occurs at the intersection of demand and supply as presented in Image 1. In Image 1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance. Price determination depends equally on demand and supply. Image 1. Figure 1, Graph showing price equilibrium curves
It is truly a balance of the market components. To understand why the balance must occur, examine what happens when there is no balance, such as when market price is below that shown as P in Image 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market. The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored. A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business. Change in equilibrium priceWhen either demand or supply shifts, the equilibrium price will change. The section on understanding supply factors explains why a market component may move. The examples below show what happens to price when supply or demand shifts occur. Example 1: Unusually good weather increases output When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand. Image 2. Figure 2, Graph showing movement along demand curve
In Image 2, price falls from P1 to P2 if a bumper crop is produced. If the demand curve in this example was more vertical (more inelastic), the price-quantity adjustments needed to bring about a new equilibrium between demand and the new supply would be different. To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve (or line) with a slope more vertical than that depicted in Image 2. Then compare the size of price-quantity changes in this with the first situation. With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic. The opposite is true for quantity. A larger change in quantity will occur when demand is elastic compared with the quantity change required when demand is inelastic. Example 2: Consumers lower their preference for beef A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left, as seen in Image 3. Image 3. Figure 3. Graph showing movement along supply curve
With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward shift of demand causes price to fall and also the quantity exchanged to fall. The amount of change in price and quantity, from one equilibrium to another, is dependent upon the elasticity of supply. Imagine that supply is almost fixed over the time period being considered. That is, draw a more vertical supply curve for this shift in demand. When demand shifts from D1 to D2 on a more vertical supply curve (inelastic supply) almost all the adjustment to a new equilibrium takes place in the change in price. Price stabilityTwo forces contribute to the size of a price change: the amount of the shift and the elasticity of demand or supply. For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding demand curve is elastic. That would show up in Example 1 above, if the demand curve is drawn flatter (more elastic). In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture when either supply or demand shifts in the short-term. Price levelThe two examples above focus on factors that shift supply or demand in the short-term. However, longer-term forces are also at work, which shift demand and supply over time. One particular supply shifter is technology. A major effect of technology in agriculture has been to shift the supply curve rapidly outward by reducing the costs of production per unit of output. Technology has had a depressing effect on agricultural prices in the long-term since producers are able to produce more at a lower cost. At the same time, both population and income have been advancing, which both tend to shift demand to the right. The net effect is complex, but overall the rapidly shifting supply curve coupled with a slow moving demand has contributed to low prices in agriculture compared to prices for industrial products. At various levels of a market, from farm gate to retail, unique supply and demand relationships are likely to exist. However, prices at different market levels will bear some relationship to each other. For example, if hog prices decline, it can be expected that retail pork prices will decline as well. This price adjustment is more likely to happen in the long-term once all participants have had time to adjust their behaviour. In the short-term, price adjustments may not occur for a variety of reasons. For example, wholesalers may have long-term contracts that specify the old hog price, or retailers may have advertised or planned a feature to attract customers. SummaryMarket prices are dependent upon the interaction of demand and supply. An equilibrium price is a balance of demand and supply factors. There is a tendency for prices to return to this equilibrium unless some characteristics of demand or supply change. Changes in the equilibrium price occur when either demand or supply, or both, shift or move. By the end of this section, you will be able to: Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as (Figure) summarizes.
To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{{\mathrm{Q}}_{2}–{\mathrm{Q}}_{1}}{\left({\mathrm{Q}}_{2}+{\mathrm{Q}}_{1}\right)/2} × 100\\ \text{% change in price}& =& \frac{{\mathrm{P}}_{2}–{\mathrm{P}}_{1}}{\left({\mathrm{P}}_{2}+{\mathrm{P}}_{1}\right)/2} × 100\end{array}[/latex] The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases.
Let’s calculate the elasticity between points A and B and between points G and H as (Figure) shows.
Calculating the Price Elasticity of Demand We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price.
First, apply the formula to calculate the elasticity as price decreases from ?70 at point B to ?60 at point A: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{3,000–2,800}{\left(3,000+2,800\right)/2} × 100\\ & =& \frac{200}{2,900} × 100\\ & =& 6.9\\ \text{% change in price}& =& \frac{60–70}{\left(60+70\right)/2} × 100\\ & =& \frac{–10}{65} × 100\\ & =& –15.4\\ \text{Price Elasticity of Demand}& =& \frac{ 6.9%}{–15.4%}\\ & =& 0.45\end{array}[/latex] Therefore, the elasticity of demand between these two points is [latex]\frac{ 6.9%}{–15.4%}[/latex] which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. Mathematically, we take the absolute value of the result. We will ignore this detail from now on, while remembering to interpret elasticities as positive numbers. This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values. The following Work It Out feature will walk you through calculating the price elasticity of demand.
Finding the Price Elasticity of Demand Calculate the price elasticity of demand using the data in (Figure) for an increase in price from G to H. Has the elasticity increased or decreased? Step 1. We know that: [latex]\begin{array}{rcl}\text{Price Elasticity of Demand}& =& \frac{\text{% change in quantity}}{\text{% change in price}}\end{array}[/latex] Step 2. From the Midpoint Formula we know that: [latex]\begin{array}{rcl}% \text{change in quantity}& =& \frac{{\text{Q}}_{2}–{\text{Q}}_{1}}{\left({\text{Q}}_{2}+{\text{Q}}_{1}\right)/2} × 100\\ % \text{change in price}& =& \frac{{\text{P}}_{2}–{\text{P}}_{1}}{\left({\text{P}}_{2}+{\text{P}}_{1}\right)/2} × 100\end{array}[/latex] Step 3. So we can use the values provided in the figure in each equation: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{1,600–1,800}{\left(1,600+1,800\right)/2} × 100\\ & =& \frac{–200}{1,700} × 100\\ & =& –11.76\\ \text{% change in price}& =& \frac{130–120}{\left(130+120\right)/2} × 100\\ & =& \frac{10}{125} × 100\\ & =& 8.0\end{array}[/latex] Step 4. Then, we can use those values to determine the price elasticity of demand: [latex]\begin{array}{rcl}\text{Price Elasticity of Demand}& =& \frac{\text{% change in quantity}}{\text{% change in price}}\\ & =& \frac{–11.76}{8}\\ & =& 1.47\end{array}[/latex] Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve.
Assume that an apartment rents for ?650 per month and at that price the landlord rents 10,000 units are rented as (Figure) shows. When the price increases to ?700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity?
Price Elasticity of Supply We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price.
Using the Midpoint Method, [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{13,000–10,000}{\left(13,000+10,000\right)/2} × 100\\ & =& \frac{3,000}{11,500} × 100\\ & =& 26.1\\ \text{% change in price}& =& \frac{?700–?650}{\left(?700+?650\right)/2} × 100\\ & =& \frac{50}{675} × 100\\ & =& 7.4\\ \text{Price Elasticity of Supply}& =& \frac{26.1%}{ 7.4%}\\ & =& 3.53\end{array}[/latex] Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and we read it as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change. If you’re starting to wonder if the concept of slope fits into this calculation, read the following Clear It Up box.
Is the elasticity the slope? It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in (Figure), at each point shown on the demand curve, price drops by ?10 and the number of units demanded increases by 200 compared to the point to its left. The slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning. When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage. Thus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we’d have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic. As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a ?1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change.
From the data in (Figure) about demand for smart phones, calculate the price elasticity of demand from: point B to point C, point D to point E, and point G to point H. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
From point B to point C, price rises from ?70 to ?80, and Qd decreases from 2,800 to 2,600. So: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{2600–2800}{\left(2600+2800\right)÷2}× 100\\ & =& \frac{–200}{2700}× 100\\ & =& –7.41\\ \text{% change in price}& =& \frac{80–70}{\left(80+70\right)÷2}× 100\\ & =& \frac{10}{75}× 100\\ & =& 13.33\\ \text{Elasticity of Demand}& =& \frac{–7.41%}{13.33%}\\ & =& 0.56\end{array}[/latex] The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point D to point E: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{2200–2400}{\left(2200+2400\right)÷2}× 100\\ & =& \frac{–200}{2300}× 100\\ & =& –8.7\\ % \text{change in price}& =& \frac{100–90}{\left(100+90\right)÷2}× 100\\ & =& \frac{10}{95}× 100\\ & =& 10.53\\ \text{Elasticity of Demand}& =& \frac{–8.7% }{10.53%}\\ & =& 0.83\end{array}[/latex] The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point G to point H: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{1600–1800}{1700}× 100\\ & =& \frac{–200}{1700}× 100\\ & =& –11.76\\ \text{% change in price}& =& \frac{130–120}{125}× 100\\ & =& \frac{10}{125}× 100\\ & =& 8.00\\ \text{Elasticity of Demand}& =& \frac{–11.76% }{8.00%}\\ & =& –1.47\end{array}[/latex] The demand curve is elastic in this interval.
From the data in (Figure) about supply of alarm clocks, calculate the price elasticity of supply from: point J to point K, point L to point M, and point N to point P. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
From point J to point K, price rises from ?8 to ?9, and quantity rises from 50 to 70. So: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{70–50}{\left(70+50\right)÷2}× 100\\ & =& \frac{20}{60}× 100\\ & =& 33.33\\ \text{% change in price}& =& \frac{?9–?8}{\left(?9+?8\right)÷2}× 100\\ & =& \frac{1}{8.5}× 100\\ & =& 11.76\\ \text{Elasticity of Supply}& =& \frac{33.33%}{11.76%}\\ & =& 2.83\end{array}[/latex] The supply curve is elastic in this area; that is, its elasticity value is greater than one. From point L to point M, the price rises from ?10 to ?11, while the Qs rises from 80 to 88: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{88–80}{\left(88+80\right)÷2}× 100\\ & =& \frac{8}{84}× 100\\ & =& 9.52\\ \text{%change in price}& =& \frac{?11–?10}{\left(?11+?10\right)÷2}× 100\\ & =& \frac{1}{10.5}× 100\\ & =& 9.52\\ \text{Elasticity of Demand}& =& \frac{9.52%}{9.52%}\\ & =& 1.0\end{array}[/latex] The supply curve has unitary elasticity in this area. From point N to point P, the price rises from ?12 to ?13, and Qs rises from 95 to 100: [latex]\begin{array}{rcl}\text{% change in quantity}& =& \frac{100–95}{\left(100+95\right)÷2}×100\\ & =& \frac{5}{97.5}×100\\ & =& 5.13\\ \text{% change in price}& =& \frac{?13–?12}{\left(?13+?12\right)÷2}× 100\\ & =& \frac{1}{12.5}× 100\\ & =& 8.0\\ \text{Elasticity of Supply}& =& \frac{5.13%}{8.0% }\\ & =& 0.64\end{array}[/latex] The supply curve is inelastic in this region of the supply curve.
What is the formula for calculating elasticity?
What is the price elasticity of demand? Can you explain it in your own words?
What is the price elasticity of supply? Can you explain it in your own words?
Transatlantic air travel in business class has an estimated elasticity of demand of 0.62, while transatlantic air travel in economy class has an estimated price elasticity of 0.12. Why do you think this is the case?
What is the relationship between price elasticity and position on the demand curve? For example, as you move up the demand curve to higher prices and lower quantities, what happens to the measured elasticity? How would you explain that?
The equation for a demand curve is P = 48 – 3Q. What is the elasticity in moving from a quantity of 5 to a quantity of 6?
The equation for a demand curve is P = 2/Q. What is the elasticity of demand as price falls from 5 to 4? What is the elasticity of demand as the price falls from 9 to 8? Would you expect these answers to be the same?
The equation for a supply curve is 4P = Q. What is the elasticity of supply as price rises from 3 to 4? What is the elasticity of supply as the price rises from 7 to 8? Would you expect these answers to be the same?
The equation for a supply curve is P = 3Q – 8. What is the elasticity in moving from a price of 4 to a price of 7? elastic demand when the elasticity of demand is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price elastic supply when the elasticity of either supply is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price elasticity an economics concept that measures responsiveness of one variable to changes in another variable inelastic demand when the elasticity of demand is less than one, indicating that a 1 percent increase in price paid by the consumer leads to less than a 1 percent change in purchases (and vice versa); this indicates a low responsiveness by consumers to price changes inelastic supply when the elasticity of supply is less than one, indicating that a 1 percent increase in price paid to the firm will result in a less than 1 percent increase in production by the firm; this indicates a low responsiveness of the firm to price increases (and vice versa if prices drop) price elasticity the relationship between the percent change in price resulting in a corresponding percentage change in the quantity demanded or supplied price elasticity of demand percentage change in the quantity demanded of a good or service divided the percentage change in price price elasticity of supply percentage change in the quantity supplied divided by the percentage change in price unitary elasticity when the calculated elasticity is equal to one indicating that a change in the price of the good or service results in a proportional change in the quantity demanded or supplied |
Which of the following components affect whether the supply of a good is price elastic or inelastic
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