What is Elasticity? What factors effects the elasticity of Demand ?

Elasticity
Elasticity in economics is the measurement of how changing one economic variable affects others. For example: "If I lower the price of my product, how much more will I sell?" "If I raise the price, how much less will I sell?" "If we learn that a resource is becoming scarce, will people scramble to acquire it?" Elasticity varies among in products because some products may be more essential to the consumer. Generally, an elastic variable is one which responds a lot to small changes in other parameters. Similarly, an inelastic variable describes one which does not change much in response to changes in other parameters. In more technical terms, it is the ratio of the percentage change in one variable to the percentage change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between factors of production and elasticity of intertemporal substitution. Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation,marginal concepts as they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, orgovernment surplus. In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis. A major study of the price elasticity of supply and the price elasticity of demand for US products was undertaken by Hendrik S. Houthakker and Lester D. Taylor.

Elasticity of Demand:
It is the degree of responsiveness of the quantity demanded of a commodity to change in some market variables e.g price,income etc.

Factors that effects the elasticity of Demand:

Good with close substitutes tend to have elastic demand curves. The demand for good ''A'' is ''price sensitive'' to changes in the price of good ''B'', because they both satisfy the same want. The demand for one brand of butter will vary, if another brand is put on ''special'' at your local supermarket. ''Necessities'' tend to have inelastic demand curves. If households see a good as essential to daily living, demand for the good will be ''price insensitive''. For example, if the price of milk rose by 50 cents a litre, demand for milk would not change greatly. All households want milk. Luxuries on the other hand tend to have elastic demand curves. If soft drinks are put on ''special'' at your local supermarket, and their price is lowered, demand for them will rise markedly. Part of this ''necessities'' versus ''luxuries'' distinction is based on the cost of the item. Many necessities are inexpensive: they have low prices - a loaf of bread, a litre of milk, a box of matches, all only cost a very small part of your available disposable income. An increase in the price of a litre of milk of 50 cents is still ''small change'' for many consumers, and they will continue to demand milk at the same levels as they did before the price rise. Luxuries on the other hand can be very expensive and cost a large part of your available disposable income. You may decide not to buy that French champagne to celebrate a birthday, if the price rises from $30 to $32. The price of $30 is already a large enough disincentive. Some goods are habit forming, or addictive. Cigarettes are a clear example. Once ''hooked'', the average smoker will continue to pay more and more for cigarettes, as governments increase taxes on tobacco. Very few smokers give up smoking because of price increases; most give up for health reasons.

Perfect Competition:
In economic theory, perfect competition (sometimes called pure competition) describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets. Still, buyers and sellers in some auction-type markets, say for commodities or some financial assets, may approximate the concept. Perfect competition serves as a benchmark against which to measure real-life and imperfectly competitive markets.

Basic structural characteristics:

Generally, a perfectly competitive market exists when every participant is a "price taker", and no participant influences the price of the product it buys or sells. Specific characteristics may include: Infinite buyers and sellers An infinite number of consumers with the willingness and ability to buy the product at a certain price, and infinite producers with the willingness and ability to supply the product at a certain price. Zero entry and exit barriers A lack of entry and exit barriers makes it extremely easy to enter or exit a perfectly competitive market.

Perfect factor mobility In the long run factors of production are perfectly mobile, allowing free long term adjustments to changing market conditions.

Perfect information - All consumers and producers are assumed to have perfect knowledge of price, utility, quality and production methods of products.

Zero transaction costs - Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.

Profit maximization - Firms are assumed to sell where marginal costs meet marginal revenue, where the most profit is generated.

Homogenous products - The qualities and characteristics of a market good or service do not vary between different suppliers.

Non-increasing returns to scale - The lack of increasing returns to scale (or economies of scale) ensures that there will always be a sufficient number of firms in the industry.

Property rights - Well defined property rights determine what may be sold, as well as what rights are conferred on the buyer.

In the short run, perfectly-competitive markets are not productively efficient as output will not occur where marginal cost is equal to average cost (MC=AC). They are allocatively efficient, as output will always occur where marginal cost is equal to marginal revenue (MC=MR). In the long run, perfectly competitive markets are both allocatively and productively efficient. In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost (P=MC). This implies that a factor's price equals the factor's marginal revenue product. It allows for derivation of the supply curve on which the neoclassical approach is based. This is also the reason why "a monopoly does not have a supply curve". The abandonment of price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition. :

Approaches and conditions

In neoclassical economics there have been two strands of looking at what perfect competition is. The first emphasis is on the inability of any one agent to affect prices. Usually justified by the fact that any one firm or consumer is so small relative to the whole market that their presence or absence leaves the equilibrium price very nearly unaffected. This assumption of negligible impact of each agent on the equilibrium price has been formalized by Aumann (1964) by postulating a continuum of infinitesimal agents. The difference between Aumann's approach and that found in undergraduate textbooks is that in the first, agents have the power to choose their own prices but do not individually affect the market price, while in the second it is simply assumed that agents treat prices as parameters. Both approaches lead to the same result. The second view of perfect competition conceives of it in terms of agents taking advantage of and hence, eliminating profitable exchange opportunities. The faster this arbitrage takes

place, the more competitive a market. The implication is that the more competitive a market is under this definition, the faster the average market price will adjust so as to equate supply and demand (and also equate price to marginal costs). In this view, "perfect" competition means that this adjustment takes place instantaneously. This is usually modeled via the use of the Walrasian auctioneer(see article for more information). The widespread recourse to the auctioneer tale appears to have favored an interpretation of perfect competition as meaning price taking always, i.e. also at non-equilibrium prices; but this is rejected e.g. by Arrow (1959) or Mas-Colell et al. Steve Keen notes, following George Stigler, that if firms do not react strategically to one another, the slope of the demand curve that a firm faces is the same as the slope of the market demand curve. Hence, if firms are to produce at a level that equates marginal cost and marginal revenue, the model of perfect competition must include at least an infinite number of firms, each producing an output quantity of zero. As noted above, an influential model ] of perfect competition in neoclassical economics assumes that the number of buyers and sellers are both of the power of the continuum, that is, an infinity even larger than the number of natural numbers. K. Vela Velupillai quotes Maury Osborne as noting the inapplicability of such models to actual economies since money and the commodities sold each have a smallest positive unit. Thus nowadays the dominant intuitive idea of the conditions justifying price taking and thus rendering a market perfectly competitive is an amalgam of several different notions, not all present, nor given equal weight, in all treatments. Besides product homogeneity and absence of collusion, the notion more generally associated with perfect competition is the negligibility of the size of agents, which makes them believe that they can sell as much of the good as they wish at the equilibrium price but nothing at a higher price (in particular, firms are described as each one of them facing a horizontal demand curve). However, also widely accepted as part of the notion of perfectly competitive market are perfect information about price distribution and very quick adjustments (whose joint operation establish the law of one price), to the point sometimes of identifying perfect competition with an essentially instantaneous reaching of equilibrium between supply and demand. Finally, the idea of free entry with free access to technology is also often listed as a characteristic of perfectly competitive markets, probably owing to a difficulty with abandoning completely the older conception of free competition. In recent decades it has been rediscovered that free entry can be a foundation of absence of market power, alternative to negligibility of agents. Free entry also makes it easier to justify the absence of collusion: any collusion by existing firms can be undermined by entry of new firms. The necessarily long-period nature of the analysis (entry requires time!) also allows a reconciliation of the horizontal demand curve facing each firm according to the theory, with the feeling of businessmen that "contrary to economic theory, sales are by no means unlimited at the current market price" (Arrow 1959 p. 49). Sraffian economists[6] see the assumption of free entry and exit as characteristic of the theory of free competition inClassical economics, an approach that is not expressed in terms of schedules of supply and demand.