Equilibrium Price

In my previous blog, I had explained about the price elasticity of demand. In this blog, I will explain about the Income Elasticity of Demand, Price Elasticity of Supply, Equilibrium Price and Cross-price.

Income is the cause and demand is the effect. Income elasticity of demand can be positive or negative.

Income is the cause and quantity demanded is the effect. Income can shift demand.

Let us assume the income elasticity of demand for a product is 0.68, it means that for each 1% change in the income, the change in the quantity of the product that people will buy would 0.68.

Normal products — If your income goes up, the product people purchases also goes up. The income elasticity of demand is +ve for normal products.

Inferior products — If the income increases people would buy less quantity of the product. The income elasticity of demand is -ve for inferior products.

If the |Income Elasticity Of Demand| < 1, it is inelastic.

This understanding helps a business to predict how the changes in the economy would affect the product people are going to buy. You can see ahead and decide whether you need to produce more quantity of the product or ramp down.

If the |Income Elasticity Of Demand| > 1, it is highly elastic

A good example is environmental protection policy of a country. In a developed country and people are rich, they are more worried about the quality of air and water versus if they are poor, they are more concerned about food, basic medical facility education etc. For e.g. if the income elasticity of demand for environmental protection is 1.9, then people want 1.9 percent more environmental protection for the 1% increase in their income.

Income elasticity of demand, helps you prepare for recessions in advance.

Let us take the example of cars, and assume that the income elasticity of demand for cars is 2.1. It is highly elastic, which means that the car manufacturers need to know that if the income of the population in your country is decreasing, you have to manufacture less.

Price elasticity of supply

As explained earlier, price is the cause and supply is the effect.

Usually the price elasticity of supply looks like the figure above. If the price increases, the supply increases. As per the law of supply, mostly the price elasticity of supply is +ve.

The buyers and sellers determine the price. The equilibrium price is where the quantity demanded is equal to the quantity supplied. The equilibrium price is the only place where the price is stable.

Let us take the case of real estate as an example. If the price elasticity of supply in real estate is 8%. For each 1% change in the price of houses, the number of houses built is going up by 8%. This also means that for a 10% decrease in the price of the house, there will be 80 fewer houses built. So, a real estate business needs to watch for a price drop.

Let us see how the price elasticity of supply curve is for a very high elasticity.

For a small in change in price, if the elasticity is high, there is a huge change in the quantity. If the initial demand curve is D1 and the equilibrium price of houses are in the range of 18 Lakh rupees, due to increase in people’s income, the demand goes up to D2. For a small increase in the price, the quantity of houses built, shoots up.

I read that medical specialists were fewer in United States. For e.g. Let us assume that the number of surgeries done per day was normal (supply say the curve S1) and the equilibrium price (due to D1) was also normal. But over a period of time, due the aging population as well as due to more health insurance, if the demand increased, the cost of the surgeries would also increase (depicted by the curve D2). Let us assume that it reached a stage where the number of surgeries became stagnant, but the demand kept increasing, as a result, the cost of the surgery would also increase. As the demand increased, price increased and if the doctors were doing lesser surgeries, then the supply curve S1 would bend backwards. Doctors would be earning more and doing lesser surgeries, probably for having their own personal time. The only solution is to increase the number of doctors. If there is an increase in the number of doctors (supply), the cost of the surgeries would reduce.

Cross-price elasticity of demand — where cross-price is the cause and demand, is the effect. Here, we have to look at two different products. If the cross-price elasticity of demand is negative there is an inverse relationship and the products are compliments. If it is a positive value, then the products are supplements