Kno-how! on elasticity

Students should be able:Define, measure and interpretprice elasticity of supply,price, income and crosselasticity of demandDistinguish between normaland inferior goods.

Students should be able:Define, measure and interpretprice elasticity of supply,price, income and crosselasticity of demandDistinguish between normaland inferior goods.

Elasticity

Background Reading:Phillip Allan p.?Nutter p.?

Background Reading:Phillip Allan p.?Nutter p.?

Elasticity – The conceptThe responsiveness of one variableto changes in another

Elasticity4 basic types used:

Price elasticity of demandPrice elasticity of supplyIncome elasticity of demandCross elasticity of demand

4 basic types used:Price elasticity of demandPrice elasticity of supplyIncome elasticity of demandCross elasticity of demand

Price Elasticity of DemandIf price rises by 10% - what happens toquantity demand?We know quantity demanded willcontractBy more than 10%?By less than 10%?Or exactly 10%?Elasticity measures the extent to whichdemand will change.

If price rises by 10% - what happens toquantity demand?We know quantity demanded willcontractBy more than 10%?By less than 10%?Or exactly 10%?Elasticity measures the extent to whichdemand will change.

Price Elasticity of DemandThe responsiveness of demand to asmall change in price

Where % change in demand is greaterthan % change in price – elasticWhere % change in demand is lessthan % change in price - inelastic

The responsiveness of demand to asmall change in price

Where % change in demand is greaterthan % change in price – elasticWhere % change in demand is lessthan % change in price - inelastic

Price Elasticity of DemandThe formula:

% Change in Quantity DemandedPED = ___________________________

% Change in Price

Note: PED has – sign in front of it; because as price risesdemand falls and vice-versa (inverse relationship betweenprice and demand)

Price Elasticity of DemandAlternative formula: PED =

QD P1Q1*P

Different demand curvesPrice (£)

Quantity Demanded

Inelastic demandPrice (£)

10 % Δ Price = -50%

% Δ Quantity Demanded = +20%

PED = -0.4 (Inelastic)

Producer decides to lower price to attract sales

Quantity Demanded

D

5

5

6

PED = -0.4 (Inelastic)

Total Revenue would fall

Not a good move!

Elastic demandPrice (£)

Producer decides to reduce price to increase sales% Δ in Price = - 30%

% Δ in Demand = + 300%Ped = - 10 (Elastic)

Total Revenue rises

Quantity Demanded

D

10

5 20

7

Total Revenue rises

Good Move!

ElasticityIf demand is priceelasticPED will be between-1 and infinityIncreasing pricewould reduce TotalRevenue (%Δ Qd > %Δ P)Reducing price wouldincrease TR(%Δ Qd > % Δ P)

If demand is priceinelastic:PED will be between0 and -1Increasing pricewould increase TotalRevenue(%Δ Qd < % Δ P)Reducing price wouldreduce TR (%Δ Qd <% Δ P)

If demand is priceelasticPED will be between-1 and infinityIncreasing pricewould reduce TotalRevenue (%Δ Qd > %Δ P)Reducing price wouldincrease TR(%Δ Qd > % Δ P)

If demand is priceinelastic:PED will be between0 and -1Increasing pricewould increase TotalRevenue(%Δ Qd < % Δ P)Reducing price wouldreduce TR (%Δ Qd <% Δ P)

Price Elasticity of Demand andConsumer Expenditure

Special cases

P2

P

D

b

Perfectly inelastic demand (PD = – )

QO Q1

P1 a

P

P1 Da b

Perfectly elastic demand (PD = –)

Q2 QO Q1

P

20a

Unit elastic demand (PD = –1)

QO 40

D

100

8b

Price Elasticity of Demand andConsumer Expenditure

Special cases =PED = 0 (perfectly inelastic)PED = (perfectly elastic)PED = –1 (unitary)

Special cases =PED = 0 (perfectly inelastic)PED = (perfectly elastic)PED = –1 (unitary)

Elasticity Value Diagram Meaning Increased Price willlead to...

PossibleExamples

PerfectlyElastic

∞ Demand infinite at a givenprice. Demand 0 at anyother price

Total Revenue falls tozero.

Theoreticalspecial cases

Elastic 1<∞ % change in qty demandedis greater than % change inprice

A fall in total revenue. SUV’s, 5 starhotels, flatscreen TV’s

Unitary 1 % change in demand equalto % change in price

Total revenue remainsunchanged.

Special cases,potenital anygood?

Special cases,potenital anygood?

Inelastic 0<1 % change in qty demandedis less than % change inprice.

A rise in total revenue. Petrol,cigarettes, rice.

PerfectlyInelastic

0 No change in demand whenprice changes

A rise in total revenue. Highly addictivegoods.

Determinants of PriceElasticity of Demand

Number and closeness of substitutes – thegreater the number of substitutes the moreelasticNOT anything else. Goods which might appear tobe inelastic for other reasons such as smallproportion of income but even these would notbe if they had substitutes.Only determinant of PED is

SUBSTITUTABILITY

Number and closeness of substitutes – thegreater the number of substitutes the moreelasticNOT anything else. Goods which might appear tobe inelastic for other reasons such as smallproportion of income but even these would notbe if they had substitutes.Only determinant of PED is

SUBSTITUTABILITY

Income Elasticity ofDemand

The Formula: % Change in Quantity DemandedYED = ___________________________

% Change in Income

Alternative formula: YED =QD Y

Q1*Y

Income Elasticity of Demand(YED)

The responsiveness of demand to asmall change in income.Superior Good – demand rises asincome rises and vice versa (apositive sign) Inferior Good –demand falls as income rises andvice versa (a negative sign)

The responsiveness of demand to asmall change in income.Superior Good – demand rises asincome rises and vice versa (apositive sign) Inferior Good –demand falls as income rises andvice versa (a negative sign)

Income Elasticity of Demand(YED)

E.G.YED = 0: Good’s demand does not varywith income – it is a necessity.YED is between + 1 and -1: Good isincome inelastic (close to necessity).YED is greater than +1: Good is a luxuryand is income elastic.YED is less than - 1: Good is an inferiorgood and is income elastic.

E.G.YED = 0: Good’s demand does not varywith income – it is a necessity.YED is between + 1 and -1: Good isincome inelastic (close to necessity).YED is greater than +1: Good is a luxuryand is income elastic.YED is less than - 1: Good is an inferiorgood and is income elastic.

Cross Elasticity of DemandThe responsiveness of demand of onegood to a small change in the price ofanother good – either a substitute or acomplement % Δ Qd of good a

The responsiveness of demand of onegood to a small change in the price ofanother good – either a substitute or acomplement

XED = % Δ Qd of good a________________% Δ Price of good b

Alternative formula: XED =QDa Pb

QDa*Pb

Cross Elasticity of DemandGoods which are complements:

XED will have negative sign (inverserelationship between the two)

Goods which are substitutes :XED will have a positive sign (positiverelationship between the two)

Goods which are complements:XED will have negative sign (inverserelationship between the two)

Goods which are substitutes :XED will have a positive sign (positiverelationship between the two)

Price Elasticity of SupplyThe responsiveness of supply to a small changein price

If PES is inelastic: Suppliers find it difficultto react swiftly to changes in priceIf PES is elastic: Suppliers can react tochanges in price

The responsiveness of supply to a small changein price

If PES is inelastic: Suppliers find it difficultto react swiftly to changes in priceIf PES is elastic: Suppliers can react tochanges in price % Δ Quantity Supplied

PES = ____________________% Δ Price

Alternative formula: PED =QS P1

Q1*P

P

P1

S2

S1

Supply curves with different price elasticityof supply

Supply curves with different price elasticityof supply

QO Q2

P0

Q0 Q1

Factors determining the priceelasticity of supply

1. Spare production capacity – high PES when businesses orthe economy has plenty of spare capacity, eg when a business oreconomy is coming out of recession2. Inventories / stocks of finished products and components– high level of stocks (inventories) means that supply can quickly beadjusted to meet changes in demand – this is important incommodity markets3. The ease and cost of factor substitution - if both capital andlabour resources are occupationally mobile then the elasticity ofsupply for a product is high because capital and labour can beswapped with little loss of efficiency or productivity4. Time period involved in the production process – PES ishigher the longer the time period that a firm is allowed to adjust itsproduction levels. In some agricultural markets, momentary supplyis fixed and is determined mainly by planting decisions mademonths before.

1. Spare production capacity – high PES when businesses orthe economy has plenty of spare capacity, eg when a business oreconomy is coming out of recession2. Inventories / stocks of finished products and components– high level of stocks (inventories) means that supply can quickly beadjusted to meet changes in demand – this is important incommodity markets3. The ease and cost of factor substitution - if both capital andlabour resources are occupationally mobile then the elasticity ofsupply for a product is high because capital and labour can beswapped with little loss of efficiency or productivity4. Time period involved in the production process – PES ishigher the longer the time period that a firm is allowed to adjust itsproduction levels. In some agricultural markets, momentary supplyis fixed and is determined mainly by planting decisions mademonths before.

Importance of elasticityRelationship between changes inprice and total revenueImportance in determining whatgoods to tax (tax revenue)Importance in analysing time lagsin productionInfluences the behaviour of a firm

Relationship between changes inprice and total revenueImportance in determining whatgoods to tax (tax revenue)Importance in analysing time lagsin productionInfluences the behaviour of a firm