Elasticities

1.2 Elasticities: Price elasticity of demand

Price elasticity of demand (PED): the measure of the responsiveness of the quantity demanded of a good to a change in its price, along a demand curve

Mathematically the value is negative, as the demand curve slopes downwards, but we treat it as a positive value

PED= (Δ% Qd) / (Δ%P)

This shows price elastic demand: PED>1

This means that a small percentage change in price causes a large percentage change in quantity demanded.

This is usual for luxury goods with many substitutes, such as ferraris, gucci bags and superyachts.

This shows price inelastic demand: 0<PED<1

This means that a large percentage change in price causes a small percentage change in quantity demanded.

This is usual for necessity goods with few substitutes, like bread, milk and electricity

This shows price unitary elastic demand: PED=1

This means that a percentage change in price causes a proportionate percentage change in quantity demanded.

This shows perfectly price elastic demand: PED=∞

This means that an infinitesimally small percentage change in price causes infinitely large percentage change in quantity demanded.

This shows perfectly price inelastic demand: PED=0

This means that an infinitely large percentage change in price causes infinitesimally small percentage change in quantity demanded.

In order to remember this graph just remember the demand curve is a vertical line like an 'I' so it must be 'I'nelastic.

Determinants of PED

Income spent: the higher the proportion of income spent of purchasing a product, the higher the product’s PED.

Degree of necessity and how widely defined: if a product has a high degree of necessity and is well defined, then it will have a low PED, as it is more inelastic

For instance water will have a high PED.

Number and closeness of substitutes: the great quantity of close substitutes a product has the higher the PED value, meaning it is more elastic.

For instance toothbrushes have high elasticities, as there are lots of brands selling similar toothbrushes.

Time period considered: when price of a product changes it takes time for consumers to adapt (lag time) and it takes time to adjust purchasing habits. This means that the more time it takes the higher the PED. The product will be inelastic in the short term, but elastic in the long term.

To remember these determinants of PED, just think TINS.

Calculate PED

The slope of a straight-line demand curve, one with a constant slope, has constantly changing elasticity. It includes all five elasticity alternatives--perfectly elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly inelastic. No two points on a straight-line demand curve have the same elasticity because the slope and elasticity are different concepts. Slope measures the steepness or flatness of a line in terms of the measurement units for price and quantity. Elasticity measures the relative response of quantity to changes in price.

Calculate the PED, when there is a price increase from P1 to P2.

PED = (1/3*100) / (3/3*100)

PED = 0.33 = inelastic

Applications of PED

Significance to firms: if PED is inelastic then the firm can increase its revenue by increasing the price per unit, because demand will remain high.

If PED is elastic then the firm can decrease its price to increase revenue because demand will increase by a more than proportional quantity.

Significance to governments: if the government uses indirect taxes to tax a good with inelastic PED, then they will gain higher government revenues than a good with elastic PED.

This is part of the reason why cigarettes, petrol and alcohol are so highly taxed.

Manufactured goods: tend to have a high PED because they are usually not necessity good but have many close substitutes.

For instance cotton socks, seeded bread, Demerara sugar.

Primary commodities: tend to have a low PED because they are usually necessity goods with no close substitutes.

For instance wheat, cow leather, raw cane sugar, coal, cotton plant.

Cross Price Elasticity

Cross price elasticity (XED): the measure of the responsiveness of the quantity demanded of one good to a change in price of another good.

XED= (Δ% Qd of A) / (Δ%P of B)

There is a movement along the demand curve for one good causing a shift in the demand for another good.

IF XED is zero then the two goods are unrelated to each other.

For example the XED will be about zero for makeup and soup, fluffy toys and glasses, coffee and a sofa.

IF XED is negative then the two goods are compliments of each other. The higher the value the closer the compliments.

For example the XED will be a high negative value for games console and x-box, pencils and pencil case, car and petrol.

IF XED is positive then the two goods are substitutes of each other. The higher the value the closer the substitutes.

For example the XED will be a high positive value for iPhones and blackberries, CDs and online music purchasing, crunchy nut cereal and cheerios cereal.

The absolute XED value therefore depends on the closeness of the relationship between the goods.

For instance petrol and cars are likely to have a higher negative XED value than toast and marmite, even though they are also compliments

Applications of XED

High negative XED value: firms may wish to have this because it means that the goods are more likely to complement each other, so they will often be purchased together. Therefore, the firm has greater a greater market to sell to and a higher demand is sustained.

Low positive XED value: firms may wish to have this because it means that the goods are less likely to be substituted for each other, so there is less competition. Therefore, the firm can keep the price higher.

Income Elasticity of Demand

Income elasticity of demand (YED): the measure of the responsiveness of the quantity demanded of a good to a change in income.

YED= (Δ% Qd) / (Δ% income)

A change in income shifts the demand curve.

Normal good: demand increases for a normal good as income increases, so they have a positive YED.

For instance televisions and mobile phones

Inferior good: demand decreases for an inferior good as income increases, so they have a negative YED.

For instance own brand food, second hand cars

Luxury goods: income is elastic as 1<YED, so the percentage change in demand is very significant as income rises. This is because once needs have been fulfilled, people purchase their wants in a great number.

For instance jewellery, gadgets, expensive holiday homes, caviar, champagne.

Necessity good: income is inelastic as 0<YED<1, so the percentage change in demand is very small as income rises

For instance food, water, clothing, shelter.

Applications of YED

If there is a high YED for manufactured goods, then consumers will continue to buy it as long as they can afford it.

During an economic crisis producers are unlikely to be making a lot of revenue on manufactured goods as they are income elastic.

If there is relatively low YED, the producer can raise or lower the prices, despite the state of the economy, consumers will continue to buy the good because it is income inelastic.

If there is an even higher YED for services, the demand will decrease because it is merely a luxury good and not a necessity, meaning it is income elastic.

Price elasticity of supply

Price elasticity of supply (PES): the measure of the responsiveness of the quantity supplied of a good to a change in its price, along a supply curve

PES= (Δ% Qs) / (Δ%P)

The value will always be positive because the supply curve slops upwards.

This shows price elastic supply: PES>1

This means that a small percentage change in price causes a large percentage change in quantity supplied.

This shows price inelastic supply: 0<PES<1

This means that a large percentage change in price causes a small percentage change in quantity supplied.

This shows unitary price elastic supply: PES=1

This means that a percentage change in price causes a proportionate percentage change in quantity supplied.

This shows perfectly price inelastic supply: PES=0

This means that an infinitely large percentage change in price causes infinitesimally small percentage change in quantity supplied.

This shows perfectly price elastic supply: PES=∞

This means that an infinitesimally small percentage change in price causes infinitely large percentage change in quantity supplied.

Determinants of of PES

Ability to store stock: if the producers are able to store more stock, then the supply is more elastic because they are able to respond to price increases with swift supply increases.

Mobility of factors of production: the more mobile the factors of production are the more elastic supply is. This is because it is easier to move to another production, with lower average costs, when price rises.

For instance a printing press can easily be switched from printing magazines to printing cards.

Unused capacity: the more unused capacity the more elastic supply is because not all resources are being used so output can easily be increased by using these without incurring great costs.

For instance the supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.

Time period considered: the longer the time period considered the more elastic the supply is as there is greater time to increase the factors of production, like capital.

Calculate PES

Calculate the PES, when there is a price increase from P1 to P2.

PES = (1/3*100) / (3/3*100)

PES = 0.33 = inelastic

Applications of PES

Primary commodities: tend to have a low PES because there cannot be a sudden change in how much is produced.

They also have relatively inelastic PED, PES and YED.

Therefore, the PES is low because they have a high degree of necessity, but it takes time to grow/harvest to increase the quantity supplied and there are few or no substitutes.

Manufactured goods: tend to have a high PES because it is easier to change production in factories or shops.

Also they have relatively elastic PED, PES and YED.