1.2. Elasticity

Syllabus Content

• Price elasticity of demand (PED) - Price elasticity of demand and its determinants; Applications of price elasticity of demand
• Cross elasticity of demand (XED) - Cross price elasticity of demand and its determinants; Applications of cross price elasticity of demand
• Income elasticity of demand (YED) - Income elasticity of demand and its determinants; Applications of income elasticity of demand
• Price elasticity of supply (PES) - Price elasticity of supply and its determinants; Applications of price elasticity of supply

Triple A Learning - Elasticities

Triple A Learning - Elasticities questions

Triple A Learning - elasticities simulations & activities

1.2. Elasticity

Elasticity is a central concept in economics, and is applied in many situations. Basic demand and supply analysis tells us that economic variables, like price, income and demand, are causally related. Elasticity can provide important information about the strength or weakness of such relationships.

Elasticity refers to the responsiveness of one economic variable, such as quantity demanded, to a change in another variable, such as price.

Types of elasticity

There are four types of elasticity, each one measuring the relationship between two significant economic variables. They are:

● Price elasticity of demand (PED), which measures the responsiveness of the quantity demanded to a change in price. PED can be measured over a price range, called arc elasticity, or at one point, called point elasticity.

● Price elasticity of supply (PES), which measures the responsiveness of the quantity supplied to a change in price.

● Cross elasticity of demand (XED),which measures the responsiveness of the quantity demanded of one good, good X, to a change in the price of another good, good Y.

● Income elasticity of demand (YED), which measures the responsiveness of the quantity demanded to a change in consumer incomes.

Price elasticity of Demand (PED)

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded.

The following equation enables PED to be calculated.

We can use this equation to calculate the effect of price changes on quantity demanded, and on the revenue received by firms before and after any price change.

For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be:

- 50% / + 20%

= (-) 2.5

The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate.

Price elasticity of Demand and its determinants

There are several reasons why consumers may respond elastically or inelastically to a price change, including:

• The number and ‘closeness’ of substitutes

A unique and desirable product is likely to exhibit an inelastic demand with respect to price.

• The degree of necessity of the good

A necessity like bread will be demanded inelastically with respect to price.

• Whether the good is habit forming

Consumers are also relatively insensitive to changes in the price of habitually demanded products.

• The proportion of consumer income which is spent on the good

The PED for a daily newspaper is likely to be much lower than that for a new car!

• Whether consumers are loyal to the brand

Brand loyalty reduces sensitivity to price changes and reduces PED.

• Life cycle of product

PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common.

Task 1: Assume there is a rise of about 10% in the prices of the following goods. State whether there is likely to be a large, small or no change in the quantity demanded. Then state whether you think demand is price elastic or inelastic and why.

● Oil

● DVD recorders

● Bread

● Cars – mid-range market segment

● Newspapers

Elasticity and total revenue along a linear demand curve

Why does a firm want to know PED?

There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price.

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.

Non-pricing policy

When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity.

Taxation and PED

The relative burden, or incidence, of an indirect tax is determined by the price elasticity of demand (PED) of the consumer in response to a price rise. If the consumer is unresponsive, and PED is inelastic, the burden will fall mainly on the consumer. However, if the consumer is responsive to the price rise, and PED is elastic, the burden will fall mainly on the firm.

Tax burden on the consumer

Tax burden on producer

Tax burden evenly split

Example - the incidence of a tax on cigarettes

If a government puts a £1 tax on each packet of cigarettes, the legal incidence is on the cigarette smoker. However, the local market may have many sellers, and be highly competitive. This means that a retailer, fearing they will lose sales, may decide to put up the price by only 50p, and pay the balance of 50p to the government themselves. In this case, the economic incidence is shared because both are worse off.

Task 2: Questions on PED

1: (a)Calculate the price elasticity of demand

(b) Comment on its value

(c) What will the demand curve for beans look like?

2: (a) In each case calculate the price elasticity of demand and comment on the values.

(b) Calculate the total revenue for bread and for HTC smartphones at each price.

(c) Would you advise bread-makers to cut the price of a loaf from €0.25 to €0.20? Explain your answer

(d) Would you advise manufacturers to cut the price of a HTC Smartphone from €500 to €400? Explain your answer.

Q4: Using the information above decide which of the words in italics below does not apply in each case.

(a)Demand is price elastic when the percentage change in quantity demanded is more/less than the percentage change in price. A fall in price will cause a large/small extension in quantity demanded so that total sales revenue falls/rises. If price is increased, total revenue would fall/rise.

(b) Demand is price inelastic when quantity demanded changes by a greater/smaller percentage than price. A fall in price will cause a large/small extension in quantity demanded so that total sales revenue falls/rises. A rise in price therefore causes total revenue to fall/rise.

Q5: Using the price elasticities of demand determine:

(a) Which items have an elastic demand and which have an inelastic demand?

(b) The effect on the quantity demanded of a price decrease of 20%

(c) For which items revenue will increase when the price increases

Q6: Calculate the PED for the following goods.

(a) The price of movie theatre tickets goes up by 10% causing the quantity demanded to go down by 4%.

(b) Computer prices fall by 20% causing the quantity demanded to increase by 15%.

(c) The price of apples rises by 5% causing the quantity demanded to fall by 5%.

(d) The price of ice cream falls by 6%, causing the quantity demanded to rise by 10%.

Q7: Use the following data for a demand curve.

(a) Calculate the PED between a price of $10 and $11

(b) Calculate the PED between a price of $3 and $4

(c) At what point is total revenue maximised?

Price elasticity of Supply (PES)

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate PES.

inelastic, to infinite, perfectly elastic.

Consider the following example:

A firm’s market price increases from £1 to £1.10, and its supply increases from 10m to 12.5m. PES is:

+25 +10

= (+) 2.5

The positive sign reflects the fact that higher prices will act an incentive to supply more. Because the coefficient is greater than one, PES is elastic and the firm is responsive to changes in price. This will give it a competitive advantage over its rivals.

Types of PES

Determinants of PES

How firms respond to changes in market conditions, especially price, is an important consideration for the firm itself, and to an understanding of how markets work.

The key considerations are:

1. Are resource inputs readily available?

2. Are factors mobile - are workers prepared to move to where they are needed?

3. Can finished products be easily stored, and are there existing stocks?

4. Is production running at full capacity?

5. How long and complex is the production cycle or production process?

What is the most desirable PES for a firm?

It is desirable for a firm to be highly responsive to changes in price and other market conditions. This is because a high PES makes the firm more competitive than its rivals and it allows the firm to generate more revenue and profits.

Improving PES

Because a high PES is desirable, it may be necessary for firms to undertake actions that improve their speed of response to changes in market conditions. Examples of these actions include:

1. Creating spare capacity

2. Using the latest technology

3. Keeping sufficient stocks

4. Developing better storage systems

5. Prolonging the shelf life of products

6. Developing better distribution systems

7. Providing training for workers

8. Having flexible workers who can do a range of jobs

9. Locating production near to the market

10. Allowing inward migration of labour if there is a labour shortage

Task 4: Questions on Price elasticity of supply (PES)

Q1: Calculate the PES when price increases from $1 to $2

Q2: What conclusion can you come to about natural rubber and man-made rubber

Q3: Currently the price of a good is €10 and the QS is 300 units. For every €1 increase in price, QS rises by 5 units. What is the QS at a price of €22?

Q4: The PES for a firm’s product is 0.80. At a price of €40 the QS by a firm is 600 units. Then price rises to €50. What is the firm’s revenue before and after the price rise?

Q5: Primary commodities are goods arising directly from the use of natural resources, or the factor of production ‘land’. Primary commodities therefore include agricultural, fishing and forestry products as well as products of extractive industries (oil, coal, minerals and so on). Agricultural products include food, as well as other, non-edible commodities (cotton and rubber).

Examples of agricultural products and PES

(a). Why do so many agricultural products have an inelastic PES in the short-run?

(b). What are the consequences of a low PES for primary commodities? (take a unit elastic demand curve and shift it rightwards and leftwards from the original equilibrium). Compare this situation to a manufactured product (assume unit elastic demand also)

Cross Elasticity of Demand (XED)

Cross elasticity of demand (XED) is the responsiveness of quantity demanded for one product to a change in the price of another product. Many products are related, and XED indicates just how they are related.

The following equation enables XED to be calculated.

% change in (∆) quantity demanded of good A % change in (∆) price of good B

It is a measure of the extent to which the quantity demanded of a good changes when the price of a substitute or complement changes, other things remaining the same (ceteris paribus)

Why does a firm want to know XED?

1. Knowing the XED of its own and other related products enables the firm to map out its market. Mapping allows a firm to calculate how many rivals it has, and how close they are. It also allows the firm to measure how important its complementary products are to its own products.

2. This knowledge allows the firm to develop strategies to reduce its exposure to the risks associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute.

3. Risks can be reduced in a number of ways, including adopting the following strategies:

Horizontal integration

Horizontal integration usually means merging with a rival, such as the merger of pharmaceutical giants Glaxo Wellcome and SmithKline Beecham to create GlaxoSmithKline (GSK) in 2000. Horizontal integration occurs when two or more firms producing similar products merge with each other, or where one takes over the other.

Vertical integration

Vertical integration means merging with a complement producer, such as a record producer merging with or taking over a record store, or radio station.

Alliances and collusion

Joint alliances with competitors can also take place, such as Sony-Ericsson combining resources to create mobile phones.

Collusion is also a possibility. For example, firms may enter into price fixing agreements so that they avoid having to fight a price war. This is more likely to occur in oligopolistic markets, where there are only a few competitors.

Task 5: Questions on Cross Elasticity of Demand

1. An increase in the price of hot dogs from £1.50 to £2.10 per pound increased the average number of beef burgers demanded per week from 300 to 360 Assuming that all other economic variables were held constant, the cross-price elasticity of demand between hot dogs and beef burgers is [A]___________ which indicates that the two goods are [B]___________

2. A café observed an increase in the demand for its coffee following a rise in the price of a cup of tea from £1.20 to £1.50. Assuming the cross price elasticity of demand for coffee with respect to a change in the price of tea is +0.8, by how much (in per cent) will the demand for coffee have increased?

3. The price of good X falls by 15 %. As a result, the demand for a complementary good Y rises by 30 %. What is the cross-elasticity of demand for good Y with respect to good X?

4. If the cross-price elasticity of demand for Coke and Pepsi is 0.6 and presently 1000 units of Coke are consumed, how many units of Coke will be consumed if the price of Pepsi increases by 10%

5. Good Y has a cross price elasticity of demand with respect to Good X of 0.5 and 100 units of Good Y are demanded when Good X costs 50 pence. A rise in the price of Good X to 75 pence will lead to a change in the demand for Good Y to

A. 25 units

B. 125 units

C. 150 units

D. 75 units

6. Which of the following pairs of goods is likely to have a positive cross price elasticity of demand?

A. A Sony Playstation and the games that are played on it

B. A Sony Playstation and Microsoft X Box

C. Airline travel and airline fuel

D. Washing powder and shampoo

7: The following table gives information about the market for two models of cars.

If the prices of the cars remain unchanged, but the price of petrol increases by 100%, what will be the effect on the number of cars sold per week

A. decrease by 15,000

B. decrease by 5,000

C. increase by 5,000

D. no change in total sales

8. As Oil and Gas Prices Rise, Wood Stoves Gain Converts

"After a summer of high oil and gas prices, suburb dwellers around New York, and across the country, are going low-tech in hopes of reducing their energy bills this winter." In Canada in 2008, data showed that the price of heating oil rose by 25% and the price of natural gas increased by 17% and the demand for wood stoves increased by 54%.

(1) Comment on the cross price elasticity of demand for wood stoves with respect to natural gas burning heaters

(2) Is the cross-price elasticity of demand elastic or inelastic for wood stoves in respect of changes in the price of heating oil? Briefly explain your answer

Source: Tutor2U

Question on XED

'Light-Bites', a sandwich shop, finds that when its rival, 'Super-Snack' reduced the price of its chicken wraps from $5 to $4.60, the demand for 'Light-Bites' sandwiches falls from 400 sandwiches a week to 340 sandwiches a week. In addition, 'Super-Snack' finds that following the fall in price of their chicken wraps, the demand for soft drinks rises from 600 cans to 630 cans per week.

(a) Calculate the cross elasticity of demand between 'Light-Bites' sandwiches and 'Super-Snack' chicken wraps

(b) Explain the relationship in part (a) in terms of XED

(c) Calculate the XED between 'Super-Snack' chicken wraps and the 'Super-Snack' soft drinks

(d) Explain the relationship in part (C) in terms of XED

Source: Oxford Textbook p.54

Income elasticity of Demand

Income elasticity of demand measures the responsiveness of quantity demanded of a good to a change in consumers’ income.

Income elasticity of demand (YED) shows the effect of a change in income on quantity demanded. Income is an important determinant of consumer demand, and YED shows precisely the extent to which changes in income lead to changes in demand. YED can be calculated using the following equation:

Normal goods

When the equation gives a positive result, the good is a normal good. A normal good is one where demand is directly proportional to income. For example, if, following an increase in income from £40,000 to £50,000, an individual consumer buys 40 DVD films per year, instead of 20, then the coefficient is:

+100/+25

= (+) 4.0

The positive sign means that the good is a normal good, and because the coefficient is greater than one, demand for the good responds more than proportionately to a change in income. This indicates the good is not a necessity like food, and would be considered a relative luxury for this individual.

Inferior goods

When YED is negative, the good is classified as inferior. For example, if, following an increase in income from £40,000 to £50,000, a consumer buys 180 loaves of bread per year instead of 200, then the YED is:

-10/+25

= (-) 0.4

The negative sign means that the good is inferior, and, because the coefficient is less than one, demand for the good does not respond significantly to a change in income. This indicates that the good is not particularly inferior compared with a good which has a YED of > (-)1.

The sign and the number provide different information about the relationship between income and demand. Income elasticity of demand can also be illustrated by Engel curves.

Why does a firm want to know YED?

There several reasons why a firm would want to know YED, including the following:

Sales forecasting

A firm can forecast the impact of a change in income on sales volume (Q), and sales revenue (P x Q).

For example, a hypothetical car manufacturer has calculated that YED with respect to its luxury car is (+) 3.8, and it has also undertaken research to discover that consumer incomes will rise by 2% next year. It can now predict the impact of this change.

Pricing policy

Knowing YED helps the firm decide whether to raise or lower price following a change in consumer incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand.

Diversification

Firms can diversify and offer a range of goods with different YEDs to spread the risks associated with changes in the level of national income. For example, a car manufacturer may produce cars with a range of YED values, so that sales are stabilised as the economy grows and declines.

YED and the business cycle

Changes in real national income tend to be cyclical. The demand for normal goods increases when the economy is expanding, but decreases when the economy is contracting. Conversely, the demand for inferior goods is counter-cyclical.

Task 6: Questions on Income elasticity of demand (YED)

1. When demand for a product is income inelastic, the percentage change in quantity demanded is __________ the percentage change in income

2. The income elasticity of demand for a normal good is always __________________________________.

3. It was estimated in 2003 that milk has an income elasticity of demand of -0.6. What can be concluded about milk from this information?

4. An income reduction of 15% causes Geoff to increase his purchases of minced beef by 10%. Which of the following statements is most likely to be correct?

A. The income elasticity of demand for minced beef is -2/3 and ground beef is a superior good

B. The price elasticity of demand for ground beef is -1.5 and ground beef is a normal good

C. The income elasticity of demand for minced beef is -2/3 and ground beef is an inferior good

D. The price elasticity of demand for ground beef is -2/3 and minced beef is a normal good

5. The income elasticity of demand for private dental services, rental movie services, and private (or own) label clothing available in supermarkets have been estimated to be +2.5, +0.8, and -1.5 respectively.

Write an answer interpreting these coefficients for income elasticity

6. If, when income rises by 5% and other things remain the same, the quantity demanded of good C increases by 1%:

(a) Is good C a normal good or an inferior good? Why?

(b) Describe how the demand for good C changes when income changes

(c) Calculate the income elasticity of demand for good C

7: When Jody’s income increases by 10% and other things remain the same, Jody decreases the quantity demanded of macaroni and cheese by 20% and increases the quantity demanded of chicken by 5%

(a) Calculate the income elasticity of demand for macaroni and cheese

(b) Is the product macaroni and cheese a normal good or inferior good? Why?

(c) Is chicken a normal good or inferior good? Why?

(d) Is chicken income elastic or income inelastic?

8: When income increased by 10%, the quantity of memberships of athletic clubs increased by 15%, the quantity demanded of spring water increased by 5% and the quantity demanded of soft drinks decreased by 2%. Use the information to answer the following questions:

a) Calculate the income elasticity of demand for each good

b) Which of the goods is income elastic and which income inelastic

c) Is any good an inferior good?

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