20 Elasticity |ElasticityExplain the concept of elasticity. Elasticity is measure of the extent to which one variableresponds to a change in a second variable. For instance a variable such as demand can be eithersensitive to a change in price (price elastic) or unresponsive (price inelastic)Why is elasticity important? Elasticity estimates predict how consumers and producers arelikely to respond to a change in market conditions. Accurate elasticity data helps a firm estimatethe likely impact of, say, a price rise on demand for the product and for substitutesList the main types of elasticity.Type of elasticityPrice elasticity of demand The responsive of demand to a change in its own priceIncome elasticity of demand The responsive of demand to a change in incomePrice elasticity of supply The responsive of supply to a change in its own priceCross elasticity of demand The responsive of demand for one product to a change in the price of another itemWhat is an elasticity value? An elasticity estimate has a number value eg -0.5. 0, +2, etc. Anelasticity value greater than 1 means a variable such as demand is elastic ie responsivePrice elasticity of demandDefine price elasticity of demand (PED). The responsiveness of demand to a change in theprice of the product.How are price and quantity changes compared? Price is measured using £s; quantity in unitssold. Comparisons is made possible by contrasting the percentage in price and amountHow is PED calculated? Like all elasticity values, PED is a number. PED is estimated by dividingthe percentage change in demand by the percentage change in price, using the equation: PED =percentage change in demand/ percentage change in price, ie PED= %ΔQd/ %ΔP. Eg if a 10%fall in price results in a 5% increase in quantity demanded, PED = 5%/10% = -0.5How are percentage changes in a variable calculated? To calculate a percentage change(%Δ) in one variable (A), use the equation: %ΔA = (new A – old A) / old A x 100where A is a variable such as price or quantity demanded.Give a worked example of calculating PED. Suppose a price fall from £15 to £10 results in anincrease in quantity demanded from 20 to 45 %ΔP = (new P – old P) / old P x 100 = (10-15)/15 x 100 = -5/15 x 100 = -33% %ΔQ = (new Q – old Q) / old Q x 100 = (45-20)/20 x 100 = 25/20 x 100 = 125% PED = % change in quantity demanded / % change in price = 125%/33% = -3.8What is the range of PED estimates? PED can lie between zero and infinity. If PED is less than1, demand is price inelastic ie quantity demanded is unresponsive to price changes. If PED isgreater than 1, demand is price elastic ie quantity demanded is responsive to a price change.Why do PED estimates usually minus values? Price and quantity demanded are almostalways inversely related: they move in opposite directions. This means PED is a negative valueWhat does the phrase demand is price elastic mean? Demand is price sensitive ie responsiveto a change in price. This means a given change in price brings about a greater percentagechange in demand. Eg a 10% fall in price results in a 20% increase in demand. PED is -2.What does the phrase demand is price inelastic mean? Demand is price insensitive ieunresponsive to a change in price. A given change in price brings about a smaller percentagechange in demand. Eg a 10% price rise results in only a 4% fall in demand. PED is -0.4.
| Elasticity 21What factors determines own price elasticity of demand? Main determinants include: Availability and closeness of substitutes. The greater the number of alternative products,the easier it is for consumers to switch if prices change. Demand becomes price elastic Definition of the market. The narrower the definition of a product eg sliced white bread,the greater the number of substitutes eg unsliced white bread. This means the demandfor sliced white bread is more price elastic than the demand for all types of bread Proportion of income spent on a good. Usually the smaller the proportion of income takenup purchasing the good or service the more price elastic demand Habit forming products such as cigarettes and drugs are price inelastic in demand. Consumers take time to adjust to price changes. This means PED becomes more priceelastic in the long run as consumers have time to find and switch products.How can PED affect a demand curve? The gradient (slope) of a demand curve generallyreflects its PED:A product with perfect substitutesPED = ∞ at all points on the curveA product with no substitutesPED = 0 at all points on the curveSpecial case: PED is -1 at all pointson the curveDemand is perfectly price elasticat all points on the curve D1;perfectly price inelastic at allpoints on the curve D2; andalways unitary (1) on D3Demand is mainly own priceelastic on most points on thecurve D4 and price inelastic atmost points on the curve D5A product with many close andavailable substitutes PED<1 atalmost all points on the curveAs price rises quantity demandednormally becomes more elasticA product with few close andavailable substitutes PED>1 atalmost all points on the curveIs PED constant along all a straight-line demand curve? Yes: perfectly price elastic (D1), perfectly price inelastic (D2) and unit elastic D3 No: for relatively price elastic (D4) or relatively price inelastic demand curves (D5) in theabove diagrams. PED becomes more price inelastic as you move down a demand curveQuantity (Qd)price(P)D1Perfectly price elasticdemand curveQuantity (Qd)price(P)D2 Perfectly priceinelastic demandcurveQuantity (Qd)price(P)D3Unit priceelastic demand curveQuantity (Qd)price(P)D4Relatively priceelastic demand curveQuantity (Qd)price(P)D5Relatively priceinelastic demandcurve
22 Elasticity |Income elasticity of demandDefine income elasticity of demand (YED). YED measures the extent to which of demand for aproduct responds to a change in income.How is YED calculated? The YED estimate is found by dividing the percentage change indemand by the percentage change in income, using the equation:YED = % change in demand / % change in income.Eg if a 10% rise in income results in a 8% increase in demand YED = 8%/10% = 0.8Give a worked example of calculating YED. Suppose an increase in income from £105 to £125results in an increase in demand of Good X from 75 to 110 %ΔY = (new Y – old Y) / old Y x 100 = (125-105)/105 x 100 = 20/105 x 100 = 19% %ΔQ = (new Q – old Q) / old Q x 100 = (110-75)/75 x 100 = 35/75 x 100 = 47%YED for Good X = percentage change in demand of good X / percentage change in income =47%/19% = 2.5. Demand is income elastic.What does a positive YED value means? Income and demand are positively related. A rise inincome results in a rise in demand. Items with a positive YED value are called normal goods.Explain the term income elastic. Income elastic products have a YED estimate greater than 1.A change in income leads to a proportionately bigger increase in demand eg if YED = 2 a 10%rise in income leads to 20% rise in demandExplain the term income inelastic. Income elastic products have a YED estimate less than 1. Achange in income leads to a proportionately smaller increase in demand eg if YED = 0.2 a 10%rise in income leads to 2% rise in demandExplain the term normal good. A normal good is a product with have a positive YED estimate.Consumers use an increase in income to buy more of the good.Can YED have a negative value? Inferior goods have a negative YED and are only boughtbecause consumers cannot afford normal goods. For instance some consumers use an increasein income results to switch from an inferior good (eg spam) to a normal good (eg meat).What is the range of YED values? If YED is positive, the product is a normal good. If YED is positive but less than 1, demand is income inelastic. A change in income results in aproportionately smaller change in demand – a characteristic of necessities eg bread If YED is positive and greater than 1, demand is income elastic. A change in income results ina proportionately larger change in demand. This is the characteristic of luxury goods eg cars If YED is negative, an increase income leads to fall in demand. The item is an inferior goodWhat is a superior good? If YED is positive and greater than one, then the good is a luxuryitem. Consumers use a given increase in income to buy proportionally more of the product.How do incomes change over time? Overtime economies enjoy economic growth. Economicgrowth increases income as households earn more from creating extra output.How does the economic cycle affect income? Many economies experience an economic cycle.A boom means output and income is growing, while output and income fall in a recession.How does a recession affect demand? A recession means falling output and incomes. Theimpact on demand for particular products depends on their YED. The higher the YED estimatethe greater the volatility of sales during an economic cycle.
| Elasticity 23Price elasticity of supplyDefine price elasticity of supply (PES). The responsiveness of supply to a change in the priceof the product.How is PES calculated? PES is a numerical estimate. The PES value is found by dividing thepercentage change in quantity supplied by the percentage change in price, using the equation:PES = percentage change in quantity supplied / percentage change in price Eg if a 10% fall inprice results in a 2% decrease in quantity supplied, then PES = 2%/10% = 0.2.What is the range of PES estimates? PES can lie between zero and infinity. If PES is less than 1then supply is price inelastic ie quantity supplied is unresponsive to price changes. If PES isgreater than 1, then supply is price elastic ie quantity supplied is responsive to a price change.Price and quantity supplied are directly related which means they move in the same direction.This means PES has a positive valueWhat factors determines price elasticity of supply? The following factors affect the ability offirms to adjust output in response to a change in price: Manufacturing lead time: the amount of time take to make an item varies betweenindustries. Eg the time lags in agriculture can be a year before extra field yield crops Availability of stocks: Stocks are stored components, and goods held ready for future useor sale. Non-perishable goods can be added to stock following a price fall. Firms withlarge of stocks of finished products can respond quickly to a price increase. As servicescannot be stored their price elasticity of supply is perfectly price inelastic Availability of resources: supply is price elastic if staff are willing to work overtime or ifcurrently idle machines are bought into use. Capacity: Firms operating at capacity can only increase output by investing in newequipment and hiring extra staff thus making PES inelastic Time period: firms take time to adjust production to price changes. PES becomes moreprice elastic in the long run as producers have time to hire staff, install new capital etcHow can PES affect the slope of a supply curve? The slope of a supply curve reflects its PES.Supply is always perfectly priceelastic at all points on the curve S1and perfectly price inelastic at allpoints on the curve S2Always unit PES for any straight linesupply curve passing through theorigin eg S3 or S4Relatively elastic at all points on anylinear supply curve intersecting the yaxis eg S5 and relatively inelastic atall points on any linear supply curvecutting the x axis eg S6Quantityprice(P)S1Perfectly price elasticsupply curvesupply curvePerfectly priceinelasticsupply curveQuantityprice(P)S2Quantityprice(P)S3Unit priceelastic supply curvesS4Quantityprice(P)S5Relatively price elasticsupply curveQuantityprice(P)S6Relatively priceinelasticsupply curve
24 Elasticity |Cross elasticity of demandDefine cross elasticity of demand (XED). XED measures responsiveness of demand for oneproduct to a change in the price of another product. This means XED measures the strength ofrelationship between two different productsHow is XED calculated? XED is a numerical estimate. The XED value is found by dividing thepercentage change in quantity demanded of one product (A) by the percentage change in priceof a second product (B), using the equation: XED = percentage change in quantity demanded forgood A / percentage change in price of good B. Eg if a 10% rise in price of good B results in a5% rise in demand for good A, then XED = 5%/-10% = 0.5What does XED = +1.2 mean? The positive sign means the two goods are substitutes. 1.2means the demand for this product is responsive to a change in the price of the other item. Thetwo items are strong substitutesWhat does XED = -0.8 mean? The negative sign means the two goods are complements. 0.8means the demand for this product is unresponsive to a change in the price of the other item.The two items are weak complementsWhat does XED=0 mean? A change in the price of one item has no effect of the demand for thesecond product because they are not substitutes or complements. They are independent goodsWhat is the range of XED estimates? XED estimates can be positive negative or zeroXED value Relationship betweenproducts A and Ba 10% rise in the price of this productcauses a proportionatelyPositive and greater than oneeg +2Strong substitutes: demand isresponsive to a price changelarger rise in demand for a substituteproduct eg 20%. XED = 20%/10% = +2Positive and less than one eg0.5Weak substitutes: demand isunresponsive to a price changesmaller rise in demand for a substituteproduct eg 5%. XED = 5%/10% = +0.5Zero Independent goods no change in demand for the other itemNegative and less than one eg-0.8Weak complements: demand isunresponsive to a price changesmaller fall in demand for a complementproduct eg 8%. XED = -8%/10% = -0.8Negative and greater than oneeg -1.5Strong complements: demandis responsive to a price changeLarger rise in demand for a complementproduct eg 20%. XED = -15%/10% = -1.5
| Elasticity 25Business Use of ElasticityHow can firms make use of elasticity estimates? Elasticity estimates predict how consumersand producers are likely to respond to a change in market conditions. This means elasticities area useful tool in decision making.What is decision making? Decision making is the process of selecting a course of actionbetween several alternatives. For instance whether or not to cut price to increase revenueWhy does decision making necessarily involve uncertainty? Decisions are taken on thebasis of available data and assumptions about the future. Incomplete or inaccurate data, faultyassumptions, or unexpected future events, eg economic downturn or a new competitor, meansthere is a risk a decision may not work out as expected or have unintended consequences.How can risk and uncertainty be reduced? Research, planning and the use of decision makingtools such as elasticity forecasts can reduce but not eliminate risk and uncertainty.How do firms estimate elasticities? Firms use market research to gather the data needed tomeasure the response of consumers and producers to changes in market conditions. Eg Undertake a survey of a representative sample of the population to ask how they mightrespond to a change in price of this product or a substitute. Interrogate secondary data to identify price demand relationships or data on elasticityestimates published by government agencies or universitiesAre elasticity estimates reliable? Elasticity values are estimates and treated with caution.Sampling errors can make market research findings biased and unrepresentative. Past datatrends may not be hold true over time. Eg consumer buying patterns change with fashion andthe state of the economyHow can firms make use of PED? Firms can use PED estimates to predict the impact of a pricechange on 1) quantity demanded and 2) total revenueGive an example of PED used to predict sales. If a shop estimates the PED for cake is 1.5 itcan predict that it needs to increase output by 15% if it runs a 10% price reduction special offerWhat is total revenue? The total amount a firm receives from selling a given level of outputHow is total revenue calculated? Total revenue (TR) is found by multiplying price (P) by thenumber of units sold (Q). TR = P x Q. Eg selling 50 items at £4 each generates £200 of TRHow are total revenue and price linked? Price and quantity demanded are inversely related.A change in price has an uncertain effect on total revenue. A fall in price means each item is soldat a lower price, reducing revenue. But more items are sold which acts to raise revenue. Theoverall impact of a price change depends on which effect is biggerHow does PED affect revenue? The impact of a pricechange on revenue depends on PED. When PED is elastic,price and revenue move in opposite directions. When PEDis inelastic price and revenue move in the same direction.P1 and Q1 are the initial equilibrium market price andquantity traded. Initial revenue = P1 x Q1. Assume a pricefall from P1 to P2. There are two impacts on revenue: more units are being sold: (Q2-Q1) at the lowerprice of P2, the shaded area of gain at a lower price: Q1 units are being sold at for (P1–P2) less, the shaded area of lossTotal revenue falls as the area of gain is smaller than the
26 Elasticity |area of loss. However, if price elasticity of demand is elastic, the gain effect of selling more unitsoutweighs the loss effect of selling at a lower price.Give an example of how businesses use PED in pricing decisions. Some businesses like trainoperating companies or electricity suppliers charge different prices in peak and off peakmarkets to maximise total revenue. Given few close, available substitutes the demand for peaktime use is price inelastic. Revenue is increased by raising price. Where off peak demand is priceelastic, price cuts increase total revenue.How can the government make use of PED? Governments raise revenue through indirecttaxes on spending eg VAT and duties on tobacco and petrol. Taxing relatively price inelastic,luxury or harmful products, raises price but has a minimal impact on quantity demanded.How do businesses make use of YED? YED helps firms predict the effect of economic growthor the economic cycle on sales. Upturn. Assume predicted growth means a 10% rise in incomes over the next year.Firms producing superior goods experience a proportionately larger increase in demandeg if YED is 2, the 10% increase in growth and income results in a 20% increase indemand. Recession Firms producing necessities with a low YED are less exposed to a slowdown inthe economy eg if YED for product is 0.3, a 10% fall in growth and income results in justa 3% fall in demand.Does the economic cycle affect all firms equally? Superior products with high YEDexperience greater sales volatility over the economic cycle than necessities. Inferior productssee a rise in sales during a recession as some consumers can no longer afford normal items.How does YED affect government spending? Public services such as health and educationhave high positive YEDs. As incomes rise over time, the demand for better health and educationrises by a larger percentage putting increased pressure on government to raise its spending.Gove examples of how a business can use of XED estimates in pricing decisions? Firms can use (XED) estimates to predict the impact of pricing strategies on demand forsubstitute products made by rivals. If XED is high and positive eg +3 then a 10% price cutsees a 30% fall in demand for rival’s product. However raising prices leads to asignificant loss of sales to rivals – assuming they do not match the price increase Pricing strategies for complements that maximise revenue. For example, popcorn andcinema tickets have a high negative XED value – they are strong complements. Popcornhas a very high mark-up ie popcorn costs pennies to make but sells for pounds. If firmshave a reliable estimate for XED they can estimate the effect, say, of a two-for-onecinema ticket offer on the demand for popcorn. The additional profit from extra popcornsales may more than compensate for the lower cost of cinema entry.