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Elasticity - Economics HL


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Economics HL The Lions team - Price, Income and Cross elasticities of demand.

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Elasticity - Economics HL

  1. 1. ELASTICITYThe Lions team
  2. 2. Definition Measure of the responsiveness of demand and supply of a good or service to an increase or decrease in its price.
  3. 3. Price Elasticity of Demand (PED) ELASTICITY Cross Elasticity of Demand (XED)Income Elasticity of Demand (YED)
  4. 4. Price Elasticity of Demand (PED)A measure of the responsiveness of the demand for aproduct to changes in its own price. Values:PED=0 - perfectly inelastic demand0<PED<1 - inelastic demandPED=1 - unit elastic demand1<PED<∞ - elastic demandPED=∞ - perfectly elastic demand
  5. 5. PED determinants - 1The number and closeness of substitutes: It is perhapsthe most important determinant of PED. The moresubstitutes for the product there are, and the closer theyare, the more elastic will be the demand for it. Forexample, if there are different brands of milk, and alarge increase in the price of one brand will lead to alarge number of customers switching to another brandof milk, which is cheaper. The more substitutes thereare and the closer they are, the more elastic is thedemand for the product.
  6. 6. PED determinants - 2Degree of necessity: If a good is a necessity then thedemand is unlikely to change for a given change inprice. A necessity like bread will be demandedinelastically with respect to price. However, if we definebread more narrowly: whole wheat or rye, and then evenmore narrowly into buns or pretzels, and then intodifferent brands of pretzels, for example, the demandbecomes even more elastic.
  7. 7. PED determinants - 3The time period considered: e.g. as soon as the newmovie is released, it is screened only in cinemas, andthis is the only place you can watch it (inelastic demandin the short run). However, after a certain period of timeit is released on DVDs, pirated, etc. So there are moreways to watch it after a while, therefore, in the long run,the demand is more elastic.
  8. 8. PED determinants - 4Price elasticity of demand and taxation: Governments canimpose taxes on certain goods if they are inelastic, which meansthat a great change in price causes only a relatively small changein quantity demanded. They also do it, because they know thatthese taxes are not going to affect the demand much, and,therefore, people will not lose their jobs.
  9. 9. PED - real life exampleSupermarket sells 1 kg of Granny Smith apples for $4. Afterlowering the price of apples to $3.50 the supermarket noticed anincrease in sales by 15%. These apples are products with elasticdemand, as they have other close substitutes (other types ofapples such as McIntosh). Lets prove it.As the value of PED is greater than 1, we can state that this type of appleshas elastic demand. That being said, the change in quantity is more thanproportionate to the change in price.
  10. 10. Income Elasticity of Demand (YED)A measure of the responsiveness of the quantity demanded to changes in real income.
  11. 11. Inferior, normal, necessity andsuperior goodsIncome elasticity may be positive or negative. If incomeelasticity is negative, demand falls as real income rises.Goods or services with such elasticity are calledinferior goods. These might include supermarket ownbrands or cheap jeans from a Chinese factory.People start to switch their expenditure from the inferiorgoods that they had been buying to superior goods, whichthey can now afford.
  12. 12. Inferior, normal, necessity and superior goods If the income elasticity is positive, demand increases with real income. These goods are known as normal goods. If your income increases you might choose to buy more clothes or go to the cinema more often, for example.Necessity goods: Superior goods:Necessity goods are products that Superior goods are products that havehave low income elasticity. The high income elasticity. The demand fordemand for them will change very little them changes significantly if incomeif income rises. For example, the rises. As people have more incomedemand for bread does not increase and have satisfied their needs, theysignificantly as income rises, because begin to purchase products that arepeople feel that they already have wants, i.e. non-essential, in greaterenough bread and so will not increase number. For example, the demand forconsumption. holidays in foreign countries is likely to be income-elastic.
  13. 13. Cross Elasticity of Demand (XED)A measure of the responsiveness of the demand for one product to changes in the price of another product.
  14. 14. Income Elasticity of Demand (YED)The demand for a normal good rises as incomerises and the demand for an inferior good falls asincome rises.
  15. 15. Complements and substitutesXED explains the relationship between products. Unlike price elasticity ofdemand, where the vast majority of products have a positive value for PED, thevalue of XED may be positive or negative and the sign is important, since it tellsus what the relationship between the two goods in question is.Some products tend to be bought together, others are purchased in competitionto each other. Products bought together are called complementary goods.Products which are in competition with each other are called substitute goods.
  16. 16. Complements and substitutesExamples of complements are steak and chips, rice and curry,cars and petrol, torches and batteries, gas and gas cookers.Complementary goods have negative cross price elasticities.Perfect complements will have a cross price elasticity of -infinity: negative infinity.Examples of substitutes are beef and lamb, gas and heating oil,petrol and diesel fuel. (Note that the substitution may not bepossible at once, it may occur over time). Substitutes havepositive cross price elasticities.
  17. 17. XED - real life exampleIce-cream shop sells 1 kg of chocolate chip ice-creamfor $5. After lowering the price of chocolate chip ice-cream to $4.50 the ice-cream shop noticed a decrease inquantity demanded of vanilla ice-cream from 20 kg to17 kg. As these types of ice-cream are substitutes foreach other (people usually prefer one over the other), adecrease in the price of one leads to a decrease in thequantity demanded of the other one.
  18. 18. XED - real life exampleThe Cross Elasticity of Demand value of 1.5 justreaffirms that chocolate chip and vanilla ice-cream aresubstitutes for each other.
  19. 19. Role of elasticities inGovernment DecisionIndirect Taxes: Elasticity of a product determines the governments decision toput an indirect tax on a product.Putting an indirect tax on it would lead to increase in the price of a product. Ifthe product is elastic then the the increase in price would lead to aproportionately large decrease in quantity demanded. This is the case wherethe government would support the product by giving it a subsidy.If a product has inelastic demand (e.g. cigarettes), then the government caneasily make money by imposing the tax on it, knowing that the demand for itwill not change significantly.
  20. 20. Role of elasticities inGovernment DecisionThe government should take into the account consumers and producers’interests, see what businesses are dominating in the country and how muchbenefit they bring to the economy. If it is detrimental to the economy, then itshall bring it down by imposing the tax on its products in order to give itsmarketing position to the small local producers. The government also lookshow beneficial it is to the health of the consumers – they might impose a taxon cigarettes, but give a subsidy to vegetables.
  21. 21. PED for Primary CommoditiesPrimary Commodities are raw or unprocessed goods, which require minimumwork to be made available.The elasticity is usually low for primary commodities as the description forthese goods usually put them in the inelastic category with the PEDdeterminants.The primary goods tend to be inelastic because they are basic necessities andthey do not have many substitutes. So even if there is a change in the price ofthese goods, the quantity demanded would not be impacted much as peoplewould continue to but the same quantity of the product as it is a basicnecessity.
  22. 22. Example of PrimaryCommodity PED Determinants of PED Primary Commodity (Tomato) Luxury Good No Necessity Yes, used to create many other foods Substitutes Very minimal
  23. 23. PED for ManufacturedProductsThe PED for manufactured products are usually high because manydeterminants deem these products as elastic.Manufactured goods usually have many substitutes. So people have a choicebetween the products. This makes the manufactured goods elastic.Thus a change in the price of a manufactured good will lead to aproportionately larger change in the Quantity demanded thus making the PEDfor manufactured goods elastic.
  24. 24. Example of Manufacturedproduct PED Determinants of PED Manufactured Product (Sports Car) Luxury Good Yes, require better than average income Necessity No, any car could travel from A to B Substitutes Yes, any other automobile
  25. 25. THANKS FORWATCHING!!! :P By Robert, Aishwarya and Mark