Elasticity! Price, Income and Cross Elasticity

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1 Elasticity! Price, Income and Cross Elasticity

2 Elasticity the concept l The responsiveness of one variable to changes in another l When price rises what happens to quantity demanded? Demand falls BUT! How much does demand fall?

3 Elasticity the concept l If price rises by 10% - what happens to Q d? We know Q d will fall By more than 10%? By less than 10%? l Elasticity measures the extent to which quantity demanded will change

4 Elasticity l 4 basic types used: Price elasticity of demand PED Price elasticity of supply PES Income elasticity of demand YED Cross elasticity Cross ED or XED

5 Elasticity l Price Elasticity of Demand The responsiveness of quantity demanded to changes in price Where % change in Q d is greater than % change in price elastic Where % change in Q d is less than % change in price - inelastic

6 Elasticity The Formula: Ped = % Change in Quantity Demanded % Change in Price If answer is <1: the relationship is inelastic If the answer is between 1 and infinity: the relationship is elastic Note: PED has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

7 Elasticity Price ( ) The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

8 Elasticity Price 5 The Total importance revenue is of price elasticity x is quantity the information sold. In this it provides example, on TR the = 5 effect x 100,000 on total = 500,000. revenue of changes in price. This value is represented by the green shaded rectangle. Total Revenue D 100 Quantity Demanded (000s)

9 Elasticity Price 5 If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. 3 Total Revenue D Quantity Demanded (000s)

10 Elasticity Price ( ) 10 5 Producer decides to lower price to attract sales % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = 0.4 (Inelastic) Total Revenue would fall Not a good move! D 5 6 Quantity Demanded

11 Elasticity Price ( ) 10 7 Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = 10 (Elastic) Total Revenue rises Good Move! D 5 Quantity Demanded 20

12 Elasticity l If demand is price elastic: l Increasing price would reduce TR (%Δ Qd > % Δ P) l Reducing price would increase TR (%Δ Qd > % Δ P) l If demand is price inelastic: l Increasing price would increase TR (%Δ Qd < % Δ P) l Reducing price would reduce TR (%Δ Qd < % Δ P)

13 Elasticity Versus Slope l Elasticity of demand describes the shape of a demand curve, but it is not the same as slope. l Slope measures the rise or fall in a curve divided by its horizontal run. l Elasticity measures the horizontal run by the rise or fall.

14 Task #1 Calculating PED Calculate the price elasticity of demand in each of the following examples: l The change in demand is 5%, the change in price is 7% l The change in demand is 12%, the change in price is 3% l The change in demand is 9%, the change in price is 4% l The change in demand is 13%, the change in price is 25% l The change in demand is 6%, the change in price is 8% In each case say whether the price elasticity is inelastic or elastic.

15 Spending and Elasticity l If demand is inelastic, buyers spend more on the good when its price is higher. l If demand is elastic, buyers spend less on the good when its price is higher. l If demand is unit-elastic, buyers spend the same amount on the good when its price is higher.

16 Determinants of Elasticity l Time period the longer the time under consideration the more elastic a good is likely to be l Number and closeness of substitutes the greater the number of substitutes the more elastic l The proportion of income taken up by the product the smaller the proportion the more inelastic l Luxury or Necessity - for example, addictive drugs

17 Factors Affecting Elasticity of Demand l Availability of Substitutes Demand for a good is more elastic when close substitutes for it are available to buyers.

18 Factors Affecting Elasticity of Demand l Fraction of Income Spent on the Good As people spend higher fractions of their incomes on a good, their demand for the good becomes more elastic. As they spend smaller fractions of their income on a good, their demand for it becomes less elastic.

19 Factors Affecting Elasticity of Demand l Adjustment Time Demand is more elastic when people have more time available to adjust to a change in price.

20 Other Types of Elasticity Explain how to calculate Income Elasticity of Demand (YED), Cross-Price Elasticity of Demand (XED) and Price Elasticity of Supply (PES)

21 Elasticity YED l Income Elasticity of Demand (YED): The responsiveness of demand to changes in incomes l Normal Good demand rises as income rises and vice versa l Inferior Good demand falls as income rises and vice versa

22 Elasticity YED Income Elasticity of Demand: l A positive sign denotes a normal good l A negative sign denotes an inferior good

23 Elasticity YED (% QD/% Y) l For example: l l l l Yed = - 0.6: Good is an inferior good but inelastic Yed = + 0.4: Good is a normal good but inelastic Yed = + 1.6: Good is a normal good and elastic Yed = - 2.1: Good is an inferior good and elastic

24 Elasticity XED l Cross Elasticity: l The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement XED = % Δ Qd of good t % Δ Price of good y

25 Elasticity XED l Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two) l Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two)

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27 Practice! l Is the following graph showing a situation where the goods are complements or substitutes? How can you tell? l Substitutes. l As the P for good B increases, the Qd for good A increases (XED>0).

28 Elasticity l Price Elasticity of Supply: The responsiveness of supply to changes in price If PES is inelastic - it will be difficult for suppliers to react swiftly to changes in price If PES is elastic supply can react quickly to changes in price PES = % Δ Quantity Supplied % Δ Price

29 PES: determinants length of time

30 Importance of Elasticity l Relationship between changes in price and total revenue l Importance in determining what goods to tax (tax revenue) l Importance in analyzing time lags in production l Influences the behavior of a firm

31 As you go back to read/review l Think about how to solve for each: equations, plugging in, what changes might occur given certain values l Think about what the graphs would look like for each l Think about determinants of each, and how that might affect how the graph looks l Think about substitutes, complements, inferior, superior, normal and luxury goods and how they apply to each