1.2 Elasticities

1
1.2 Elasticities
2

• 1.2a Price elasticity of demand (PED)
• Elasticity is a measure of responsea measure of
  how a change in one thing will create change in
  another thing.

3

• In economics, there are four measures of
  elasticity we use to help describe peculiarities
  of certain markets
• Price elasticity of demand
• Cross-price elasticity
• Income elasticity of demand
• Price elasticity of supply

4

• Price elasticity of demand measures the response
  of quantity demanded to a difference in price.
• ? Qd ? Price
• For some goods the response is small. This is
  called inelastic demand and the price elasticity
  of demand is less than one.

5
(No Transcript)
6

• When the Elasticity of Demand is inelastic the
  higher price will always generate more revenue.
• In the graph above, a price of 4 generates 160
  in revenue. At the lower price of 2, revenue is
  only 100.
• When price elasticity is greater than one, we say
  that demand is elastic, and more revenue will be
  generated at the lower price.

7
(No Transcript)
8

• In the graph above, a price of 6 generates 180
  in revenue. At the higher price of 8, revenue is
  only 160.

9
Determinants of PED

• Number and closeness of substitutes The fewer
  close substitutes that are available for a given
  good or service the more price inelastic of
  demand. For example, the demand for Nikes will
  be relatively elastic as there are many close
  substitutes for their shoes. However, the demand
  for electricity is relatively inelastic.

10

• Proportion of Income The price of a good
  relative to consumer income will influence
  elasticity. For example, if the price of
  automobiles increases by 15, the quantity
  demanded will most likely fall as the expenditure
  represents a large portion of consumer budgets.
  Conversely, a 15 increase in the price of
  potatoes, probably wont result in much change in
  the quantity demanded as the change represents a
  small proportion of household income.

11

• Necessity or Luxury Good Goods that are
  necessities, such as bread or utilities, will
  have low PED as consumers will use the product
  regardless of the price. On the other hand,
  goods and services that are considered luxuries
  would be more price elastic of demand. Examples
  of these sorts of items would be vacation travel
  or jewelry.

12
Extreme cases of PED are rare but are possible.
13

• Perfectly elastic demand is usually observed in
  perfectly competitive markets with price takers
  such as the market for rice.
• Perfectly inelastic demand is rare and is
  associated with items like insulin for diabetics
  who would willingly pay any price for the life
  saving qualities of the drug.

14
Implications of PED

• Usually the PED for commodities is relatively low
  which makes it difficult for producers to raise
  their output levels to increase their income.
  Foodstuffs are a good example of products where
  there are few close substitutes and people spend
  a relatively small proportion of income on any
  particular food item.

15

• Manufactured goods tend to have a higher PED as
  consumers will spend a higher proportion of
  income on such products. Consequently, pricing
  strategies for autos, household appliances and
  computers can be very important for producers
  when trying to increase sales.

16

• PED is very important for governments when they
  are setting indirect taxes. If they want to
  generate more revenues from a particular good or
  service, then they will want to tax items that
  are relatively price inelastic of demand.
• Addiction results in a more inelastic demand for
  a given good. PED is one factor when governments
  decide to levy taxes on tobacco and alcohol.
  This scenario also presents a problem for law
  enforcement when they are considering the demand
  for illicit substances and possible criminal
  activity.

17
1.2b Cross-price elasticity of demand

• Cross-elasticity of demand, also known as cross
  price elasticity, is a test for determining if
  goods act as complements or as substitutes.
• Complements are goods that are used together,
  like computers and monitors. We expect if people
  use more of one, they will use more of the
  complement as well.

18

• Substitutes are goods that are used one instead
  of the other, like tea and coffee. If people
  drink more tea they are probably going to drink
  less coffee.
• The actual measure of cross price elasticity
  looks like this
• ? Qdgood1 ? Pricegood2

19

• If the price of a cup of coffee went up, we would
  expect the demand for tea to go up as well,
  because people would buy less coffee.
• So for substitute goods the cross price
  elasticity is always positive.

20

• We might see 40 computers sold in a week if
  monitors were priced at 100, but only 20
  computers sold if monitors were 150.
• The higher price is associated with the lower
  quantity, and the lower price with the higher
  quantity.
• This means cross price elasticity is negative and
  the goods are complements.

Quantity computers Price monitors
40 100
20 150
21
1.2c Income elasticity of demand

• Income elasticity of demand is used for
  designating three types of goods based on their
  response to income levels
• Inferior goods
• Normal goods
• Luxury goods

22
(No Transcript)
23

• An inferior good is a good we buy more of when
  our income is relatively low. Used cars might be
  a good example, or second-hand clothing.
• A normal good is something we buy more of as our
  income grows higher, but we spend a smaller
  percentage of our income at higher levels. Most
  goods fit in this categorymost food, clothing,
  housing.

24

• Luxury goods are things people buy lots more of
  when their incomes are higher, things like
  yachts, expensive jewelry, and fancy holidays.
• The formula for income elasticity of demand
• ? Qd ? Income
• is negative for inferior goods
• is between zero and one for normal goods
• is greater than one for luxury goods.

25
1.2d Price elasticity of supply

• Price Elasticity of Supply measures producers
  response to a difference in pricethe difference
  in supply compared to a difference in price.
• ? Qs ? Price
• This can be applied to an individual producer or
  to all the producers in a specified market.

26

• One application that is particularly useful is in
  distinguishing short term and long term responses
  to a change in price.
• Because firms have trouble finding the new
  resources, short run responses tend to be
  inelastic (less than one) especially when prices
  rise. This is because new resources are required
  for increases in production and they are not
  always available.
• Even decreases in price might not allow for less
  production because firms must honor contracts to
  buy certain amounts of the resources they use.

27
(No Transcript)
28

• Long term, firms are able to find new resources
  and to renegotiate contracts, so production is
  more responsive to differences in price and
  supply is more elastic (greater than one).

29
1.2e Applications of concepts of elasticity

• A simple outline to review the application of
  each measure of elasticity
• Price Elasticity of Demand
• ? Qd ? Price
• If value is less than one demand is inelastic
• If greater than one demand is elastic
• Revenues always greatest when elasticity one

30

• Cross Price Elasticity
• ? Qd good1 ? Price good2
• If value is positive the goods are substitutes
• If value is negative the goods are complements

31

• Income Elasticity of Demand
• ? Qd ? Income
• If value is negative the good is an inferior good
• If between zero and one it is a normal good
• If greater than one the good is a luxury good

32

• Price Elasticity of Supply
• ? Qs ? Price
• If value is less than one supply is inelastic
• If greater than one supply is elastic
• Long run supply is usually more elastic than
  short run supply