Elasticity

Topic 4
 Elasticity of Demand and Supply
• In order to turn supply and demand into a truly useful tool, we need to know how
much supply and demand respond to changes in prices.

• Some purchases like those for vacation travel are very sensitive to price changes.
Others like food or electricity are necessities for which consumer purchases
respond very little to price changes.

• The quantitative relationship between price and quantity purchased is analyzed

during the crucial concept of elasticity.
 Price Elasticity of Demand
• The price elasticity of demand (sometimes simply called price elasticity) measures
how much the quantity demanded of a good changes when its price changes.

• The precise definition of price elasticity is the percentage change in quantity

demanded divided by the percentage change in price.

• Goods vary enormously in their price elasticity. When the price elasticity of a good
is high, we say that the good has elastic demand, which means its quantity
demanded responds greatly to price changes.

• When the price elasticity of a good is low, it is “inelastic” and its quantity
demanded responds little to price changes.

• For necessities like food, fuel, shoes and prescription drugs demand tends to be
inelastic.
 Price Elasticity of Demand
• By contrast, you can easily substitute other goods when luxuries like European holiday
or Italian designer clothing rise in price.

• Goods that have ready substitute tend to have more elastic demand than those that
have no substitutes.

• If all food or footwear prices were to rise 20 percent tomorrow, you would hardly
expect people to stop eating or to go around barefoot, so food and footwear
demands are price-inelastic.

• The length of time that people have to respond to price changes also play a role. A
good example is that of gasoline.
 Price Elasticity of Demand
• Suppose you are driving across the country when the price of gasoline suddenly
increases. Is it likely that you will sell your car and abandon your vacation? Not really.

• So in the short run, the demand for gasoline many be very inelastic. In the long run
you can adjust your behaviour to the higher price of gasoline. You can buy a smaller
and more fuel efficient car.

Calculating Elasticities:

• If we can observe how much quantity demanded changes when price changes, we
can calculate the elasticity.

• Price elasticity of Demand = Ed = % change in quantity demanded/ % change in price.

 Price Elasticity of Demand
• E.g. If a 1 percent increase in price yields a 5 percent decrease in quantity
demanded, the commodity has a highly price-elastic demand.

• When a 1 increase in price yields only 0.2 percent decrease in demand, the
commodity has price inelastic demand.

• One important special case is unit elastic demand, which occurs when the
percentage change in quantity is exactly the same as the percentage change in
price.

• In this case a 1 % increase in price yields a 1% decrease in demand.

 Elasticity and Revenue
• Many businesses wants to know whether raising price will raise or lower revenue.
This question is of strategic importance for businesses like airlines, restaurants,
and magazines.

• Which decide whether it is worthwhile to raise prices and whether the higher
prices make up for lower demand.

• Total revenue is equal to price times quantity (PxQ). If consumers buy 5 units at $3
each, total revenue is $15. If you know the price elasticity of demand, you know
what will happen to total revenue when prices changes:

1. When demand is price-inelastic, a price decrease reduces total revenue.

2. When demand is price-elastic, a price decrease increases total revenue.
3. In the borderline case of unit-elastic demand, a price decrease leads to no change in total revenue.
 Elasticity and Revenue
• E.g. Business travellers have an in-elastic demand for air travel, so an increase in
business fares tends to raise revenue.

• By contrast leisure travellers have a much more elastic demand for air travel, because
they have a far greater choice about where and when they are travelling. As a result
raising leisure fares tends to decrease revenue.

The paradox of Bumper Crop

• We can use elasticity to illustrate one of the most famous paradoxes of all economics:
the paradox of bumper harvest.

• Imagine that in a particular year nature smiles on farming. A cold winter kills off the
pest; spring comes early for planting; there are no killing frosts; rain nurture the
growing shoots; and a record crop come to market.
 Elasticity and Revenue
• At the end of the year, family Jones happily settles down to calculate its income for the
year. The family are in for a major surprise: the good whether and bumper crop have
lowered their and other farmer incomes.

• How can this be? The answer lies in the elasticity of demand for foodstuffs. The
demand for basic food product such as wheat ad corn tend to be in-elastic.

• For these necessities, consumption changes very little in response to price. But this
means farmers as whole receive less total revenue when the harvest is good than
when it is bad.

• The increase in supply arising from an abundant harvest tends to lower the price. But
the lower price does not increases quantity demanded very much.

• The implication is that a low price elasticity of food means that large harvest (high Q)
tends to be associated with low revenue (low PxQ).
 Price Elasticity of Supply
• Of course, consumption is not the only thing that changes when prices go up or
down. Businesses also respond to price in their decisions about how much to
produce.

• Price elasticity of supply is the percentage change in quantity supplied divided by

the percentage change in price.

• As with demand Elasticities, there are polar extremes of high and low Elasticities of
supply.

• Suppose that amount supplied is completely fixed, as in the case of perishable fish
brought to market to be sold at whatever price they will fetch.

• This is a completely inelastic supply which is a vertical supply curve.

 Price Elasticity of Supply
• At the other extreme, say that a tiny cut in price will cause the amount supplied to
fall to zero, while the slightest rise in price will coax out an indefinitely large
supply.

• Here the ratio of the percentage in quantity supplied to percentage change in

price is extremely large and gives rise to a horizontal supply curve.

• Between these extremes, we call supply elastic or inelastic depending on whether

the change in quantity is larger or smaller than the percentage change in price.

• The definitions of price Elasticities of supply are exactly the same as those for price
Elasticities of demand. Except that for supply the quantity response to price is
positive, while for demand the response is negative.
 Price Elasticity of Supply
• The major factor influencing supply elasticity is the ease with which production in
the industry can be increased.

• If all inputs can be readily found at going market prices, as in the case of textile
industry, then output can be greatly increased with little increase in price.

• This would indicate that supply elasticity is relatively large.

• On the other hand, if production capacity is severely limited, as in the case for the
mining of South African gold, then even sharp increases in the price of gold will call
forth but a small response in production.

• This would be inelastic supply.

 Price Elasticity of Supply
• Another important factor in supply elasticities is the time period under
consideration.

• A given change in price tends to have a larger effect on amount supplied as the
time for suppliers to respond increases.

• For very brief period after a price increase, firms may be unable to increase their
inputs of labour, materials and capital so supply may be very price inelastic.

• However, as time passes and businesses can hire more labour, build new factories
and expand capacity, supply elasticities will become larger.
 Income Elasticity of Demand
• In economics, the income elasticity of demand measures the
responsiveness of the demand of a good to the change in the income of the
people demanding the good.

• It is calculated as the ratio of the percent change in demand to the percent change
in income.

• For example, if, in response to a 10% increase in income, the demand of a good
increased by 20%, the income elasticity of demand would be 20%/10% = 2.

• A negative income elasticity of demand is associated with inferior goods; an

increase in income will lead to a fall in the demand and may lead to changes to
more luxurious substitutes.
 Income Elasticity of Demand
• A positive income elasticity of demand is associated with normal goods; an
increase in income will lead to a rise in demand.

• If income elasticity of demand of a commodity is less than 1, it is a necessity

good. If the elasticity of demand is greater than 1, it is a luxury good or a
superior good.

• A zero income elasticity (or inelastic) demand occurs when an increase in income
is not associated with a change in the demand of a good. These would be sticky
goods.
 Cross Price Elasticity
• cross price elasticity of demand measures the responsiveness of the
demand of a good to a change in the price of another good.

• It is measured as the percentage change in demand for the first good that occurs
in response to a percentage change in price of the second good.

• For example, if, in response to a 10% increase in the price of fuel, the demand of
new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand
would be −20%/10% = −2.

• In the example above, the two goods, fuel and cars(consists of fuel consumption),
are complements; that is, one is used with the other.
 Cross Price Elasticity
• In these cases the cross elasticity of demand will be negative, as shown by the
decrease in demand for cars when the price of fuel increased.

• In the case of perfect complements, the cross elasticity of demand is negative

infinity.

• Where the two goods are substitutes the cross elasticity of demand will be
positive, so that as the price of one goes up the demand of the other will increase.

• For example, in response to an increase in the price of carbonated soft drinks, the
demand for non-carbonated soft drinks will rise. In the case of perfect substitutes,
the cross elasticity of demand is equal to infinity.
 Cross Price Elasticity
• Where the two goods are independent, the cross elasticity of demand will be zero:
as the price of one good changes, there will be no change in demand for the other
good.