ELASTICITIES

Elasticity is the term used to describe the responsiveness of one variable to a change in
another. We are going to examine 4 types of elasticity:

 Price elasticity of demand (B pp46-53, T pp47-58)

 Price elasticity of supply (B pp 56-59, T pp66-71)
 Income elasticity of demand (B pp 55-56, T pp 62-66)
 Cross price elasticity of demand (B pp53-54, T pp 58-62)

Elasticity is a measure of the responsiveness of one variable to a change in another.

If the change in the second variable is more than proportional to the change in the first variable
then this is described as elastic; if the change in the second variable is less than proportional to
the change in the first variable then this is described as inelastic; and if the change in the
second variable is proportional to the change in the first variable then this is described as
unitary elasticity.

PRICE ELASTCITIY OF DEMAND

PED or the price elasticity of demand is an attempt to judge the responsiveness of quantity
demanded to a change in the price of that product.

The PED can be measured using the following formula:

FORMULA 1 (B p46, T p47)

The equation that is given will result in a negative number in the case of demand. This is due to
the inverse relationship that exists between price and quantity demanded, and highlighted in the
law of demand. As we are only interested in the degree of responsiveness (and not the direction
of the change) in the case of demand elasticity we ignore the negative sign.

The equation will also give a result that is:

 >1 referred to as elastic demand (relatively elastic) OR

 <1 referred to as inelastic demand (relatively inelastic) OR
 =1 referred to as unitary elasticity (proportional elasticity)

It is important to note that the degree of elasticity (responsiveness) or quantity demanded to a

change in price changes over the length of the demand curve. Other than in the case of where
the demand curve displays unitary elasticity, elasticity will be different at different points along
the demand curve. This also means that you should not assume that ‘slope’ or ‘gradient’ are
indicators of elasticity – they are not! However, it is possible to illustrate different elasticities in
graphical form which assume the same scale.
GRAPHS 1, 2 AND 3

We are also able to study the effects of price movements and elasticity on the Total Revenue
(TR) of firms. We are able to conclude the following:

PED TR

Price increase Elastic >1 Decrease

Unitary =1 Unchanged

Inelastic <1 Increase

Price decrease Elastic >1 Increase

Unitary =1 Unchanged

Inelastic <1 Decrease

It is important to remember that in the case of PED that the slope/gradient of the demand curve
is NOT the same as elasticity. (B p50, T p50)

The issue of total revenue can also be displayed graphically as indicated in the graphs above.

It should be pointed out that extreme values of PED are theoretical and that no single product
would possess PED with a value of zero GRAPH 7 (B Fig 4.1, T Table 3.1d) or in the case of
the other extreme, infinity GRAPH 8 (B Gig 4.2, T Table 3.1e)

Graph 7 displays the situation where a price change has absolutely NO change on the quantity
demanded. PED is described as being perfectly inelastic – in other words quantity demanded
does not change even though price has.

Graph 8 displays a situation where a price change (even the smallest imaginable price change)
results in an infinite change in quantity. We observe that at P1 demand goes on for infinity.
Thus, any change in Price has an infinite change in quantity.

DETERMINANTS OF PED

1. The number and closeness of substitutes B p50, Tp51

2. The passage of time/ time period B p52, T p51
3. The necessity (nature) of the product/it’s addictiveness quality B p51, T p51
4. The proportion of income spent on the product or service T p52

Applications of PED (B p52, 59-60, T pp54-58)

THE PRICE ELASTICITY OF SUPPLY (B pp 56-59, T pp66-71)

PES or the price elasticity of supply is an attempt to judge the responsiveness of quantity
supplied to a change in the price of that product. We are endeavouring to judge the
responsiveness of producers to a change in price.

The PES can be measured using the following formula:

FORMULA 2 (B p56, T p66)

The equation that is given will result in a positive number in the case of supply. This is due to
the direct relationship that exists between price and quantity supplied, highlighted in the law of
supply.

The equation will also give a result that is:

 >1 referred to as elastic supply (relatively elastic, high elasticity, highly responsive)
OR
 <1 referred to as inelastic supply (relatively inelastic, low elasticity, low
responsiveness ) OR
 =1 referred to as unitary elasticity (proportional elasticity, unitary elasticity)

In the case of PES, where there is a straight supply curve (constant gradient) elasticity also
remains constant over its length.
  Any supply curve that goes through the origin, no matter what it’s gradient, it will
possess unitary elasticity.
 Perfectly Inelastic Supply: Fixed quantity beyond which we cannot change the supply
function (Does not matter how much the price of an item, there cannot be more supply of
it by the supplier.)
 Perfectly Elastic Supply: At any price, will supply an infinite amount of items

*Time is one of the factors that impact elasticity

Graphs 1, 2 and 3

As with PED, there are extremes of elasticity for price elasticity of supply. The values for PES
range between two extremes of zero GRAPH 4 (B Fig 4.10, T Fig 3.11d) or in the case of the
other extreme, infinity in GRAPH 5 (B Fig 4.11, T Fig 3.11e)

Graph 4 displays a situation where the PES is equal to zero and is said to be perfectly inelastic.
It is completely unresponsive to any change in price – suppliers/producers are not encouraged
to change the quantity supplied by the change in price. No matter what the price, the quantity
will remain unchanged.

Graph 5 displays a situation where the PES is equal to infinity and is said to be perfectly elastic.
Quantity supplied is totally responsive to a change in price – suppliers/producers will cease to
produce and supply the market if the price falls below a particular price. If there is a move below
the current price then there will be total cessation of supply. Thus the change in quantity would
be infinity as the original supply was considered to go on for ever at the given price.

DETERMINANTS OF PES

1. The passage of time (B p59, T p68-69)

2. Unused capacity/resource mobility and costs of inputs (B p58-59, T p69)
3. Ability to store stocks (B p59, T p69)
The longer the period of time the item can be stored, the flexibility to supply in response
to the price change.

Applications of PES (B p60, T pp 69-71)

INCOME ELASTICITY OF DEMAND (B pp 55-56, T pp 62-66)

YED or the income elasticity of demand is an attempt to judge the responsiveness of quantity
demanded to change in the level of income. This helps us to understand the impact on the level
of aggregate demand in the economy when we increase incomes.

FORMULA 3

The equation that is given will result in either a positive or negative number. This reflects
whether as a result of a change in income a consumer will demand more or less of the good or
service. (It is unlikely that a change in income will result in NO change in quantity demanded
and thus a YED of zero.)

The equation will give a result that is:

 -ve this indicates that as income increases demand for the product has decreased
OR
 +ve this indicates that as income increases demand for the product also increases

Where the result is –ve we have identified an inferior good eg

GRAPH 1

Where the result is +ve we have identified a normal good eg

GRAPH 2
Applications of YED (T p63-65)

CROSS PRICE ELASTICITY OF DEMAND (B pp53-54, T pp 58-62)

XPED or the cross price elasticity of demand is an attempt to measure the degree of
responsiveness of one good to the change in the price of another. This helps us to understand
the impact of a change in price on the quantity demanded of a related or similar product.

FORMULA 4
The equation that is given will result in either a positive or negative number. This reflects
whether as a result of a change in price the demand for the other product increases or
decreases. This tells us something about the nature of the relationship between the two goods,
good x and good y.

Where the result is positive it indicates that raising the price of good y will result in an increase
in the quantity demanded of good x – this would be the case if good x and good y were
substitutes.

GRAPH 1

If we use Margarine as good A and Butter as good B we can observe from the graphs that as
the price of Margarine (good A) rises there is a decrease in the quantity demanded. Quantity
decreases from Q1 to Q2. As a result of the increase in price consumers are changing their
preferences and moving away from the consumption of Margarine (good A). This gives rise to a
+ve % change in price in the Margarine (good A) market. This is rational behaviour that follows
the law of demand.

The consumers move their consumption to an alternative product, in this case Butter (good B).
We can observe there is a complete shift of the demand curve to the right (D-D1). This is
because there has been a change in the conditions of demand for Butter – there has been a
change in the price of a substitute/alternative/related product. The impact of the shift in the
demand curve to the right, in the Butter market, is that the equilibrium price increases as does
the equilibrium quantity. Thus, there is a +ve change in quantity in the Butter (good B) market.

Degree of substitutability for substitutes (refer green box T p60)

GRAPH 2

If we consider products that have a different relationship that is not a competing one, such as
with Butter and Margarine, but rather a compatible one, such as with ipods and itunes we obtain
a different kind of XPED.

We can see that if there is an increase in the price of ipods from P1 to P2 there will be a
decrease in the quantity demanded of ipods from Q1 to Q2. This is rational behaviour displayed
by consumers as they assess the opportunity cost of paying more for an ipod and respond by
buying less of them. This is consistent with the law of demand. What we can observe here is
that the price increase results in a positive percentage change in price (+ve value for % change
Price good A)

If we look at the effect of the increased price of ipods on the itunes market we can see it will
result in a shift of the demand curve (function). This is because one of the conditions of demand
for itunes has changed – there has been a change in the price of a related/alternative product. .
The impact of the shift in the demand curve to the left, in the itunes market, is that the
equilibrium price decreases as does the equilibrium quantity. Thus, there is a -ve change in
quantity demanded in the itunes (good B) market. Consumers buy less itunes because they
have had to spend more money buying the ipod leaving less for the purchase of itunes, and
secondly because there have been fewer ipods purchased in total as quantity demanded
dropped (Q1 to Q2 in the ipod market) when the price increased from P1 to P2 (in the ipods
market).

Degree of complementarity for complements (refer green box T p60)

We can conclude that if:

XPED = +ve then the products/services are substitutes

XPED = -ve the products are complements (and are in joint demand)

Applications of XPED (T p60-62)