HL1 ECONOMICS

MICROECONOMICS

An Introduction
to Elasticity
 ELASTICITY
Price Elasticity of Demand (PED)
PED measures how sensitive the quantity
demanded is to changes in the price.
You would expect the demand for most goods
to fall as the price increases, but PED
measures how much of a fall is likely.
It is important to distinguish between elastic
and inelastic demand.
 ELASTICITY
Price Elasticity of Demand (PED)
Formula for PED:
% change in quantity demanded
% change in price

How do we calculate the % change???

Change in Quantity
Original Quantity
________________ (divided by)

Change in Price
Original Price
 PED Example
The price of a popular chocolate bar increases
from $3 to $4 per bar.
The quantity demanded per week falls from
10000 bars to 9000 bars.
Calculate the PED.
Change in Quantity = 1000
Original Quantity 10000 = .1 .1__
.333 = .3
Change in Price = 1 = .3333 What does this number
mean ? the product is
Original Price 3 inelastic.
What does inelastic
mean? Read on!
 ELASTICITY
Price Elasticity of Demand (PED)
Elastic Demand
A small change in prices results in a relatively
larger change in the quantity demanded.
Eg: If the price of a textbook increases by 10%
and as result demands fall by 30%, demand is
said to be elastic.
Demand is price elastic if the value calculated
is more than 1. Therefore using our formula:
30 / 10 = 3
 ELASTICITY
Price Elasticity of Demand (PED)
Inelastic Demand
A relatively large change in price, led to a smaller
change in the quantity demanded.
If the price of a product increases by 10% and demand
only falls by 1%, then demand is said to be inelastic.
The same is of course true, for price drops, leading to a
rise in demand.
Demand is inelastic if the figure calculated is less than
1. Therefore using our formula: 1/10 = .1
Our chocolate bar was an example of an inelastic good.
 ELASTICITY
Price Elasticity of Demand (PED)
Unitary Elasticity
If PED is exactly 1, this is know as unitary
elasticity, which means that a change in price
will lead to an identical change in quantity
demanded.
 ELASTICITY
Price Elasticity of Demand (PED)
The Importance of PED for Business
It is useful for business to look at PED when
deciding whether or not to change the price.
Revenue (price x quantity) will be affected by
any change in price, but how it is affected
depends on whether a product is elastic or
inelastic.
 ELASTICITY
Price Elasticity of Demand (PED)
PED is Inelastic (less than 1) =
Business Can Increase Revenue by Increasing Price

They will lose some revenue from quantity

demanded, but will gain more revenue from the
higher prices, as demand changes less than
proportionally to the change in price.
 ELASTICITY
Price Elasticity of Demand (PED)
PED is Elastic (Greater than 1) =
Businesses Can Increase Revenue by Lowering Prices

They will lose some revenue from the lower prices,

but will gain more revenue from the higher quantity
demanded, as demand changes more than
proportionally to the change in price
This means that businesses must be careful to
interpret their sales data correctly before making
decisions on price changes.
 PED EXERCISES (1)
American Airlines (AA) decides to increase its
airfares on the New York to the US Virgin Islands (St
Thomas) from $200 one way to $400 one way
during the Christmas & New Year period. Weekly
demands for the seats at this price level falls from
10000 per week to 9500 per week.
Calculate the Price Elasticity of Demand (PED)
Explain what the number means are airfares on
this route at this time elastic or inelastic??
From a revenue perspective was this a wise and
smart decision for AA.
 PED EXERCISE (2)
APPLE decides to decrease the selling price of its
basic IPAD from $499 to $399. Weekly demand
in a specific market increases from 10,000 units
to 11,000 units.
Calculate the Price Elasticity of Demand
Explain what this number means
From a revenue perspective, was this a wise/
smart decision for APPLE.
 ELASTICITY
Income Elasticity of Demand (YED)
YED measures the change in
demand for a product if there
is a change in consumers
income.
 ELASTICITY
Income Elasticity of Demand (YED)
Formula:
% Change in Quantity Demanded
% Change in Income

How do we calculate the % change???

Change in Quantity
Original Quantity
________________ (divided by)

Change in Income
Original Income
 ELASTICITY
Income Elasticity of Demand (YED)
Elastic Income Demand
If demand is more than proportionally affected by
a change in income it is elastic.
If incomes rises by 5% and demand increases by
20% it clearly is elastic.
Income elastic goods are known as luxury goods.
Expense jewelry is a good example demand will
be significantly affected by changes in income.
 ELASTICITY
Income Elasticity of Demand (YED)
You would expect most goods to have a
positive relationship to income with demand
rising as income rises.
After all, if you have more money you will
spend more. However, we need to
distinguish between two different types of
goods:
Normal Goods
Inferior Goods
 ELASTICITY
Income Elasticity of Demand (YED)
Normal Goods
Normal goods which will have a positive YED,
because more is demanded as income rises
both the top and bottom of the calculation will
have the same size.
Inferior Goods
Demand actually falls as income rises.
The best examples are the low cost value ranges
stocked by most supermarkets.
As income rises, instead of customers buying
more of these products, they may choose to
swap to a higher quality or brand alternative.
 ELASTICITY
Income Elasticity of Demand (YED)
Inferior Goods
These products are extremely popular in times of
recession and when incomes are falling, but are
quickly abandoned once incomes and
employment start to rise.
The success of low cost chains across Europe such
as Lidl and Aldi will increase as the global
economy tips into a recession.
As demand falls when income rises, the top and
bottom of the equation will have different signs
and therefore have a negative YED.
 Income Elasticity of Demand (YED)
Exercise
The average middle income salary increases
from $50,000 to $70,000. The amount spent by
these consumers on restaurant meals (fine
dining) increases from $80 per week to $150.
Calculate the YED.
Explain the meaning of the number.
Are restaurant meals a normal or an inferior
good? Why?
 ELASTICITY
Cross Elasticity of Demand (XED)
XED is a measure of
responsiveness of change in
the demand of one product to
the change in the price of
another (a complement or a
substitute).
 ELASTICITY
Cross Elasticity of Demand (XED)
The formula is:
% Change in Quantity Demanded of Product A
% Change in the Price of Product B

How do we calculate the % change???

Change in Quantity A
Original Quantity A
________________ (divided by)

Change in Price of Product B

Original Price of Product B
 ELASTICITY
Cross Elasticity of Demand (XED)
Substitutes
Products that can replace each other
(substitutes) will have a positive XED the
price of butter goes up, demand for margarine
will increase as some people choose to swap
to the option that has become relatively
cheaper.
 ELASTICITY
Cross Elasticity of Demand (XED)
Complements
Products that are linked (complements) have a
negative XED as the price of airfares
increases, the demand for hotels in resort
locations may go down.
 ELASTICITY
Cross Elasticity of Demand (XED)
No Relationship Between Goods
Goods with no relationship will have an XED of
zero for example if the price of cars
increases, demand for cheese will remain
unchanged.
 ELASTICITY
Cross Elasticity of Demand (XED)
What does the number mean?
The higher the number calculated, the stronger
relationship between the products, whether a
complement or a substitute.
Examples
Coke and Pepsi are likely to have a very high,
positive XED as they are very close substitutes.
Coke and Spirit will still have a positive XED, but it
is likely to be lower, as Spirit is alternative soft
drink, but not quite as close a match as another
Cola.
 Cross Elasticity of Demand (XED)
Exercise
The number of subscribers to Super Cable
increases from 10,000 per month in September
to 11,000 per month in October. During
October Direct TV decided to increase the cost
of platinum TV package (all channels) from $60
per month to $80 per month.
Calculate XED
Explain the meaning of the number.