1.2 Elasticities

1.2a Price elasticity of demand (PED)

• Elasticity is a measure of response—a measure of how a change in one thing will create change in another thing.

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

• 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.

• 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.

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

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.

• 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 won’t result in much change in the quantity demanded as the change represents a small proportion of household income.

• 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.

Extreme cases of PED are rare but are possible.

• 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.

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.

• 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.

• 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.

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.

• 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

• 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.

• 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

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

• 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 category—most food, clothing, housing.

• 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.

1.2d Price elasticity of supply

• Price Elasticity of Supply measures producers’ response to a difference in price—the 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.

• 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.

• 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).

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

Cross Price Elasticity

• % ∆ Qd good1 ÷ % ∆ Price good2

• If value is positive the goods are substitutes• If value is negative the goods are

complements

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

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