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1.2 – Elasticity

Price Elasticity of Demand (PED)

Price Elasticity of Demand and Its Determinants

Price elasticity is a measure of how responsive the demand is to change in price. If demand

is very elastic, then it is easily influenced by price. On the other hand, if demand is inelastic,

then changing the price will have little effect on demand: the demand is less sensitive to

price.

The price elasticity of demand for any given demand curve can be calculated according to

the equation:

𝑷𝑬𝑫 = 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅

𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆

When doing these calculations, it is important to note that, although the calculated value is

usually negative, it is treated as a positive number. The absolute value is used instead of the

negative number.

Values can be compared using the following measures: if the absolute value is between 0

and 1, the demand is said to be inelastic, as changes in price have only a minor effect on

demand. On the other hand, values above 1 indicate that the demand is elastic. When the

value is exactly equal to 1, this is called unit elastic demand. This means that a change is

price by one percent corresponds to a change in demand by one percent.

When the value is equal to 0, the demand is known as perfectly inelastic. Changing the price

would have no effect on demand. Likewise, when the value is ∞, the demand is perfectly

elastic. A price change would cause an infinite change in demand.

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The determinants of PED are:

Degree of necessity - i.e. is it addictive? a basic need? Food items like bread and milk

would be largely inelastic because they are necessary to life.

The proportion of income spent on the purchase - expensive items like cars or

houses cost a high proportion of income, making the demand for them more elastic

Number and closeness of substitutes - if there is a large number of similar products

on the market, demand becomes more elastic. The greater the similarity of the

products, the more likely consumers are to switch after a price change.

Timeframe between measurements - to accurately determine price elasticity,

sufficient time must be allowed to measure the proportion of the market that stops

purchasing the product. For example, if the price of insurance increased, consumers

would need time to transfer to another company before the impact of the price

change would be seen. Some products are inelastic in the short-term, but very

elastic in the long-term.

It is important to realise that PED varies along the demand

curve and is not represented by the slope of the curve.

Instead, PED is an arc that touches the straight-line demand

curve. At lower prices, the gradient of the arc approaches 0

and at higher prices the gradient approaches ∞.

The gradient of the two lines are equal only at the point

where they touch. The gradient of the PED curve is

constantly changing as price changes.

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Applications of Price Elasticity of Demand

Role of PED for Firms

Businesses use PED to determine the effect of price changes on their total revenues. This is

crucial for their decision making - would it be worth it to increase the price of their product,

or would it have too much of a negative effect on demand? Their revenue is represented by

the area under the demand curve.

𝑹𝒆𝒗𝒆𝒏𝒖𝒆 = 𝑷𝒓𝒊𝒄𝒆 × 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚

Firms will sell their product at the price that maximises their revenue. They must consider

PED in order to compare the revenue at different prices.

Role of PED for Governments

PED can be used by governments to predict the effect of implementing taxes. They will

compare the elasticity of different products and tax the most

inelastic ones.

Incidence of Taxation

This is the question of whether producers or consumers pay the

cost of taxes. If a product is price inelastic, the producers can pass

on the cost of the tax to the consumers without much effect on

demand. Consumers wear the cost of the tax.

Looking at the graph on the right, it can be seen that a price

increase for a price inelastic product only causes a small decrease

in demand

On the other hand, if the product is price elastic, the

producers must absorb the cost of the tax, since the increase

in price causes demand to fall, thereby decreasing the

producer’s revenue.

The graph, left, shows that increasing the price of a price

elastic product would cause a large decrease in demand.

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Note that on these two graphs, the price changes due to a shift of the corresponding supply

curve, as below. The shift in the supply curve is caused by the change in the costs of

production as a result of the tax.

Generalising Elasticity

Primary commodities, including raw materials, are usually price inelastic because they are

necessary for life: things like food products or sources of energy.

Conversely, manufactured products tend to be price elastic because there are more

alternative products available from other suppliers.

Cross Price Elasticity of Demand (XED)

Cross Price Elasticity of Demand and Its Determinants

This is the responsiveness of the quantity demanded of a good to the price of another good.

It indicates the relationship between two related products when there is a shift in the

demand curve. This is mainly used for products that compete with each other - i.e. if the

price of Y chips goes up, how does the demand for X chips change? It is calculated using the

equation:

𝑿𝑬𝑫 = 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒈𝒐𝒐𝒅 𝒙

𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒈𝒐𝒐𝒅 𝒚

In the chips example, X chips are considered a substitute to Y chips if the

demand for X increases as the price of Y increases, leading to a positive XED.

By definition, substitute goods have a positive value of XED.

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Another type of related products is complementary products - these are products that are

dependent on each other. An example of this is CD players and CDs: you only buy a CD

player if the price of CDs is affordable. If the price of CDs goes up, then the demand for CD

players would go down, leading to a negative XED. Therefore, by definition, complementary

goods have a negative value of XED.

However, the XED alone does not determine whether goods are substitutes or

complements. For these relationships to exist, the products must be closely related. You

could calculate the XED for hairspray and pillows, but it would not give any useful data,

since the goods are not actually related. Hence, the absolute value of XED depends on how

closely related the products are.

Applications of Cross Price Elasticity of Demand

XED is useful for supermarkets, as it allows them to see whether increasing prices to

maximise their profits may have a negative effect on sales for complementary goods.

Competitors can also test whether a price increase would cause too many customers to

switch to substitute goods. This way, they can be aware of effects on sales and revenue

before making price decisions. Furthermore, if their rival businesses change their prices,

they can predict how much this will affect their sales.

Income Elasticity of Demand (YED)

Income Elasticity of Demand and Its Determinants

This calculation is used to show how dependent the demand for a product is on the income

of consumers. Therefore, it assesses the shift in the demand curve that results when income

increases or decreases. It is calculated using the equation:

𝒀𝑬𝑫 = 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅

𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆

Normally, when income increases, people can afford to purchase higher quantities of a

given good. As a result, the definition of normal goods is items with positive YED - that is,

the demand increases as income increases.

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On the other hand, some goods are cheaper, low quality substitutes to more expensive

items. While low income causes the demand for these goods to increase, when income is

high, the luxury of purchasing more expensive items can be afforded. Therefore, the

definition of inferior goods is items with negative YED - that is, as income increases, the

demand for the item decreases.

When the YED is greater than 1, a product is income elastic. This means that the product is a

luxury good, as consumers will purchase it based on their income. On the other hand, a

product with YED les than 1 is income inelastic. This means the product is a necessity good,

since consumers must continue to buy it even when income is low.

Applications of Income Elasticity of Demand

For the economy, income elasticity can be used to determine which products to produce.

Since primary products have a very low YED, the demand will be relatively constant despite

any changes in income. Manufactured products will have a higher YED, so demand is higher

once the average income increases. Services have an even higher YED, which means that

any decrease in income will have a significant impact on demand.

In a growing economy, firms will try to avoid producing inferior goods. Those producing

necessity products know that demand will not change when income changes. It can also be

useful for firms to monitor income in other countries, as this may indicate new markets for

normal goods.

Furthermore, when the economy develops, a country tends to shift from primary to

secondary and tertiary production. For primary sector businesses, the demand for goods will

be relatively constant. However, with this change of sectors, more elastic products will be

purchased. Firms in the secondary or tertiary sector will see higher demand for their goods.

Therefore, YED is a crucial consideration in business decision-making.

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Price Elasticity of Supply (PES)

Price Elasticity of Supply and Determinants

Producers use increases in price as indicators that more of a good should be supplied. The

price elasticity of supply is the measure of the responsiveness of the quantity supplied of a

particular good to a change in its price. It is calculated according to the formula:

𝑷𝑬𝑺 = 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒔𝒖𝒑𝒑𝒍𝒊𝒆𝒅

𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆

PES > 1 - Supply is elastic (usually manufactured goods)

PES < 1 - Supply is inelastic (usually primary products)

PES = 1 - Unit elastic supply

PES = 0 - No response to prices; the supply curve is vertical and perfectly inelastic

PES = ∞ - Perfectly elastic supply; horizontal supply curve

The PES always has a positive value.

PES is determined by factors including:

Time - The faster the goods can be produced, the more

elastic the supply is in response to changes in demand.

This also relates to the time it takes to train people to

produce the goods. While there is always a delay

between the change in price and the change in supply,

this delay may be longer from some products than for

others.

Mobility of Factors of Production - Elasticity is higher if the factors of production can be

moved easily. A firm might have to buy new machinery or train staff.

Unused Capacity - This means that it is easy to increase production if there is a shift in

demand. A supplier might not be producing the maximum amount, so there is room for

them to increase production if the price increases. If there is a lot of unused capacity, the

PES will be higher.

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Ability to Store Stock - If stock can be stored easily, then the supply is more elastic in

relation to the demand. Many food products deteriorate quickly, whilst other non-

perishables can be stored for extended periods of time. Supply for perishable items is more

inelastic.

Number of Competitors - If there are fewer barriers to entry for new competitors, then

more firms can enter the market to meet increasing demand.

Number of Suppler Substitutes - A firm might be able to product multiple types of product.

When the price of one decreases, the supplier is able to switch to producing the other. If

they have a large number of substitutes that are closely related, the supply is more elastic.

Applications of Price Elasticity of Supply

Primary commodities often require large amounts of time to produce, such as crops and

minerals. As a result, a change in demand will see a delay in the response of the suppliers.

On the other hand, manufacturers can easily change their supply by altering the hours of

the workers or the output from machinery. This makes the PES of manufactured goods

higher.