Lecture 3 and 4: Analysis of Elasticity

Lecture Objectives:1. Define Ped & its determinants2. Use worked examples 3. Consider its relevance to real

world business problems 4. Introduce other elasticity

measures (supply)

Relevance of Elasticity?

“Know your customer. This phrase means understand the demand curve and

know the values of elasticity measures”

(Boyes, 2004, The New Managerial Economics, p. 77)

ELASTICITY (PED)

• Price elasticity of demand:

Determinants– number / closeness of substitute goods– the proportion of income spent – time horizon…product search– product life cycle

PED is Calculated as:

PED - Values

Perfectly In-Elastic

Relatively In-elastic

Unit Elastic

Relatively Elastic

Perfectly Elastic

PED and tax incidence

Role of PED in determining the extent to which a tax on a product (indirect tax) can be passed on to the consumer as a higher price.

This is often referred to as the incidence of the tax on the consumer.

Lump-sum and percentage taxes

Perfectly inelastic demandWhere the demand curve is perfectly inelastic (D), the equilibrium price rises from P to P.1, i.e. by the full amount of the tax (equilibrium quantity is unchanged at Q).We conclude that all the tax is passed on to the consumer, i.e.:•100% tax incidence on the consumer; •0% tax incidence on the producer.

Perfectly elastic demandWhere the demand curve is perfectly elastic (D.1), the equilibrium price is unchanged at P (equilibrium quantity falls to Q.1). We conclude that none of the tax is passed on to the consumer, i.e.:•0% tax incidence on the consumer;

•100% tax incidence on the producer.

Relatively Inelastic / Elastic Demand

Tax and government revenue

Cross Elasticity of Demand

The magnitude of the shift in DŠX will depend upon how close X and Y are as substitutes or complements in consumption. The closer the two products are as substitutes or complements, the greater will be the numerical value of cross-elasticity of demand.

Income Elasticity of Demand

1.The nature of the need satisfied by the commodity.

2.The time period.3.The initial level of national income.

Advertising Elasticity of Demand