Elasticity Concepts

Elasticity

A measure of the responsiveness of Qd to a change in one of its determinants

Price Elasticity of Demand (PED)

Measures the responsiveness of Qd of a good to changes in its own price, ceteris paribus

E_p = (% Change in Qd / % Change in Px)

= (Change in Qd / Qd) / (Change in Px / Px)

= (Change in Qd / Change in Px) * (Px / Qd)

NOT = Gradient of Demand curve

• Always negative due to Law of Demand
• Sign may be taken for granted and ignored
• 0 < |E_p| < Infinity

Price Elastic demand:  1 < |E_p| < Infinity

• Change in Px brings about MORE than proportionate change in Qd
• Gradient of DD is gentle
• 1 Reason: Close substitutes

Price Inelastic demand: 0 < |E_p| < 1

• Change in Px brings about LESS than proportionate change in Qd
• Gradient of DD is steep
• 1 Example: Necessity

Perfectly Price Inelastic: |E_p| = 0

• Change in Px does not change Qd
• DD is vertical straight line
• 1 Example: Insulin to diabetic, for as long as needed and can afford to pay

Unit Price Elastic (theoretical): |E_p| = 1

• Change in Px brings about proportionate change in Qd
• DD is hyperbola

Perfectly Price Elastic (theoretical): |E_p| = Infinity

• Change in Px brings about Infinite decrease in Qd
• DD is horizontal straight line

Determinants of Price Elasticity of Demand

• Substitutes: More substitutes available, More Px elastic
• Proportion of Income: Higher proportion, More Px elastic
• Time period: Longer time period after Px change, More Px elastic
• Habit/Addiction: Px inelastic
• Nature of Good: Luxuries more Px elastic than necessities (better to use YED)

Application

• Useful for increasing TOTAL REVENUE
• Px elastic, reduce Px
• Px inelastic, increase Px

Income Elasticity of Demand (YED)

The degree of responsiveness of DEMAND to a change in the income of consumers, ceteris paribus

E_y = (% Change in Qd / % Change in Y)

= (Change in Qd / Qd) / (Change in Y / Y)

= (Change in Qd / Change in Y) * (Y / Qd)

• Can be +ve or –ve
• +ve: DD moves same direction as Y
• -ve: DD moves opposite direction from Y

Income Elastic: E_y > 1 (Luxury Goods)

• Change in Y brings about more than proportionate change in Qd

Unit Income Elastic: E_y = 1

• Change in Y brings about proportionate change in Qd

Income Inelastic: 0 < E_y < 1 (Necessities)

• Change in Y brings about less than proportionate change in Qd

Zero income elasticity: E_y = 0

• Change in Income has no effect on Qd (E.g. Pepper, table salt)

Determinants of YED

• Degree of necessity: More basic = Lower elasticity
• Rate at which desire is satisfied as consumption increases: Faster = Lower elasticity
• Level of Y: Lower income will buy more with increase in Y than higher income

Application

• Decide type of good to produce: Introduce better quality goods in economic boom

Cross Elasticity of Demand

The degree of responsiveness of DEMAND for one product to a change in the Px of another good, ceteris paribus.

E_xy = (% Change in Qd_{good X} / % Change in Px_{good Y})

= (Change in Qd_{good X} / Qd_{good X}) / (Change in Px_{good Y} / Px_{good Y})

= (Change in Qd_{good X} / Change in Px_{good Y}) * (Px_{good Y} / Qd_{good X})

• -ve Infinity to +ve Infinity
• +ve: substitutes, Px_{good Y} increase, Qd_{good X} increase
• -ve: complements, Px_{good Y} increase, Qd_{good X} decrease

Magnitude of CED

• Closer substitute/complement, bigger effect, greater magnitude
• Perfect substitutes: CED tends towards +ve infinity
• Independent goods: CED = 0

Application: How to react

• Rival firms/substitutes: (E_xy > 0) – Slash price when competitor slash price, attempt to differentiate
• Complement: (E_xy < 0) – Joint promotions, sell complements

Limitations of DEMAND Elasticity Concepts

E_p: At best able to strategise whether to raise or lower prices. Exactly how much is determined by the point where Marginal Revenue = 0, (Covered under market structures)

E_y: May not work when different factors affecting Demand change simultaneously (Different from the problem of ceteris paribus)

E_xy: Imperfect information to consumers would means that owners may not need to lower prices when competitors reduce prices

General:

• Concepts assume ceteris paribus, which may not hold in real life
• Concepts only useful in increasing total revenue or sales, NOT profit, as Profit = Total Revenue – Total cost
• Price elasticity of supply needs to be taken into consideration
• Concepts assume perfect competition

Price Elasticity of Supply

A measure of the responsiveness or sensitivity of Qs of a commodity to a change in its own Px, ceteris paribus

E_s = (% Change in Qs / % Change in Px)

= (Change in Qs / Qs) / (Change in Px / Px)

= (Change in Qs / Change in Px) * (Px / Qs)

• Always positive, higher price induces higher supply

Determinants

• Number of Firms: Greater number, more price-elastic
• Length of production period: Longer length, less price-elastic
• Spare capacity: More spare capacity, more price-elastic
• Ease of accumulating stocks: Easier to store, more price-elastic
• Ease of factor substitution: Easier to substitute, more price-elastic

Application

• Price inelastic: SS cuts horizontal axis, output increases less than proportionately to increase in price
• Price elastic: SS cuts vertical axis, output increases more than proportionately to increase in price