Price Elasticity
What is it?
Many factors affect supply and demand
The question elasticity aims to answer is: by how much?
Definition:
It is a term used to measure the extent to which buyers and sellers respond to any
particular change in market conditions.
How elasticity is relevant to economics.....:
Types of Elasticity
•
•
•
•
Price Elasticity of Demand (PED)
Income Elasticity of Demand (YED)
Cross Elasticity of Demand (XED)
Price Elasticity of Supply (PES)
Price Elasticity of Demand
PED measures the responsiveness of a product’s demand when there is a change in
price.
We assume ‘ceteris paribus’
PED = P x ∆Q
Q
∆P
All this means is that:
Price Elasticity of Demand =
original price
original quantity
X
change in quantity
change in price
Or....
PED = %∆QD
%∆P
All this means is that:
Price Elasticity of Demand = percentage (%) change in quantity demanded
percentage (%) change in price
Diagrams...
Elastic or inelastic?
We need to be able to describe the elasticity of the
demand, we do this by calculating the PED and then
using the result to determine which one of three
categories the good fits into:
1. Price elastic
2. Unit elastic
3. Price inelastic
Elasticity boundaries
PED = 0
1 > PED > 0
PED = 1
∞ >PED > 1
PED = ∞
=
=
=
=
=
perfectly inelastic
inelastic
unit
elastic
perfectly elastic
Example:
Suppose a hill sheep farmer sells 100 lambs to a
local butchers at £10 per lamb. He then decides
to raise his price to £12 per lamb but in response
the butchers now only want 50.
What is the PED of lambs in this market?
Is it elastic, inelastic or unitary elastic?
Remember:
PED = P x ∆Q
Q
∆P
Determinants:
• Substitutes
• Relative expense with respect to income
• Time
Income Elasticity of Demand (YED)
Definition:
The responsiveness of demand to a change in
income.
Again we assume ceteris paribus and we look to
see by how much QD changes based upon a rise
or fall in income levels.
(Note: We use Y to describe income as I is already
taken)
• We are no longer considering any price
change.
• It is the case that in most circumstances if our
income rises our demand for a good will
increase. However this is not the case in all
circumstances!
• Examples?....
The Equation
YED = %∆QD
%∆Y
All this means is that:
Income Elasticity of Demand = percentage (%) change in quantity demanded
percentage (%) change in income
Or....
YED = Y x ∆Q
Q
∆Y
All this means is that:
Income Elasticity of Demand = original income
original quantity
X
change in quantity
change in income
• BEWARE: this time it IS important to consider
whether the sign is positive or negative!
• This is because it indicates whether the QD
increases or decreases after a ∆Y
• (i.e. Whether the gradient of the demand
curve is upward or downward sloping)
Income Elastic
• Definition: goods for which a change in
income produces a greater proportionate
change in demand.
• YED > 1
• Diagram:
Income Inelastic
• Definition: goods for which a change in
income produces a less than proportionate
change in demand.
• YED < 1
• Diagram:
EXAMPLES
Normal vs Inferior goods
Normal: goods with a positive income elasticity of demand (+YED)
Superior: goods with a relatively high YED , difficult to define due to personal
preferences.
Inferior: goods with a negative income elasticity of demand (- YED)
Diagrams:
Example:
Imagine my income rises from £100 to £120 because
the school is exceptionally kind. Now I love spending
money on nice shirts to stand out from the crowd.
On my starting income I could only afford a demand
of 40 but after my pay rise I can now demand 60.
What is my income elasticity? What does that tell
you?
YED = Y x ∆Q
Q
∆Y
Cross Elasticity of Demand (XED)
• We have looked at what happens when price
levels change for a product (PED).
• However we need to consider the effect of a
price change on one good (good A) on another
good’s demand (good B)
• Why would that be important?
Definition:
“XED measures the responsiveness of demand
for one product following a change in price of
another product.”
Again we need to assume ceteris paribus
when considering XED. Income and supply
remain fixed as do all other market conditions.
Formula:
XED = %∆QD A
%∆P B
All this means is that:
Cross Elasticity of Demand = percentage (%) change in quantity demanded of product A
percentage (%) change in price of product B
Intuition:
• What is likely to affect XED? (It’s
determinants?)
• What about the elasticity? Does it matter if
XED is positive or negative?
Diagram:
Price of
Product B
D3
D1
D2
0
Quantity demanded of product A
• So what does it mean if we look at the ‘D1’
Curve?
Price of
Product B
D1
0
Quantity demanded of product A
We have a Substitute
So what does it mean if we look at the ‘D2’ Curve?
Price of
Product B
We have a Complement
D2
0
Quantity demanded of product A
Finally, what does the D3 curve mean?
Price of
Product B
D3
That there is zero cross
elasticity of demand. A
change in the price of B has
no bearing to change in
quantity demanded of A.
0
Quantity demanded of product A
Elasticity
•The more elastic XED is, the stronger the
relationship is between the two products.
•A high XED would suggest the goods are strong
compliments / substitutes
•A low XED would suggest the goods are modest or
weak compliments / substitutes.
•A zero value for XED would suggest the goods are
completely unrelated and have no effect on each
other. Example?
Price Elasticity of Supply
Price elasticity of supply, or PES, measures the
responsiveness of supply to a change in price.
We know that supply curves slope upward, meaning that as
prices rise suppliers want to supply more, but how quickly can
they react?
In just the same way as Demand curves, supply curves obey the same
rules with regards to elasticity.
You can easily tell
the elasticity of a
supply curve by
looking at where it
will intersect the
axis.
S1
Price (£)
S2
S3
0
Quantity supplied
Y axis: elastic
X axis: inelastic
Origin: unit
Equation
PES = P x ∆QS
QS
∆P
All this means is that:
Price Elasticity =
of Supply
original price
original quantity supplied
X
change in quantity supplied
change in price
Or....
PES = %∆Qs
%∆P
All this means is that:
Price Elasticity of Supply =
percentage (%) change in quantity supplied
percentage (%) change in price
We will always get a positive value for PES
What determines the elasticity of
supply?
1. Availability of stock
2. Availability of factors of production
3. Time Period
• long run
• short run
Relevance of elasticity
Businesses find that knowing the elasticity of their supply and the
consumers demand vital to create an effective pricing structure to
maximise their profits (or revenue depending on the firms goal).
But how reliable is elasticity data? What problems are there?
1. They are estimates only
2. Inaccuracies in data collection
3. Difficulty in obtaining data
4. Other factors can influence D/S which are hard to differentiate (e.g.
Change in perception of a brand – Burberry, Abercrombie & Fitch)
How different types have different
uses:
PED: revenue maximization -
e.g. Segment demand through price
discrimination
YED: forecasting future prospects for a good / service. As incomes tend to rise
over time, normal goods that are elastic tend to do well (in the long term).
Or if economic uncertainty looms, goods with inelastic YED can survive more
successfully as they are affected less by rise and falls in the standard of living.
XED: Most important in highly competitive markets with substitutes and
compliments
PES: Important for a firm to consider in determining its stock holdings and
whether to enter the market, the more elastic PES is the easier it is to benefit
from price increases.
Elasticity is
FINISHED