MICROECONOMICS [DETERMINANTS OF ELASTICITY]
PED
YED
Def
PED measures the degree YED measures the degree
of responsiveness of
of responsiveness of
quantity demanded of a
quantity demanded to a
good to a change in its
change in the income of
own price, ceteris paribus consumers, ceteris paribus
Formula % change in qty demanded % change in qty demanded
% change in price
% change in income
Sign
Always negative
Can be positive or negative
Price
1 <|PED|< ∞Normal
YED > 1 Normal goods/
Elastic goods
Luxury goods
YED < 0 Inferior goods
Price
0 <|PED|< 1 Necessities
0 < YED < 1 Necessities
Inelastic
October 2,
2012
CED
CED measures the degree of
responsiveness of quantity
demanded of a good to a change in
the price of another good, ceteris
paribus
% change in qty demanded of good X
% change in price of good Y
Can be positive or negative
CED > 0 Substitutes
CED <0 Complements
CED = 0 Unrelated goods, sales
independent of each other
Determinants of PRICE Elasticity of Demand:
o Availability of Substitutes
Most important determinant is the number and closeness of substitutes. The greater the number
of substitutes available for a good and the closer the substitutes, the more price elastic is the
demand for that good. This is because more consumers are likely to switch to alternatives when
the price of the good increases. Conversely, the demand for electricity is price-inelastic as there are
no close substitutes for electricity currently.
*number and closeness of substitute goods also depend on the broadness of the definition of the
good. The broader the definition, the more price-inelastic is the demand.
o Necessity
Basic Goods: if goods are necessities, the consumption of such goods is essential and usually
cannot be delayed or postponed. These are goods that are required for daily consumption in order
to sustain a basic quality of life. It is easier to forgo luxuries but not necessities. As such, the
demand tends to be relatively price inelastic.
Habit/Addiction: demand for these goods tends to be price inelastic if the good is bought on a
habitual basis. If consumers are addicted to the product, they cannot easily change their
consumption habits in response to price changes.
o Proportion of Income
The higher the proportion of income spent on the good, the more price-elastic is the demand. For
example, table salt is relatively price-inelastic as consumers spend a tiny fraction of their income on
it. Consumers would have little difficulty paying even if there is a relatively large percentage
By Tong Xueyin
1
MICROECONOMICS [DETERMINANTS OF ELASTICITY]
October 2,
2012
increase in prices of salt. In contrast, there will be a much bigger effect when major items, such as
cars and houses rise in price.
o Time Period
In general, the demand for most goods and services would be relatively price-inelastic in the short
run and relatively price-elastic in the long run. This is because when prices rise, consumers may
take time to adjust their consumption patterns and find suitable alternatives. The longer the time
period after a price change, the more price-elastic will be the demand for the good as consumers
have more time to make necessary adjustments in response to the price change.
*Useful for firms and producers: pricing strategies and Government: raise tax revenues and reduce
negative externalities
Determinants of INCOME Elasticity of Demand:
o Nature of good
In general, demand of necessities is income inelastic whereas demand for non-necessities such as
luxury goods is income elastic.
Necessities: YED is mainly determined by the degree of necessity for the good. Basic goods usually
have relatively low positive income elasticities. YED is relatively low because the desire for
increased consumption usually does not grow in direct proportion to increased incomes for such
basic goods which are meant to provide for a minimum decent living standard.
Luxury Goods: YED is positive and high as people generally prefer to spend a higher percentage of
their extra income on them to enhance their quality of life when they become affluent. On the
other hand, these are goods that people will consider first in cutting back expenditures when times
are bad and incomes fall.
o Level of Affluence of Consumers
According to Engel’s law, the same good might be considered an inferior, normal or luxury good
depending on the income level of the consumer. In general, what may be considered as luxuries
to the poor or low-income households might be considered as necessities or even inferior to the
wealthy or high income households. As our income rises, we tend to want to consume better
quality goods.
*application of YED for firms: output decisions (what and when to produce?) and targeting
different income groups in different locations
*application of CED for firms’ reaction to rival firms selling SUBSTITUTES: pricing strategy – match
price-cut; non-pricing strategy – product differentiation, discounts. COMPLEMENTS: joint
promotion
By Tong Xueyin
2
MICROECONOMICS [DETERMINANTS OF ELASTICITY]
October 2,
2012
Determinants of PRICE Elasticity of Supply
PES
Definition
PES measures the degree
of responsiveness of
quantity supplied of a
good to a change in its
own price, ceteris paribus
% change in qty supplied
Formula
% change in price
Sign
Always positive
Price Elastic
1 < PES < ∞
Price Inelastic 0 < PES < 1
o The existence of Spare Capacity
If spare or unused capacity exists and if variable
inputs such as labour and raw materials are available,
it should be possible to increase production quickly
in the short run while the reverse is true.
*Spare capacity ≠ new/expansion of capacity
o Nature of Production
Ease of factor substitution (factor mobility): many
firms produce a range of products and are able to switch factors from one type of production to
another. If factors of production can be switched easily in terms of its use, then the supply of the
product will tend to be price elastic. Thus, the degree of mobility of resources determines the
extent to which factor substitution can be carried out.
*the ease at which the factors of production can move around is termed geographical and
occupationally mobility of factors
Length of production period: the shorter the time period for firms to convert factor inputs into
outputs, the more price-elastic is the supply of the good. Supply of primary products usually
tends to be highly price inelastic, while supply of manufactured goods tends to be relatively
much more elastic because it is easier to adjust the production period.
o The Ease of Accumulating Inventory or Stocks
Inventory refer to the firm’s stocks of unsold goods, which are produced but have yet to be sold
or put on sale in the market. If it is easy to store unsold stocks at low cost, firms will be able to
meet a sudden increase in demand by running down stocks. Likewise, they can respond to a
sudden fall in demand and price by taking supply off the market and by diverting production into
stock accumulation.
o Time Period
In general, the supply for most goods and services is price-inelastic in the short run and relatively
more elastic in the long run. In the short run, there may be greater difficulty for sellers to increase
supply in respond to higher demand due to the lack of spare capacity; immobility of resources or
inadequate stocks. However, in the long run, firms can take measure to rectify these “supply
bottlenecks” and thus be in a better position to increase production.
Total Revenue = Unit Price x Qty sold
= Total Expenditure = Unit Price x Qty bought
Profit = Total Revenue – Cost of Production
By Tong Xueyin
3
MICROECONOMICS [DETERMINANTS OF ELASTICITY]
October 2,
2012
*PED & PES affect: extent of price volatility, output and extent of changes in consumer
expenditure
By Tong Xueyin
4
MICROECONOMICS [DETERMINANTS OF ELASTICITY]
October 2,
2012
What are the limitations of these concepts?
Firstly, Ceteris paribus assumption is a fundamental drawback in terms of real world application as
it assumes no factors except the price (PED); income (YED); price of a related good (CED)
respectively changes. However, in the real world, at any particular point in time, many factors such
as the price of a related good, or the income level of consumers may be changing simultaneously. In
other words, demand may not behave as predicted by elasticity concepts.
Secondly, the cost-side of the profits equation is ignored as the concepts are only useful to help
firms increase revenue. PED concept helps businesses decide on appropriate pricing strategies. YED
helps businesses decide on output strategies and CED helps businesses to decide on joint and
reactionary-marketing strategies. However, none of these elasticity concepts help with cost-cutting
strategies or productivity enhancing strategies. In short, the concepts are unable to help firms
maximise profits as costs are not taken into consideration since Profit = TR – COP.
Thirdly, the validity of applying elasticity concepts in formulating business marketing strategies rest
on the crucial assumption that all information pertaining to elasticity concepts are available to
firms. It is assumed that firms have perfect information to make rational business decisions.
However, in reality, it is not possible to attain such perfect information.
Lastly, the supply side of the market is ignored. When strategising, firms should also take PES into
consideration – whether they can respond fast to the change in demand. It is simply assumed that
supply can easily cope with changes in demand, though in reality cutting prices to stimulate demand
may not be successful in raising sales and revenue if supply is price inelastic.
Usefulness of above elasticity concepts to a government in formulating her microeconomic
policies
Problems: market failure due to monopoly of power or inefficient allocation of resources for
production and consumption of goods with externalities; market fails to address the basic needs of
lower income group (income inequality).
Solutions: market based: use of tax/subsidies, non-market based: use of legislation/ education/
price control
Market failure (externalities): PED indicate the level of tax sufficient for reducing negative
externalities, and whether there is a need to use legislations in case of inelastic PED
Market failure (monopoly): legislations such as granting more licence to break up monopoly power,
price regulation and price control to achieve allocative and productive efficiency.
Income inequality: YED guides government’s planning of expenditure on social goods and services
to provide more and better social and community services to meet the increasing demand of the
public. E.g. Housing, agricultural produce
By Tong Xueyin
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