Economic Issues: An Introduction DE3A 34 Outcome 1 Topic 6 Elasticity

 When considering demand and supply another useful concept is that of elasticity.  This is basically the measurement of how the demand or supply of a product changes in response to changing a key influence on demand or supply.  The most common type of elasticity studied is price elasticity of demand.  In this part you will be studying this concept along with income elasticity of demand.

Price Q2Q1 P2 P1 Introduction Elasticity of Demand  Demand is inversely related to price, as price rises demand falls, as price falls demand rises.  We also require to know the extent to which demand is affected by a change in price. Quantity 0 D

Demand and Price A 10% change in the price of cigarettes may have a smaller effect on cigarette sales than a 10% change in the price of packaged holiday sales. A 50% change in the price of salt may have a smaller affect on salt sales than a 50% change in average house prices.

Elasticity  The responsiveness of demand to price changes doesn't only vary between goods.  Different price changes for the one good can have different effects.  Economists use the term elasticity to describe the responsiveness of demand to price changes.

Inelastic  When demand is relatively unresponsive to price changes, it is said to be inelastic.  Unresponsive = Inelastic  A change in price will have little effect on the demand for this product.

Elastic  When demand is relatively responsive to price changes, it is said to be elastic.  Responsive = Elastic  A change in price will have a greater effect on demand.  How do we decide if demand is elastic or inelastic?

Measuring Elasticity  Economists have devised a simple way of measuring the elasticity of demand. Ep = % change in demand % change in price  (Ep is elasticity of demand in response to changes in price)  This calculation will yield three kinds of numerical answers.

Results When the % change in demand > % change in Price, Ep >1. Demand is elastic. When the % change in demand < % change in Price, Ep < 1 Demand is inelastic. When the % change in Demand = % change in Price, Ep = 1 Demand has unit elasticity. So, elasticity of demand is a measurement of the degree to which demand responds to a change in price.

Measuring % changes  To measure elasticity we must be able to calculate % changes in price and demand.  The formula we use is: amount of change x 100 starting value

Measuring % changes Example Price rises from £10 to £12, what is the % change? Answer Amount of Change =£2 Starting Value=£10 % Change =2/10 X 100 =20%

Exercise Calculate the % change in the following: 1. Prices fall from £15 to £10 1. Demand falls from 20 units to 5 units 2. Demand rises from 10 units to 30 units Answers 1= 33% 2 = 75% 3 = 200%

Measuring Elasticity Example A % change in demand 30/50 x 100 = 60% % change in price 2/10 x 100 = 20% Ep = 60/20 = 3 Demand is elastic

Measuring Elasticity Example B % change in demand 10/100 x 100 = 10% % change in price 3/6 x 100 = 50% Ep = 10/50 = 0.2 Demand is inelastic

Calculating Elasticity Calculate the Ep if the price falls from £30 to £20? Formulas Ep = %change in demand % change in price If Ep > 1 than elastic demand If Ep < 1 then inelastic demand If Ep = 1 then unit elasticity

Answer Ep = % Change in Demand 60/40 x100 = 150% Divided by % Change in Price 10/30 x100 = 33.34% Ep = 4.5 Ep > 1, elastic demand

Calculating Elasticity Formulas Ep = %change in demand % change in price If Ep > 1 than elastic demand If Ep < 1 then inelastic demand If Ep = 1 then unit elasticity Calculate the Ep if the price rises from £5 to £20?

Answer Ep = % Change in Demand 5/50 x100 = 10 Divided by: % Change in Price 15/5 x100 = 300 Ep = 0.03 Ep < 1, inelastic demand

Degrees of Price Elasticity  Demand for most products is either ELASTIC or INELASTIC.  Elastic Products  Demand will be responsive to changes in price.  In this case a % change in price will cause a greater % change in demand.

Elastic Demand  Demand tends to be elastic for the following goods: 1. Goods with close substitutes, e.g. Butter and Margarine 2. Goods that take up a large proportion of consumers income. Televisions. 3. Goods perceived as luxuries, aftershave, champagne. 4. Whose purchase can be postponed, dishwashers.

Degrees of Price Elasticity  Inelastic products  When a given change in price causes a smaller % change in demand, the product has inelastic demand.  Demand will not be as responsive to changes in price.

Inelastic Demand  Inelastic goods; 1. Basic necessities (Electricity, Milk, Bread) 2. Goods and services that take up a small % of disposable income. (Cinema tickets) 3. Addictive goods (Cigarettes, Alcohol, Chocolate) 4. Goods and services with no close substitute. (Cigarettes) 5. Goods that take up a small proportion of consumers income. Chewing gum.

Availability of close substitutes The major influence on price elasticity of demand is the availability of close substitutes. When a close substitute is available in the relevant price range, demand will be elastic. The demands for a particular brand of cigarettes will be elastic due to close substitute brands. The demand for cigarettes as a whole will be inelastic due to no close substitute product. Good/Service definition The more widely defined a good or service is the less elastic demand will be. This is because there will be fewer substitutes. The more defined the product is the more substitutes are available, more elastic demand will tend to be. Meat is less as elastic as beef, which is in turn is less as elastic than rump steak. Habit FormingSome products are habit forming, e.g. cigarettes, whisky, chocolate, and the demands for such products tends to be inelastic. Demand will not fall heavily due to changes in price. Ability to be postponed If it is possible to postpone the purchase of a product or service, for example a dishwasher, demand will tend to be elastic. Time scaleDemand tends to be more elastic in the long run than in the short run. This is because it takes time for consumers to adjust to price changes. If the price of electricity rises, consumption may fall as people use less in the short term. Long term they will replace electrical goods with alternatives. Determinants of Price Elasticity

The Importance of Elasticity  Some awareness of elasticity is of great importance to suppliers.  It will affect the revenue collected by suppliers at different prices.  Total Sales Revenue (Selling price x quantity demanded) collected by the supplier at different prices depends on the elasticity of demand.  Total Sales Revenue = Price x Quantity Sold

Total Sales Revenue  Total Sales Revenue = Price x Quantity Sold  Example.  If a company sells 100 £3, what is the Total Sales Revenue?  Answer: 100 X £3 = £300.

Revenue and Elasticity Example (A) 1.Calculate the elasticity of demand for example A. 2.What has happened to Total Revenue as a result of this fall in price?

Example A Elasticity % Change in Demand = 30/50 x 100 = 60% Divided by % Change in Price = 2/10 x 100 = 20% Ep = 60/20 Ep = 3 Demand is Elastic when price is reduced, £10 to £8. Total Revenue Revenue has risen from (10 x 50 = £500) to (8 x 80 = £640). Total Sales Revenue rises from £500 to £640. When demand is Elastic a fall in price will result in an increase in Total Revenue.

Revenue and Elasticity Example (B) 1.Calculate the elasticity of demand for example B. 2.What has happened to Total Revenue as a result of this increase in price?

Example B Elasticity % Change in Demand = 10/100 x 100 = 10% Divided by % Change in Price = 3/6 x 100 = 50% Ep = 10/50 Ep = 0.2 Demand is Inelastic when price is increased, £6 to £9. Total Revenue Revenue has risen from (6 x 100 = £600) to (9 x 90 = £810). Total Sales Revenue rises from £600 to £810. When demand is Inelastic an increase in price will result in an increase in Total Revenue.

Revenue and Elasticity  These examples show that:  When demand is elastic it will pay the supplier to reduce the price because Total Revenue will rise as a result.  When demand is inelastic it will pay the supplier to increase price because Total Revenue will rise as a result.

Revenue and Elasticity  We can deduce two other rules:  When demand is elastic it will be disadvantageous to increase prices as Total Revenue will fall.  When demand is inelastic it will be disadvantageous to reduce prices as Total Revenue will fall.

Revenue Summary  Elastic Demand  Ep > 1  A given % increase in Price will cause a greater % increase in Demand.  Demand is responsive to increases in Price  Elastic Demand is inversely related to Total Revenue  Price Total Revenue  Inelastic Demand  Ep < 1  A given change in Price causes a smaller % increase in Demand.  Demand is unresponsive to increases in Price  Inelastic Demand is positively related to Total Revenue  Price Total Revenue

Elasticity of Demand and the Shape of the Demand Curve As a general rule, the more elastic the demand is, the more horizontal the demand curve will be. The more inelastic the demand is, the more vertical the demand curve will be.

Elastic Demand Curve  Here a 15% fall in price leads to a 115% rise in demand.  Demand is Elastic

Inelastic Demand Curve  Here a 15% fall in price leads to a 10% rise in demand.  Demand is Inelastic

. Elasticity  Taking this to its logical conclusion, we can represent two extreme cases – where demand is totally elastic and totally inelastic

Exercises  The following links take you to revision exercises dealing with Elasticity.  Calculating Elasticity Calculating Elasticity  Interpreting Elasticity Interpreting Elasticity  Essay on Elasticity Essay on Elasticity  Further Study Question Further Study Question

Income Elasticity of Demand  Just as we have measured the responsiveness of demand to prices, so too we can measure the response of demand to other variables, like income. Ei = % change in demand % change in income

Income Elasticity  In relatively rich countries like Britain or Germany, goods and services like DVD players, dish washers, cars and exotic holidays will a high degree of income elasticity.  Increases in consumer incomes have a very significant effect on the demand for most luxury goods and services. An economist would say that the demand for Caribbean holidays is HIGHLY INCOME ELASTIC.  The demand for more exotic holidays will increase as income rises.

Income Elasticity  The demand for more basic items such as staple foods and basic necessities will be INELASIC in relation to INCOME.  The demand for these goods will not rise considerably as levels of income rise.

The Application of Income Elasticity of Demand  Firms may wish to apply this concept when making plans for the future. If their product has a positive income elasticity of demand they may wish to expand their output as they see incomes the economy expanding.  They may wish to take the income elasticity of a product in a certain areas into account.

The Application of Income Elasticity of Demand  For instance, if incomes are rising substantially in an area of a city then producers may want to take advantage of this by supplying products with high positive income elasticities.  An example of this would be coffee and chocolate bars in the Merchant City area of Glasgow.

The Application of Income Elasticity of Demand  On the other hand, products that are pinpointed as having zero or negative elasticities may have implications for the producers of these products.  The demand for basic foodstuffs falls into this category. Now, let’s think what a zero or negative income elasticity for a product means to the producers of that product.  It means that as consumer incomes in the economy rise the demand for this product does not.

The Application of Income Elasticity of Demand  Selling this product is how the producer earns their living, so the consequence is that as the rest of the people in the economy increase their incomes the producers of this product find their incomes decreasing!  This would logically lead them to give up producing the goods.

The Application of Income Elasticity of Demand  However, governments may be interested in this because what if the capacity to produce that good is desirable – for instance farming?  Governments may wish to protect the producers of the goods and thus policy will have to be formulated for this purpose.  The Common Agricultural Policy of the European Union is a classic example of a policy in response to the concept of income elasticity of demand.

Elasticity  Revision Notes Revision Notes  The Link above take you to revision notes from Bized website on the following topics.  Demand  Supply  Equilibrium Price  Elasticity  Interactive Revision Demand/Supply/Elasticity Interactive Revision