Elasticity! Boingy, boingy, boingy! Price, Income and Cross Elasticity

Elasticity – the concept The responsiveness of one variable to changes in another When price rises what happens to quantity demanded? Demand falls BUT! How much does demand fall?

Elasticity – the concept If price rises by 10% - what happens to Qd? We know Qd will fall By more than 10%? By less than 10%? Elasticity measures the extent to which quantity demanded will change

Elasticity 4 basic types used: Price elasticity of demand – PED Price elasticity of supply – PES Income elasticity of demand – YED Cross elasticity – Cross ED or XED

Elasticity Price Elasticity of Demand The responsiveness of quantity demanded to changes in price Where % change in Qd is greater than % change in price – elastic Where % change in Qd is less than % change in price - inelastic

Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity Price (£) Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

Elasticity Total Revenue Price £5 D 100 Quantity Demanded (000s) Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5 Total Revenue D 100 Quantity Demanded (000s)

Elasticity D Total Revenue Price £5 £3 100 140 If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. £5 £3 Total Revenue D 100 140 Quantity Demanded (000s)

Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20% Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

Elasticity Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 5 20 Quantity Demanded

Elasticity If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P)

Elasticity Versus Slope Elasticity of demand describes the shape of a demand curve, but it is not the same as slope. Slope measures the rise or fall in a curve divided by its horizontal run. Elasticity measures the horizontal run by the rise or fall.

Task #1 – Calculating PED Calculate the price elasticity of demand in each of the following examples: The change in demand is 5%, the change in price is 7% The change in demand is 12%, the change in price is 3% The change in demand is 9%, the change in price is 4% The change in demand is 13%, the change in price is 25% The change in demand is 6%, the change in price is 8% In each case say whether the price elasticity is inelastic or elastic.

Spending and Elasticity If demand is inelastic, buyers spend more on the good when its price is higher. If demand is elastic, buyers spend less on the good when its price is higher. If demand is unit-elastic, buyers spend the same amount on the good when its price is higher.

Determinants of Elasticity Time period – the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes – the greater the number of substitutes the more elastic The proportion of income taken up by the product – the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Factors Affecting Elasticity of Demand Availability of Substitutes · Demand for a good is more elastic when close substitutes for it are available to buyers.

Factors Affecting Elasticity of Demand Fraction of Income Spent on the Good · As people spend higher fractions of their incomes on a good, their demand for the good becomes more elastic. · As they spend smaller fractions of their income on a good, their demand for it becomes less elastic.

Factors Affecting Elasticity of Demand Adjustment Time · Demand is more elastic when people have more time available to adjust to a change in price.

Other Types of Elasticity Explain how to calculate Income Elasticity of Demand (YED), Cross-Price Elasticity of Demand (XED) and Price Elasticity of Supply (PES)

Elasticity – YED Income Elasticity of Demand (YED): The responsiveness of demand to changes in incomes Normal Good – demand rises as income rises and vice versa Inferior Good – demand falls as income rises and vice versa

Elasticity – YED Income Elasticity of Demand: A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity – YED For example: Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8% WHY? Use your YED formula and plug it in: (x/0.03)=-0.6 (-0.6)(0.03)=x -0.018=x, or -1.8% Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3% This slide has a ten second gap in between each example to allow the teacher to explain how the figures have been calculated. This gap can be increased or reduced as appropriate using the custom animation tool.

YED Video

Elasticity – XED Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement % Δ Qd of good t __________________ XED = % Δ Price of good y

Elasticity – XED Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two)

Practice! Is the following graph showing a situation where the goods are complements or substitutes? How can you tell? Substitutes. As the P for good B increases, the Qd for good A increases (XED>0).

XED video

Elasticity Price Elasticity of Supply: % Δ Quantity Supplied The responsiveness of supply to changes in price If PES is inelastic - it will be difficult for suppliers to react swiftly to changes in price If PES is elastic – supply can react quickly to changes in price % Δ Quantity Supplied ____________________ PES = % Δ Price

PES: determinants—length of time

PES Video

Importance of Elasticity Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analyzing time lags in production Influences the behavior of a firm This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course.

As you go back to read/review Think about how to solve for each: equations, plugging in, what changes might occur given certain values Think about what the graphs would look like for each Think about determinants of each, and how that might affect how the graph looks Think about substitutes, complements, inferior, superior, normal and luxury goods and how they apply to each