Transcript 1.2 Elasticities

1.2 Elasticities
1.2a Price elasticity of demand (PED)
• Elasticity is a measure of response—a
measure of how a change in one thing will
create change in another thing.
In economics, there are four measures of
elasticity we use to help describe
peculiarities of certain markets—
• Price elasticity of demand
• Cross-price elasticity
• Income elasticity of demand
• Price elasticity of supply
• Price elasticity of demand measures the
response of quantity demanded to a
difference in price.
% ∆ Qd ÷ % ∆ Price
• For some goods the response is small. This is
called inelastic demand and the price elasticity
of demand is less than one.
• When the Elasticity of Demand is inelastic the
higher price will always generate more
revenue.
• In the graph above, a price of $4 generates
$160 in revenue. At the lower price of $2,
revenue is only $100.
• When price elasticity is greater than one, we
say that demand is elastic, and more revenue
will be generated at the lower price.
• In the graph above, a price of $6 generates
$180 in revenue. At the higher price of $8,
revenue is only $160.
Determinants of PED
• Number and closeness of substitutes –
The fewer close substitutes that are
available for a given good or service the
more price inelastic of demand. For
example, the demand for Nikes will be
relatively elastic as there are many close
substitutes for their shoes. However, the
demand for electricity is relatively inelastic.
• Proportion of Income – The price of a good
relative to consumer income will influence
elasticity. For example, if the price of
automobiles increases by 15%, the quantity
demanded will most likely fall as the
expenditure represents a large portion of
consumer budgets. Conversely, a 15%
increase in the price of potatoes, probably won’t
result in much change in the quantity
demanded as the change represents a small
proportion of household income.
• Necessity or Luxury Good – Goods that are
necessities, such as bread or utilities, will have
low PED as consumers will use the product
regardless of the price. On the other hand,
goods and services that are considered luxuries
would be more price elastic of demand.
Examples of these sorts of items would be
vacation travel or jewelry.
Extreme cases of PED are rare but are possible.
• Perfectly elastic demand is usually observed in
perfectly competitive markets with price takers such
as the market for rice.
• Perfectly inelastic demand is rare and is associated
with items like insulin for diabetics who would
willingly pay any price for the life saving qualities of
the drug.
Implications of PED
• Usually the PED for commodities is relatively
low which makes it difficult for producers to
raise their output levels to increase their
income. Foodstuffs are a good example of
products where there are few close
substitutes and people spend a relatively
small proportion of income on any particular
food item.
• Manufactured goods tend to have a higher PED as
consumers will spend a higher proportion of income
on such products. Consequently, pricing strategies
for autos, household appliances and computers can
be very important for producers when trying to
increase sales.
• PED is very important for governments when they are
setting indirect taxes. If they want to generate more
revenues from a particular good or service, then they
will want to tax items that are relatively price inelastic
of demand.
• Addiction results in a more inelastic demand for a given
good. PED is one factor when governments decide to
levy taxes on tobacco and alcohol. This scenario also
presents a problem for law enforcement when they are
considering the demand for illicit substances and
possible criminal activity.
1.2b Cross-price elasticity of demand
• Cross-elasticity of demand, also known as
cross price elasticity, is a test for determining
if goods act as complements or as substitutes.
• Complements are goods that are used
together, like computers and monitors. We
expect if people use more of one, they will use
more of the complement as well.
• Substitutes are goods that are used one
instead of the other, like tea and coffee. If
people drink more tea they are probably going
to drink less coffee.
• The actual measure of cross price elasticity
looks like this:
• % ∆ Qdgood1 ÷ % ∆ Pricegood2
• If the price of a cup of coffee went up, we
would expect the demand for tea to go up as
well, because people would buy less coffee.
• So for substitute goods the cross price
elasticity is always positive.
• We might see 40 computers sold in a week if
monitors were priced at $100, but only 20 computers
sold if monitors were $150.
Quantity computers Price monitors
40
100
20
150
• The higher price is associated with the lower quantity,
and the lower price with the higher quantity.
• This means cross price elasticity is negative and the
goods are complements.
1.2c Income elasticity of demand
Income elasticity of demand is used for
designating three types of goods based on
their response to income levels—
• Inferior goods
• Normal goods
• Luxury goods
• An inferior good is a good we buy more of
when our income is relatively low. Used cars
might be a good example, or second-hand
clothing.
• A normal good is something we buy more of
as our income grows higher, but we spend a
smaller percentage of our income at higher
levels. Most goods fit in this category—most
food, clothing, housing.
• Luxury goods are things people buy lots more
of when their incomes are higher, things like
yachts, expensive jewelry, and fancy holidays.
• The formula for income elasticity of demand—
• % ∆ Qd ÷ % ∆ Income
• is negative for inferior goods
• is between zero and one for normal goods
• is greater than one for luxury goods.
1.2d Price elasticity of supply
• Price Elasticity of Supply measures producers’
response to a difference in price—the
difference in supply compared to a difference
in price.
% ∆ Qs ÷ % ∆ Price
• This can be applied to an individual producer
or to all the producers in a specified market.
• One application that is particularly useful is in
distinguishing short term and long term responses to
a change in price.
• Because firms have trouble finding the new
resources, short run responses tend to be inelastic
(less than one) especially when prices rise. This is
because new resources are required for increases in
production and they are not always available.
• Even decreases in price might not allow for less
production because firms must honor contracts to
buy certain amounts of the resources they use.
• Long term, firms are able to find new
resources and to renegotiate contracts, so
production is more responsive to differences
in price and supply is more elastic (greater
than one).
1.2e Applications of concepts of elasticity
A simple outline to review the application of each
measure of elasticity—
Price Elasticity of Demand
• % ∆ Qd ÷ % ∆ Price
• If value is less than one demand is inelastic
• If greater than one demand is elastic
• Revenues always greatest when elasticity = one
Cross Price Elasticity
• % ∆ Qd good1 ÷ % ∆ Price good2
• If value is positive the goods are substitutes
• If value is negative the goods are complements
Income Elasticity of Demand
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•
•
•
% ∆ Qd ÷ % ∆ Income
If value is negative the good is an inferior good
If between zero and one it is a normal good
If greater than one the good is a luxury good
Price Elasticity of Supply
•
•
•
•
% ∆ Qs ÷ % ∆ Price
If value is less than one supply is inelastic
If greater than one supply is elastic
Long run supply is usually more elastic than
short run supply