Elasticities

1. Elasticities The relationship between Demand/Supply and how sensitive the good is to changes in Price, Income, or Other Goods Price Elasticity of Demand (PED) Income Elasticity of Demand (YED) Cross-Price Elasticity of Demand Price Elasticity of Supply

2. Possible test questions: • What factors determine the price and income elasticities of demand for a product? • Why might firms be interested to know the price and income elasticities of demand for various products? • What are the various factors that determine the value of (i) price elasticity of demand and (ii) income elasticity of demand? • Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.

3. Elasticity of Demand • Price Elasticity of Demand • A measure of how much the quantity demanded changes in response to a change in the price of the product. • Simple formula: % ∆ in Quantity Demanded of the product % ∆ in price of the product

4. 0 1 2 3 4 5 6 • In theory, the range in value is from “0 to infinity” in actuality neither of these values will occur • Value under 1 – the product hasprice inelastic demand • Value over 1 – the product has price elastic demand • Value equal to one – the product has unit (unitary) priceelastic demand unitary elastic inelastic -----------elastic--------------------------

5. When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. • Price elasticity of demand is -0.2 . • When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. • Price elasticity of demand is -2.6 .

6. Disregard the negative sign • The own price elasticity of demand is always negative. • Economists usually refer to the own price elasticity of demand by its absolute value (ignore the negative sign). • So, even though the formula says that the own price elasticity of demand is negative, we would say the elasticity of demand is .2 in the first example and 2.6 in the second.

7. Price Perfectly Elastic Demand (elasticity = ¥) Quantity Perfectly Elastic Demand We say that demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded. (theoretical)

8. Price Perfectly Inelastic Demand (elasticity = 0) Quantity Perfectly Inelastic Demand We say that demand is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded. (theoretical)

9. Determinants of Price Elasticity 1. The Availability/Closeness of Substitutes 2. Time Span i.e. oil, inelastic short-run, slightly less long run 3. Proportion of Income Spent 4. Necessity of the product (vs. luxury goods) i.e. habit-forming products have inelastic D

10. Warning:Elasticity and Slope of line • A straight line will have a slope that is constant, the value of PED over the same line will vary. • upper portions- more elastic • lower portions – more inelastic

11. Significance of Price Elasticity • When demand is price elastic: • Price and revenue (income) move in opposite directions (indirect relationship) • A rise in price will cause a fall in revenue • A decrease in price will cause an increase in revenue. • When demand is price inelastic: • Price and revenue (income) move in the same direction (direct relationship) • A rise in price will cause an increase revenue and vice versa

12. Elasticity and Taxation • If the government increases a tax on a product there will be a greater affect on their revenue when the product has price__________ demand.

13. PED and commodities • Oil, minerals, food (tangible raw materials) • Tend to have inelastic demand • Tend to have price volatility and the elasticity of demand has a huge effect on revenue for producers and for governments than depend on the export of commodities • Price volatility due to supply shifts (short-run supply shifts)

14. PED and price discrimination • The same good may have different elasticities of demand for different consumers; such as airline tickets and hotel rooms.

15. Income Elasticity of Demand • Measures the extent to which demand for a product changes in response to a change in income • Formula: % change in Quantity Demanded % change in Income

16. Determinants of Income Elasticity • Necessities or luxuries: • Necessities have positive, but less than 1 elasticity • Luxuries have positive and more than 1 • Income level of consumers

17. Positive Income Elasticity of Demand • A rise in income will cause a rise in demand and a fall in income will cause a fall in demand for a product (a normal good) • Positive value = normal goods • if the value is 0-1 = income inelastic demand Necessities: bread, milk, petrol • If the value is 1+= income elastic demandVery elastic: Fine wines and spirits, high quality chocolates, luxury holidays overseas, Consumer durables - audio visual equipment, 3G mobile phones and gym memberships. These are called Superior or Luxury goods

18. -+ • Negative Income Elasticity of Demand • A rise in income will cause a decrease in demand and a fall in income will cause an increase in demand for a product, an inferior good • less than 0 (negative value) = inferior good • Examples include the demand for potatoes, white-bread and low-priced own label foods in supermarkets , bikes in China, but not in developed country….. (surprisingly: cigarettes, why?)

19. Uses of Income Elasticity: • If a product is income elastic and the economy is getting better the company needs to plan investment. How? • Government needs to know what percentage of jobs are income elastic/inelastic to plan for unemployment. Why?

20. Positive Income Elastic and inelastic Demand Inelastic Income elastic Quantity Demanded

21. Cross-Price Elasticity of Demand (CPed) • Measures the extent to which demand for one product changes in response to a change in the price of another product % ∆ in Quantity Demanded of the product A % ∆ in price of the product B Note: Positive/Negative sign does matter

22. Formula CPED (XED)= %∆QDa %∆ Pb • Positive Cross Elasticity (greater than 0) • Substitute goods: a rise in the price of one product is likely to cause an increase in demand for its substitute(s) • Slightly more than 0 = remote substitutes • Greater positive number = close substitutes • Apples vs. Oranges: • Price of oranges increases 10% the demand for apples increases by 12%

23. Positive cross elasticity(substitutes) • Price of oranges quantity of apples

24. Negative Cross Elasticity (Less than 0) • Complementary Goods: A rise in price of one product is likely to cause a decrease in demand for it’s complementary good)s) • Slightly less than 0 = remote complements • Greater negative number = close complements

25. Price Elasticity of Supply • Is a measure of the responsiveness of supply to a change in price. • Formula: PES = %∆QS %∆P Elastic Supply: A percentage change in price results in a greater percentage change in Supply ( 1< PES ) Inelastic Supply: When the supply is not very responsive to changes in price ( 0<PES<1 ) Perfectly elastic and perfectly inelastic supply is possible in the short-run.

26. S1 S3 • S4 S2 • Price s5 • Quantity supplied What are the different curves? (S1, S2, S3, S4, S5)

27. Negative Cross elasticity(Complements) • ?

28. Determinants of Supply • Length of time: • The immediate time period • Not all inputs (factors of production) can be changed • The short-run • Only some inputs can change • The long-run • All inputs can be changed • Spare capacity of firms • How much costs rise as inputs increase

29. Elasticities of demand and subsidies