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1 Defining elasticity

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Law of demand and supply hold true in almost every market for g&s and resources

At higher price
Suppliers are willing to provide more
Consumers demand less due to higher opportunity cost of consumption

At lower price
Suppliers willing and able to provide less due to declining benefits of producing and
selling at lower prices
Consumers are willing to purchase more

The relationship between price and quantity demanded and supplied are stable
enough to be considered economic laws
...


Implication for business (PED, XED)
• PED has major implications on a firm when it is considering raising or lowering
their prices
• Producers of some goods must be aware of the effect that changes in the price
of other goods will have on market demand for their products
o E
...
Toyota and Honda expands production of Hybrid cars as gasoline prices
have risen steadily around the world

Implication for government (PED, YED, PES)
• Government must consider elasticities when deciding which goods to place
taxes on and whether or not to raise or lower income tax
...



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Small increase in price --> large decrease in quantity demanded---> price elastic
Large increase in price --> small decrease in quantity demanded---> price inelastic

The PED coefficient

To accommodate different levels of output and price, we must measure changes in
percentages

PED = %change in Qd / %change in P


PED = (Qd2 - Qd1)/Qd1 divided by (P2-P1)/P1

Qd2--> quantity demanded aft price change
Qd1--> original quantity demanded
P2---> new price
P1---> original price

PED coefficient is negative due to the inverse relationship between price and quantity
• Since law of demand applies to nearly all G&S --> we express PED as an absolute
value

Interpreting the PED coefficient

PED < 1 : Inelastic demand

Percentage change in quantity is less than percentage change in price
Consumers are rather insensitive to changes in price
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E
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: cigarettes, bread, water, house, clothing

PED > 1 : Elastic demand

Percentage change in quantity is more than percentage change in price
Consumers are rather sensitive/responsive to changes in price
...


E
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: Vacations, airline tickets, cars

PED = 1 : Unit elastic demand


Percentage change in price results in identical percentage change in quantity
demanded

PED = 0 : Perfectly inelastic demand

Any change in price is met with no change in quantity demanded
...

• For example, the price of insulin rises
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• As the price of insulin falls, diabetics will continue to demand the same quantity
and no one else will demand insulin, so quantity demanded will remain
unchanged
• As price rises, diabetics will continue to demand the same quantity since they
cannot afford to cut back on their consumption
...



If price of the product rises even by 1%, the quantity demanded falls to zero
...

• If one seller were to raise his price above the equilibrium price --> rational
consumers swill shun that seller and instead buy from other sellers
• If one seller were to lower his price below the equilibrium ---> rational
consumers will shun all other sellers whose prices now appear too high
...


Highly elastic --> phonecards?

Relative elasticity and the slope of the demand curve

The steeper the slope of demand --> the less elastic the demand for that good
The more horizontal (less steep) the slope --> the more elastic the demand


A demand curve that is vertical --> perfectly inelastic
A demand curve that is horizontal --> perfectly elastic

When comparing elasticity with different graphs in one diagram:
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Get the individual % change in quantity
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g
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Coffee consumers are
therefore relatively unresponsive to changes in the price of coffee
...

o In a given city, there may be several dozen coffee shops, so if one shop
alone raises its prices while others keep theirs constant, the chances are
that consumers will be more responsive to that particular instance of a
higher price than they would be if all coffee became more expensive
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Example: Increase in price of family beach vacation vs a box of toothpicks
Vacation - 10 % drop in price: $1000
Toothpick - 10 % drop in price: a few cents

Luxury or necessity?

Goods that are necessary to consumers will have less elastic demand than the luxuries
they can do without if the price rises
...
Consumers with a physical dependence on good will
be unwilling or unable to respond to price increases to much degree
...
People are willing to pay anything when they are addicted
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Time to respond

Immediately following a change in price, it is unlikely that consumers will adjust their
consumption by much
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3 Applications of price elasticity of demand

Total revenue test of PED

Generally,

At higher prices --> demand tends to be elastic for most goods
As price falls and Qd increases --> demand tends to be inelastic

Why?

When a product is first introduced at a high price, demand is very elastic due to
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And the perception that this was a luxury product that they can do without until
the price was brought down

As time goes on, the uniqueness and luxury status of the product wears off
...
The
responsiveness of consumers to change in price drops
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For business making decisions about output and price --> PED is valuable

For businesses making decisions about output and price --> understanding price
elasticity is invaluable


A firm producing at a quantity and price combination along inelastic range of its
demand curve
• Can benefit by reducing its output and increasing price
• As consumers will be relatively unresponsive to the higher prices and total
revenue will therefore increase

A firm producing at a quantity and price combination along the elastic range of its
demand curve
• The firm can benefit from lowering its price
• since consumers are relatively price sensitive and the percentage increase in
quantity sold will exceed the percentage decrease in price, increasing revenue
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(More in chapter 5)


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g
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g
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5 Income elasticity of demand (YED)

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Measures the responsiveness of consumers' demand for a particular good to a
change in income


Change in income have different effect on demand for different good depending on
the nature of the good

The YED coefficient

Normal good: rising income leads to greater demand
E
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restaurant meals, taxi rides, clothes, air travel, DVDs
Inferior good: rise in income leads to decrease in consumption
E
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fast food, generic brand groceries, public transport, second-hand clothes


YED = %change Qd / %change income -->
(new Qd - old Qd) / old Qd
------------------------------------------------------------------

(new income - old income)/old
income

%change Qd is the percentage change in the quantity demanded
%change is the percentage change in income

Direct relationship between income and demand --> YED coefficient positive: normal
good
Indirect relationship --> YED coefficient negative: inferior
good

It can be applied to measure the change in an individual's consumption of particular
goods to a change in income or it can be applied to analyze the effects of change in
national income on the demand for particular goods and services in the nation as a
whole

E
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The demand for bicycles increased during US recession as it was perceived as an
inferior
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Interpreting the YED coefficient

Income elastic --> percentage change in income will lead to a larger percentage
change in quantity demanded
Income inelastic --> percentage change in income will leader to a smaller percentage
change in demand
Income unit elastic --> particular percentage change in income will lead to a same
percentage change in demand

Applications of income elasticity of demand

YED allows businesses and governments to analyze the effect of changing incomes
among consumers and taxpayers on the level of demand for a particular good

Firms: may wish to determine whether the income of its consumers are likely to rise or
fall in the future when deciding on production numbers for its product
• If a firm produces inferior good, then a recession could be good for business and
it will increase its output in order to meet the rising demand among consumers
• If a firm produces normal goods, they would reduce production if incomes
decline

Understanding YED allows firms to produces at a more efficient level of output

Government must also recognize the effects of varying YED for different goods
produced by the economy
• The largest source of tax revenue for most governments is a direct tax on
income
• A government's decision to raise or lower income tax will directly affect
disposable income and therefore demand for goods and services
• A tax increase will reduce demand for normal goods and increase demand for
inferior good

•

A government must consider these effects in order to make informed decisions
about tax policy



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Producers can respond quickly and easily
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( the inputs are easily
acquired and numerous producers can respond instantly and easily to changes in
price)

Supply of fighter jets --> highly inelastic - especially in the short run
Producers are unable to respond quickly to the change in price and the quantity of
fighter jets will nearly remain constant in the short run
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Perfectly inelastic goods --> gold, certain antiques or artwork
elastic goods --> goods for which large inventories exist

The determinants of PES
• Amount of time following the change in price
• The mobility of factors of production
• The ability to store stocks
• The amount of unused capacity

Time following a change in price

Over time, producers are much more responsive to changes in the price of good
...

In the long run, all factors of production are variable so firms are highly responsive to
changes to demand in the marketplace
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• Land intensive good vs labour-and-capital intensive good --> affects producer's
ability to shift resources into or out of production following a price change

Relatively elastic supply: manufactured goods and low-skilled services

• Low-tech manufactured goods (clothes, toys and simple electronics) and lowskilled services (haircuts, laundry services, housekeeping) tend to have relatively
elastic supply
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Relative inelastic supply: primary commodities and heavy industrial goods

• The harder it is to shift factors of production into or out of production of a good,
the more inelastic the good's supply will be
• airplanes, residential and commercial construction, automobiles, high-tech
goods and highly skilled services (doctors, financial experts, university
professors) tend to exhibit highly inelastic supply
• Primary commodities that are land intensive: coffee, rice, corn, wheat, coal, oil
gas and minerals
o Time consuming and costly to bring into production new plants for heavy
industrial goods and primary commodities to meet rising demand or to
take them out of production in response to falling prices

The ability to store stocks

• If large inventories of a good can easily be stored in warehouses or kept on hand
by producers --> supply of the good can be highly responsive to change in price
• E
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video games, software, low-tech manufactured goods and certain nonperishable commodities
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Price controls and PES

E
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In European Union --> minimum price for butter
In the short term, supply was inelastic and surplus was not so much
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When the economy slowed down, it led to a huge surplus as producer
kept producing at a level corresponding to the price floor

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