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Elasticity – the concept
• The responsiveness of one variable
to changes in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
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Elasticity – the concept
• If price rises by 10% - what
happens to demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent
to which demand will change
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Elasticity
• 4 basic types used:
• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity
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Elasticity
• Price Elasticity of Demand
– The responsiveness of demand
to changes in price
– Where % change in demand
is greater than % change in price –
elastic
– Where % change in demand is less
than % change in price - inelastic
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Elasticity
The Formula:
Ped =
% Change in Quantity Demanded
___________________________
% 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)
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Price (£)
Elasticity
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
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Elasticity
Price
Total revenue is price x
The importance of elasticity
quantity sold. In this
is the information it
example,on the£5 x 100,000
provides TR = effect on
= £500,000. of changes in
total revenue
price.
This value is represented by
the grey shaded rectangle.
£5
Total Revenue
D
100
Quantity Demanded (000s)
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Elasticity
Price
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)
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Elasticity
Price (£)
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
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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)
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Elasticity
• Income Elasticity of Demand:
– 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
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Elasticity
• 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%
• 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%
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Elasticity
• 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
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Elasticity
• 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)
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Elasticity
• Price Elasticity of Supply:
– 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
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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
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Importance of Elasticity
• Relationship between changes
in price and total revenue
• Importance in determining
what goods to tax (tax revenue)
• Importance in analysing time lags
in production
• Influences the behaviour of a firm
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Editor's Notes
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.
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.
