Elasticity

 

Price Elasticity of Demand (PED)

Definition: Price elasticity of demand (PED) measures the responsiveness of demand after a change in price.

Example of PED

• If price increases by 10% and demand for CDs fell by 20%
• Then PED = -20/10 = -2.0

• If the price of petrol increased from 130p to 140p and demand fell from 10,000 units to 9,900
• % change in Q.D = (-100/10,000) *100 =  – 1%
• % change in price 10/130 ) * 100=  7.7%
• Therefore PED = – 1/7.7 =  -0.13

If you need help calculating a percentage, see: How to calculate a percentage

• If price increase from £50 to £55 and PED was 0.5 How much did quantity demanded fall?
• 0.5 = % change in QD
• Therefore % QD = -5

Price Elastic Demand

Definition: Demand is price elastic if a change in price leads to a bigger % change in demand; therefore the PED will, therefore, be greater than 1.

Goods which are elastic, tend to have some or all of the following characteristics.

1. They are luxury goods, e.g. sports cars
2. They are expensive and a big % of income e.g. sports cars and holidays
3. Goods with many substitutes and a very competitive market. E.g. if Sainsbury’s put up the price of its bread there are many alternatives, so people would be price sensitive.
4. Bought frequently

Price Inelastic Demand

These are goods where a change in price leads to a smaller % change in demand; therefore PED <1 e.g. – 0.5

• Inelastic demand PED <1 – Perfectly inelastic PED =0

Goods which are inelastic tend to have some or all of the following features:

1. They have few or no close substitutes, e.g. petrol, cigarettes.
2. They are necessities, e.g. if you have a car, you need to keep buying petrol, even if price of petrol increases
3. They are addictive, e.g. cigarettes.
4. They cost a small % of income or are bought infrequently.

• In the short term, demand is usually more inelastic because it takes time to find alternatives
• If the price of chocolate increased demand would be inelastic because there are no alternatives, however, if the price of Mars increased there are close substitutes in the form of other chocolate, therefore, demand will be more elastic.

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase in revenue. This is why OPEC try to increase the price of oil.

Graph showing increase in Revenue following increase in price

2. If demand is elastic, firms would be unlikely to increase revenue as this could lead to a fall in revenue. Instead, they could try advertising to increase brand loyalty and make demand more inelastic

3. Price Discrimination. Some people pay higher prices for tickets for trains because their demand is more inelastic.

Adults (with more inelastic demand) face higher prices. Students with more elastic demand get lower price.

4. Tax incidence. If demand is price inelastic, then a higher tax will lead to higher prices for consumers (e.g. tobacco tax). The tax incidence will mainly be borne by consumers. If demand is price elastic, firms will face a bigger burden, and consumers will have a lower tax burden.

Cross elasticity of demand

Cross elasticity of demand (XED) measures the percentage change in quantity demand for a good after a change in the price of another.

For example: if there is an increase in the price of tea by 10%. and the quantity demanded for coffee increases by 2%, then the cross elasticity of demand = 2/10  = +0.2

• Substitute goods will have a positive cross-elasticity of demand.
• Complements will have a negative cross elasticity of demand
• Unrelated goods will have a cross-elasticity of demand of zero. The price of apples has no effect on demand for Apple computers.

Substitute Goods and XED

Explanation of XED (Tea and coffee)

% change in Q.D. = (210-200)/200 = 10/200 = 5%

% change in price (1.5-1.2)/1.2 = 0.3/1.2 = 25%

• Weak substitutes like tea and coffee will have a low cross elasticity of demand. If the price of tea increases, it will encourage some people to switch to coffee. But for most people, their preference for a particular drink is more important than a small difference in price
• For two alternative brands, for example, Starbucks Coffee and Costa Coffee, these goods are closer substitutes as the difference is much smaller. If the price of Costa Coffee increases, more consumers will switch to an alternative brand such as Starbucks. WIth close substitutes, the XED will be higher.
• The aim of advertising is to increase brand loyalty and make consumers less willing to switch to another brand – even if price rises.

Complementary Goods and XED

These are goods which are used together, therefore the cross elasticity of demand is negative. If the price of one goes up, you will buy less of both goods.

• If the price of tea increases, there will only be a very small fall in demand for milk. It will have a negative cross elasticity of demand, but it will be a low figure.
• However, for two goods like Android Phones and Android Apps, there is a stronger relationship. If the price of Android Phones increases, this will reduce the demand for Android Phones and therefore, there will be less demand for Android Apps.

Using knowledge of cross elasticity of demand

• Substitutes? When setting prices firms will have to look at what alternatives the consumer has, if there are no close substitutes they will be able to increase the price. For this reason, firms spend a lot of money on advertising to differentiate their products and reduce cross-elasticity of demand.
• Loss leaders Firms can use knowledge of complementary products to increase overall revenue. For example, many companies sell printers as cheaply as possible because if they sell a printer, they know the demand for their replacement ink cartridges will increase. (These ink cartridges are very profitable)
•  If a firm makes a small increase in price and finds people are very willing to switch to alternatives (high XED) they may make greater efforts to pursue product differentiation and brand loyalty to reduce XED.

Income Elasticity of Demand (YED)

Income elasticity of demand (YED) measures the responsiveness of demand to a change in income.

For example, if your income increase by 5% and your demand for mobile phones increased 20% then the YED of mobile phones = 20/5  = 4.0

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Definition of Inferior Good

This occurs when an increase in income leads to a fall in demand. Therefore YED<0. When your income increase you buy better quality goods and so buy less of the low-quality goods.

Tesco value tea bags – an inferior good

Examples of inferior goods clothes from charity shops, cheap bread.

For example, if your income increased 10% and demand for Tesco Value tea fell 15%. The YED = -15/10 = -1.5

Definition of Normal good

This occurs when an increase in income leads to an increase in demand for the good, Therefore YED >0

For example, if demand for apples rose 4% after a 10% rise in income. The YED = 4/10 = 0.4

Definition of Luxury good

This occurs when an increase in demand causes a bigger percentage increase in demand, therefore YED>1.

For example, if your spending on Game Apps increases 25% after a 10% increase in income – this is luxury good; the YED = 2.5

• Luxury goods will also be normal goods and we can say they will be income elastic.
• Income inelastic. This means an increase in income leads to a smaller % increase
  in demand. Therefore 0> YED <1

To summarise

Using knowledge of income elasticity of demand

• Firms will make use of income elasticity of demand by producing more luxury goods during periods of economic growth.
• In a recession with falling incomes, supermarkets might be advised to promote more ‘value’ inferior goods.

Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied to a change in price.

The price elasticity of supply (PES) is measured by % change in Q.S divided by % change in price.

• If the price of a cappuccino increases by 10%, and the supply increases by 20%. We say the PES is 2.0.
• If the price of bananas falls 12% and the quantity supplied falls 2%. We say the PES = 2/12 = 0.16

• Inelastic supply – a change in price causes a smaller proportional change in quantity supply
• Elastic supply – a change in price causes a bigger proportional change in supply

Inelastic supply

This means that an increase in price leads to a smaller % change in supply. Therefore PES <1

In this case the PES =

• % change in Q.S. = (64-60)/60 = 0.06666
• % change in price = (106-80)/80 =  0.325
• PES = 0.2

Supply could be inelastic for the following reasons

• Firms operating close to full capacity.
• Firms have low levels of stocks, therefore there are no surplus goods to sell.
• In the short term, capital is fixed in the short run e.g. firms do not have time to build a bigger factory.
• If it is difficult to employ factors of production, e.g. if highly skilled labour is needed
• With agricultural products, supply is inelastic in the short run, because it takes at least six months to grow new crops. In September the farmer cannot suddenly produce more potatoes if the price goes up.

Examples of goods with inelastic supply

• Nuclear reactors – It takes considerable time and expertise to build a new reactor. If there is high demand, few firms would be able to increase output in quick time
• Grapes – Harvest is once a year, so in short-term, supply would be very inelastic.
• Flood defences – If there is heavy rainfall and flooding, there would be high demand for flood defences. But, to supply barriers against the floods cannot occur overnight. It will take many months of construction to build.
• During an economic boom when demand for the goods is very high and firm is running out.

Elastic supply

This occurs when an increase in price leads to a bigger % increase in supply, therefore PES >1

•  PES
• % change in Q.S. = 110-60/60 = 0.8333
• % change in Price = 106-80/80 = 0.325
• PES = 2.56

Supply could be elastic for the following reasons

• If there is spare capacity in the factory.
• If there are stocks available.
• In the long run, supply will be more elastic because capital can be varied.
• If it is easy to employ more factors of production.
• If a product can be sold from the internet which increases the scope of international competition and increases options for supply.

Examples of goods with elastic supply

• Fidget spinners. These goods are relatively easy to make, requiring only basic raw materials of plastic. Many manufacturing firms could easily adapt production to increase supply.
• Taxi services. It is relatively easy for people to work as a taxi driver. People can work part-time and only need a qualified driving license. With mobile apps like Uber, it has also become easier to fit consumers with a broader range of options. If price rises, Uber can offer higher wages and encourage more people to come out to work. There are still some supply constraints on very popular days. But, mostly, supply is quite elastic.
• During recession and excess supply. In a recession with a fall in demand, the firm will have unsold goods and a large stock.

Importance of elasticity of supply

• If supply is elastic, an increase in demand will cause only a small rise in price, but a significant increase in demand.
• If supply is inelastic, an increase in demand will cause a large rise in price but only a small increase in demand.

Question on the price elasticity of supply equation

• If the PES is 2.0 for CDS: and the firm supplied 4,000 when the price was £30.

Q. If the price increased from £30 to £36, what will be the new Q?

• Price increases by £6 (30-36), therefore as a % 6/30 = 0.2 = 20%
• PES = % change in QS/ % change in price
• 2.0 = % change in QS /20
• 40 = % change in QS
• Therefore new Q = 4000 *140/100 = 5,600

Inelastic supply

Supply is price inelastic if a change in price causes a smaller percentage change in supply.
(PES of less than one)

Example of inelastic supply –

Price of rents falls by 20%; Q.Supply declines by 1%. PES = 0.05

Diagram of inelastic supply

In this case, an increase in price from £30 to £40 has led to an increase in quantity supplied from 15 to 16.

• % change in price = 10/30 = 33.3%
• % change in supply = 1/15 = 6.66%
• Therefore price elasticity of supply (PES) = 6.6/33.3 = 0.2

With a PES of 0.2, it is inelastic because PES is less than one.

Example 2

Supply curve on right – perfectly inelastic

Supply on left PES = 0.2 (inelastic

Perfectly inelastic supply

Perfectly inelastic supply occurs when a change in price does not affect the quantity supplied.

Factors that make supply inelastic

Usually if the price increases, the firm would like to supply more. The good becomes more profitable. However, there may be several factors which make it difficult for the firm to supply more. Therefore supply is price inelastic.

• Firm operating close to full capacity. If a firm is operating close to full capacity, then it has limited ability to increase the supply. It may be able to get workers to do some overtime, but at some point, it will meet capital limits, and it cannot increase supply without long-term capital investment.
• Running out of raw materials. There will come a time when we run out of raw materials – oil, natural gas. When this occurs, the supply will be inelastic because it is physically impossible to increase supply.
• Short term. Supply will be more inelastic in the short-term. In the short-term capital is fixed. It takes time to invest and increase the size of a factory. However, in the long-term, farmers can cultivate more land or firms can increase the size of their factory and supply will become more responsive.
• Limited factors of production. Some firms may come across labour constraints, especially if the work requires highly skilled labour. For example, the supply of extra maths lessons may be limited by the ability to employ sufficiently skilled maths teachers.
• Low levels of stocks. If firms can stockpile goods, then they can respond to increases in demand and price. However, some goods cannot be stored, e.g. intangible services or food with short shelf-life like tomatoes and bananas.
• Planning restrictions. Homes are often supply inelastic because in certain areas it is hard to find suitable land or get planning permission to build more houses.

Importance of inelastic supply

This shows the UK housing market between 1998 and 2005. House prices more than doubled because supply was price inelastic. Despite rising demand and rising prices, there was only a moderate increase in supply.

• High prices. If supply is inelastic, it may be easier for firms to put up prices. For example, the supply of rented accommodation in London is inelastic because it is hard to find new places to build property. But, with inelastic supply and rising demand, this has pushed up the price of housing and rented accommodation.
• Planning. Supply is usually inelastic in the short-term. Therefore, it requires forward planning by the firm to increase supply in anticipation of future demand. However, this can be difficult to do, and there is a risk that a firm invests, but the demand fails to materialise.
• Volatile prices. In markets where supply and demand are inelastic, we are likely to see more volatile prices. This may require government intervention to stabilise prices, through a scheme, such as buffer stocks.

Examples of elasticity

Price elasticity of demand measures the responsiveness of demand to a change in price.

• Price inelastic – a change in price causes a smaller % change in demand.
• Price elastic – a change in price causes a bigger % change in demand.

Price inelastic demand

We say a good is price inelastic, when an increase in price causes a smaller % fall in demand, e.g. if price of petrol rises 40%, but demand for petrol only falls 10%  the PED = – 0.25

Examples of price inelastic demand

• Petrol – petrol has few alternatives because people with a car need to buy petrol. For many driving is a necessity. There are weak substitutes, such as train, walking and the bus. But, generally, if the price of petrol goes up, demand proves very inelastic.
• Salt. If the price of salt increased, demand would largely be unchanged. It is only a small % of income and people tend to buy infrequently. It is a good with no real substitutes at all.
• A good produced by a monopoly. Any good produced by a monopoly is likely to be inelastic demand. For example, if Sky increases the cost of premiership pay per view, many football fans will pay the extra price. Though because it isn’t a necessity, demand may be less inelastic than say petrol.
• Tap water. For householders, tap water is a necessity with no alternatives. If the water company increase the cost of water bills, people would keep buying the service. It would have to rise to a very high price before people disconnected their water supply. This is why tap water is regulated by the government.
• Diamonds. Bought very infrequently, diamonds are the ultimate luxury with few exact alternatives. You could buy other precious gems, but others may not have the same allure as diamonds. A cut in price wouldn’t increase demand very much.
• Peak rail tickets. For commuters who rely on the train to get to work in London, demand will be very inelastic. If the price of fares from Surbiton to London increase, demand will only fall by a small amount. The alternatives for commuting into London, such as driving are limited.
• Cigarettes. If cigarette tax increases and the price of all tobacco increases, demand will be inelastic because many smokers are addicted and don’t have any alternatives to keep buying.
• Apple iPhones, iPads. The Apple brand is so strong that many consumers will pay a premium for Apple products. If the price rises for Apple iPhone, many will continue to buy. If it was a less well-known brand like Dell computers, you would expect demand to be price elastic.

Examples of price elastic demand

We say a good is price elastic when an increase in prices causes a bigger % fall in demand.  e.g. if price rises 20% and demand falls 50%, the PED = -2.5

Examples include:

• Heinz soup. These days there are many alternatives to Heinz soup. If the price rises, people will switch to less expensive varieties.
• Shell petrol. We say that petrol is overall inelastic. But, if an individual petrol station increases the price, people will buy from other petrol stations. The only exception is if a petrol station has a local monopoly – e.g. at the service station on the motorway, there is a captive audience. But, in a city centre with many alternatives, people will have an elastic demand.
• Tesco bread. Tesco bread will be highly price elastic because there are many better alternatives. If the price of Tesco bread rises, consumers will switch to alternatives, such as Kingsmill.
• Daily Express. If the Daily Express increases in price, there are similar newspapers people will switch to. For example, the Daily Mail or Daily Mirror. If it was a newspaper like the Financial Times of the Economist, demand would be more inelastic, as there is no close substitute to the Financial Times.
• Kit Kat chocolate bar. If Kit Kats increase, people will switch to alternative types of a chocolate bar.
• Porsche sports car. If a Porsche increases in price, demand will probably be elastic because it is a high % of income, and so the higher price will put people off. Also, there are other alternatives, such as Jaguar or Aston Martin. However, this is a little less clear cut. Some car enthusiasts may want to buy a Porsche whatever the price.

Income elasticity of demand

Income elasticity of demand measures how demand responds to a change in income.

• If income goes up 10%, and you spend 20% more on foreign holidays. The YED = 2.0 (luxury goods)
• If income goes up 10%, and you spend 5% less on Tesco value baked beans. The YED = -0.5 (inferior good)

Examples of income elastic (luxury goods)

Income elastic – means a change in income causes a bigger % change in demand, e.g.

• Porsche sports car. As income increases, people can spend a higher % of their income on the car
• Organic bread. If income increases people may switch to the ‘luxury’ option of organic bread.
• Homemade soup. If income increases, people will buy the more expensive fresh soup, rather than cheaper tins, which aren’t as nice.
• ‘Premium unleaded’ more expensive petrol, which is supposed to be better for your engine. Most people stick with the cheapest.

Examples of income inelastic goods

• Fruit. If incomes increase, people may buy more bananas, but many already eat as much as they want. But, those on lower incomes may feel they can now afford to buy fresh bananas.

Examples of Inferior Goods

An inferior good has a negative income elasticity of demand. When incomes increase, demand falls.

• Tesco value baked beans. If your income increases, you stop buying Tesco value beans and switch to Heinz, which are better quality.
• Instant coffee. Instant coffee is cheap, if income goes up, you may buy takeaway or switch to filter coffee.
• Milk powder. A cheap way to drink milk.

Elasticity of supply

The elasticity of supply measures the responsiveness of supply to a change in price

Inelastic supply

Inelastic supply means an increase in price causes a smaller % change in supply. It means firms have difficulty increasing supply in response to a rise in price.

• Potatoes in the short term. If the price of potatoes goes up, farmers cannot increase supply because it depends on how many seeds they put in the ground in March.
• Nuclear Power. It would take considerable time to increase the supply of nuclear power because you need skilled labour, and it would take a long time to build.

Elastic supply

Elastic supply means an increase in price causes a bigger % change in supply. It means firms can easily increase supply in response to a change in price.

• Firms operating below full capacity. If a car factory is operating at 70% capacity, then it can easily increase supply and produce more cars in response to changes in price.

by Tejvan Pettinger

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