ELASTICITY. new quantity - original quantity original quantity

ELASTICITY Elasticity is the extent to which buyers and sellers respond to a change in market conditions. There are a few different types of elasticit...
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ELASTICITY Elasticity is the extent to which buyers and sellers respond to a change in market conditions. There are a few different types of elasticity. PRICE ELASTICITY OF DEMAND This measures the responsiveness of the quantity demanded to a change in the price of the product. % change in quantity demanded %∆D The formula for it is: = %∆P * % change in price *the ∆ sign means ‘change in’ To find the change in quantity demanded and the change in price, you need to know the original figure (what the quantity/price was originally) and the new figure (what the quantity/price is now). To find the change in quantity demanded, use this formula: difference in quantity new quantity - original quantity %∆D = original quantity = original quantity To find the change in price, use this formula: difference in price new price - original price %∆P = original price = original price With both of these formulas, you end up with a decimal answer. To convert to percentage, multiply the number by 100. For example, imagine that the price of a bottle of Coca-Cola is at £1.50, and 20 units are demanded at this price. When the price increases to £1.80, only 15 units are demanded. What is the price elasticity of demand for Coca-Cola? First of all, find the % change in quantity demanded and the % change in price. 15 units - 20 units -5 units %∆D = = 20 units = -0.25  -0.25 * 100 = -25% 20 units £1.80 - £1.50 £0.30 %∆P = = £1.50 = 0.20  0.20 * 100 = 20% £1.50 Use these two figures in the price elasticity formula: %∆D -25 = -1.25 % ∆P = 20 Hence we know that the price elasticity of demand for Coca-Cola is 1.25 (you don’t generally need to include the negative sign in this price elasticity value). What this means is that in general, if the price of Coca-Cola increases by 1%, the quantity demanded will decrease by 1.25% (i.e. by more than 1%). Conversely, if the price of Coca-Cola decreases by 1%, the quantity demanded will increase by 1.25%. If the price elasticity value for a product is between 0 and 1 (e.g. 0.86), then it is said to be price inelastic. In other words, the change in demand is proportionally less than the change in price. If the price elasticity value for a product is above 1 (e.g. 1.25 for Coca-Cola), then it is said to be price elastic. In other words, demand responds more than proportionally to a change in price. If the price elasticity value for a product is exactly 1, then it is said to be unitary elastic; that is to say, the change in demand is exactly proportional to the change in price.

The diagram on the right shows what a demand curve looks like when demand is elastic (D1), unitary elastic (D2) or inelastic (D3). The diagram below it shows demand when it’s perfectly elastic (D4) and perfectly inelastic (D5). Perfectly elastic means that if the price changes (even by just a bit), demand immediately goes down to zero. In the real world, there aren’t really any goods or services that are perfectly elastic. Perfectly elastic goods have an elasticity value of ∞ (infinity). Perfectly inelastic means that no matter what happens to the price, demand will stay the same. Perfectly inelastic goods have an elasticity value of 0. If you’re good at Maths: It’s worth noting that that elasticity value of a good is the inverse of the gradient of its graph: In other words, imagine that D1 is the graph that represents Coca-Cola, an elastic good. Coca-Cola has an elasticity value of 1.25. However, a line with a gradient of 1.25 falls sharply, like this line: \ Therefore, if you need to work out what 1.25 would look like on a graph, work out what 1 divided by 1.25 is (≈ 0.83). This is a gradient of less than 1, and you can now plot this line onto the graph. Similarly, a perfectly elastic good has an elasticity value of infinity. However, the line that represents a gradient of infinity is vertical, rather than horizontal, which is the opposite of what the graph is supposed to look like. If you divide 1 by infinity, you get 0, and so you know that you need to use this value to determine what the line looks like on a graph. There are different factors which can affect the price elasticity of demand of a certain product. Closeness and availability of substitutes. A substitute of a product is a competing product (i.e. an alternative). In general, the greater the amount of substitutes, and the greater their closeness (i.e. how similar they are), the greater the price elasticity. This is because if the price of the original product increases, then demand is likely to decrease if there are many cheaper substitutes available. If a product has no real substitutes, then if the price increases, there isn’t anything else that is similar to it that consumers can buy, so most of them will keep on buying the product. For example, milk and cheese tend to be very inelastic because there aren’t any real substitutes. How expensive the product is in relation to total income. If the product takes up a very small proportion of income, then a large change in price is unlikely to cause a large decrease in demand. For example, if the price of newspapers or apples doubles, the demand is not going to decrease very much because these products take up only a tiny proportion of a person’s income. In other words, such products are likely to be price inelastic. If the product takes up a fairly large proportion of income, such as a night out at a top restaurant or a holiday, demand will be more affected and more sensitive to a change in price; in other words, such products are likely to be more price elastic. However, products that the consumer is addicted to, such as cigarettes or alcohol, usually remain price inelastic even if the price increases significantly, because the consumer essentially can’t break the habit and so will continue purchasing the product.

Time In the short-term, consumers usually find it difficult to alter their spending habits. Therefore, if the price of a good increases, for a short time demand may not decrease very much. Once consumers have had enough time to find about substitutes or make changes in their spending habits, etc. demand is likely to become more price elastic. In some cases where it isn’t essential to buy a product immediately, demand for that product is usually price elastic. For example, if someone wants a new car because their old one has several problems with it, if the price of the car is higher than they are willing to pay, they might wait a few weeks or months until the price decreases, at which point they will be more likely to buy the car. In this case, buying the car immediately isn’t essential, so the person has waited before buying it; as a result, the car is price elastic, because it was the (perhaps slight) change in price that swayed the person’s decision. INCOME ELASTICITY OF DEMAND Income elasticity of demand (YED for short) measures how responsive demand is following a change in income. When calculating YED, it is assumed that all other factors affecting demand (i.e. prices of complements/substitutes and tastes and fashion) remain unchanged. It is calculated using this formula: % change in quantity demanded %∆D YED = = %∆Y % change in income Again, to calculate the percentage change in each of these, you need to know the new value and the original value, and use the same formulas: difference in quantity new quantity - original quantity %∆D = original quantity = original quantity %∆Y =

difference in income new income - original income original income = original income

Unlike price elasticity of demand, when calculating income elasticity, the sign (whether the value is positive or negative) matters, as it indicates whether a change in income causes demand to increase or decrease. For example, imagine that when a person earns £25,000, he/she bought 500 towels a year. When his/her income decreases to £23,000, he/she only buys 430 towels a year. What is the income elasticity of demand? new quantity - original quantity 430 - 500 - 70 %∆D = = 500 = 500 = - 0.14 original quantity new income - original income £23 000 - £25 000 - £2 000 %∆Y = = = = - 0.08 original income £25 000 £25 000 Multiply both figures by 100 to turn them into percentages, and you get -14% and -8%. Plug these into the YED formula: %∆D -14 %∆Y = -8 = 1.75

This value of 1.75 means that if income increases by 1%, demand for the product will go up by 1.75%. Consequently, if income decreases by 1%, the demand for the product will decrease by 1.75%. In other words, change in demand is directly proportional to a change in income. If the value had been negative, it would have meant that change demand is inversely proportional to a change in income (i.e. as income increases, demand decreases, and vice versa). Products that have a positive income elasticity of demand (i.e. greater than 0) are known as normal goods. Examples are holidays, new clothes, nights out, electronic goods, etc. If income increases, the consumer is more able to purchase these items, and so a larger quantity is demanded. D1 on the right shows a graph for a normal good. As income increases from Y1 to Y2, quantity demanded also increases from Q1 to Q2. Products that have a negative income elasticity of demand (i.e. less than 0) are known as inferior goods. Examples are supermarketbrand goods, second-hand goods and coach travel. There are betterquality substitutes available, but people on low income can’t afford them. As a result, they buy these goods instead. If their income increases, they no longer have to buy supermarket-brand goods (as they can afford the premium goods) and so demand for these decreases. D2 on the right shows a graph for an inferior good. As income increases from Y1 to Y2, quantity demanded decreases from Q2 to Q1. For both normal and inferior goods, you can have income elastic and income inelastic goods. When the income elasticity of demand of a product is greater than 1 (or less than -1 for inferior goods), the product is said to be income elastic; a change in income produces a greater proportionate change in demand. When the income elasticity of demand of a product is between 0 and 1 (or between 0 and -1 for inferior goods), the product is said to be income inelastic; a change in income produces a less than proportionate change in demand. Goods that have a high income elasticity of demand (i.e. greater than 1) are said to be superior goods. In other words, as income increases, the increase in demand is proportionally greater. These are goods that are expensive and usually scarce. It can happen that a consumer demands considerably more of a product following a small increase in income. Imagine that an individual earns £80,000 a year. He has expenses such as rent, utilities, etc. of £30,000, leaving him with £50,000 of disposable income. Of this, he spends £30,000 on caviar. If his income increases to £90,000 a year (so an increase of 12.5%), he will probably have more disposable income (£60,000 instead of £50,000). Since he now has £10,000 more to spend, he may choose to spend £10,000 more on caviar, from £30,000 to £40,000 (an increase of about 33%). Even though his income has increase by 12.5%, his quantity demanded of caviar has increased by about 33%.

This diagram shows different goods with different income elasticity of demand values. D3 represents a normal good, as it has a positive gradient (and therefore a positive income elasticity value). It is also fairly inelastic, as the value is between 0 and 1. D4 represents an inferior good, as it has a negative gradient (and therefore a negative income elasticity value). It is also quite elastic, as the value is above 1. D5 represents a superior good; it has a positive gradient, but more importantly its elasticity value is greater than 1.

CROSS ELASTICITY OF DEMAND Cross elasticity of demand measures the responsiveness of demand for one product following a change in the price of another product. Here as well, when measuring cross elasticity of demand, it is assumed that all other factors that affect demand remain unchanged. The formula for cross elasticity of demand (shortened to XED) is: % change in quantity demanded of product A %∆D product A XED = = %∆P product B % change in price of product B For XED, the sign of the value (whether the value is positive or negative) is also important. If the value is positive, the two products are substitutes. If the value is negative, the two products are complements. Imagine two products, Pepsi and Coca-Cola. Pepsi is priced at £2.00 a bottle, and 100 units of CocaCola are being demanded. When the price of Pepsi increases to £2.50 a bottle, 130 units of Coca-Cola are demanded. When the price of Pepsi increases, its quantity demanded will decrease. Pepsi and Coca-Cola are similar products (they’re both fizzy, sugary drinks with similar tastes). Consumers are looking for value for money; therefore, if the price of Pepsi increases, consumers will have better value for money by buying Coca-Cola, and so the demand for it will increase. Pepsi and Coca-Cola are therefore substitutes. The exact cross elasticity of demand value can be calculated using the above formula. new quantity - original quantity 30 %∆D product A (Coca-Cola) = = 100 = 0.3 = 30% original quantity %∆P product B (Pepsi) %∆D product A 30 %∆P product B = 25 = 1.25

=

new price - original price original price

£0.50 = £2.00 = 0.25 = 25%

Imagine two other products, flights to Barbados and hotel rooms in Barbados. When hotel rooms are advertised at £35 a night, there are 550 flights to Barbados every year. When the price of hotel rooms decreases to £28 a night, there are 700 flights every year. People who buy flight tickets to a holiday destination are usually going to need accommodation to stay in once they arrive; therefore, flights and hotel rooms are complements. This can be shown by calculating the XED value for flights to Barbados. %∆D product A (flights)

=

%∆P product B (hotel rooms) =

new quantity - original quantity original quantity

150 = 700 ≈ 0.214 = 21.4%

new price - original price original price

- £7 = £35 = -0.20 = -20%

%∆D product A 21.4% %∆P product B = -25% ≈ -0.86 This value is negative, and therefore this shows that the two products (flights and hotel rooms) are complements. If the cross elasticity of demand value is zero, that means that there is no relationship between the two products. For example, if the price of wheelbarrows increases, the demand for flutes is not likely to change as a result. Therefore, there is no relationship between these two. The size of the value indicates the strength of the relationship between two products: IF THE VALUE IS: THEN THE TWO PRODUCTS ARE: greater than 1 good/close substitutes between 0 and 1 modest substitutes between -1 and 0 modest complements less than -1 good/close complements On this diagram, line D1 shows the cross elasticity curve for Pepsi and Coca-Cola. If the price of Pepsi decreases from P1 to P3, the quantity demanded of Coca-Cola will also decrease, from Q3 to Q2. If the price of Pepsi increases once again to P1, the quantity of Coca-Cola is likely to increase back up to Q3 (or thereabouts). Line D2 shows the cross elasticity curve for flights and hotel rooms to/in Barbados. If the price of hotel rooms increases from P3 to P2, the quantity demanded of flights will decrease from Q2 to Q1. Similarly, if the price goes back down to P2, the quantity demanded will go back up to Q2 (or thereabouts).

PRICE ELASTICITY OF SUPPLY Price elasticity of supply (PES for short) is a similar concept to price elasticity of demand, except that, obviously, it deals with supply. It is defined as the responsiveness of the quantity supplied to a change in the price of the product. The formula for it is: % change in quantity supplied %∆S PES = = %∆P % change in price PES indicates how much additional supply a producer is willing to provide for the market following a change in price of the product. In the same way that PED (price elasticity of demand) is always a negative value, because the demand of a product will always increase if the price decreases and vice versa, PES is always a positive value. This is because if the price of a product increases, the supplier is never going to reduce supply if it is able to supply more (because suppliers are always looking to maximise their profits, which comes about from maximising revenue). If the PES value is between 0 and 1, supply is inelastic. If the price of the product changes, the change in supply won’t be as great as the change in price. If the PES value is greater than 1, supply is elastic. If the price of the product changes, the change in supply will be greater than the change in price. If the PES value is exactly 1, then supply is unitary elastic. If the price of the product changes, the change in supply will be proportionally equal to this change. Price elasticity of supply is affected by a few factors which mean that suppliers aren’t always able to fully adjust the quantity they supply in response to a change in price. One factor is availability of stocks of the product. Some products can be stored in warehouses. This means that if there is an increase in price as a result of an increase in demand, more products can be quickly supplied onto the market (which the supplier is likely to do because it is always looking to maximise its profits). Alternatively, if there is a decrease in demand, the producer can store goods which aren’t perishable so that they can be sold later. For example, fresh fruit is supply inelastic. If demand for fruit suddenly increases considerably, suppliers are most likely not going to be able to meet this increase in demand, because fruit takes a long time to grow (and therefore, it would take time to plant fruit trees, etc.). Also, it can’t be stored for later use, so suppliers can only produce as much as they sell, otherwise it’s a waste of money (because they’re spending money producing items that they don’t receive any revenue from). In the short term, supply for certain goods is perfectly inelastic (i.e. they cannot store any products for future use). For example, for hotels, restaurants, cinemas, etc. supply is infinitely inelastic. If a seat in a cinema isn’t used on one night, it can’t be stored for the next night. In other words, if it isn’t sold on a particular day, then the revenue from that ticket is forever lost to the business (compared to a t-shirt company, for example, who can simply store any unsold stock and sell it later on).

Another factor is availability of factors of production. Some companies will be able to increase their factors of production to produce more output within a short period of time. For example, a lot of businesses employ extra temporary workers during busy periods such as Christmas, which usually means that they can supply more onto the market if demand increases. Some businesses rely heavily on capital. If a business has machines that can quickly be adjusted to produce more (or if they have machines that are currently not being used), then supply will be quite elastic, as the supplier can just switch on more machines to produce more. However, if the business has to invest in more machinery and technology to meet the increase in demand, then supply will be quite inelastic, as such investments take a relatively long time. There is also the risk for businesses that by the time their new machinery is installed and running, the demands of the market may have changed. A third factor is the time period. If it takes a long time for supply to be adjusted, then in the short term, supply will obviously be inelastic, as suppliers haven’t got enough time to quickly adjust their supply. However, in the long term, supply tends to be elastic (as almost any company or business can increase their supply given enough time). BUSINESS RELEVANCE OF ELASTICITY ESTIMATES When measuring elasticity, data needs to be collected at two separate points in time (this is shown by the fact that elasticity formulas measure the “change” in something). This can be done through various methods: - sample surveys of consumers (for PED and YED) - past records from within a company (for PES) - competitor analysis; i.e. how well other companies are doing (for XED) It’s worth noting that all price elasticity values are estimates. This is because data is affected by many different factors and there may be inaccuracies in the way it has been collected. One factor that can affect demand is an unforeseen circumstances such as a health scare. If there is a worry that beef has been contaminated with mad cow disease, then this could cause a large decrease in demand, even though the price hasn’t changed. Also, it is difficult to generalise price elasticity estimates for a full range of prices. We may be able to measure how demand changes if price increases by a small amount, but would the same proportion be maintained if price were to increase tenfold? We don’t know, because there usually aren’t such extreme changes in price that allow us to measure change in demand. HOW IS PRICE ELASTICITY OF DEMAND USED? Price elasticity of demand figures are very useful to companies so that they know how demand for their product might change if they were to increase or decrease their prices. Train companies, for example, make good use of these estimates by charging higher fares when demand is likely to be high and inelastic (such as at peak times). Many people who travel at peak time can only travel at this time (for example, because of having to commute to work). Therefore, demand for peak travel is usually fairly inelastic, and so train companies can charge a higher price for travel at these times.

Having knowledge of price elasticity can also help businesses maximise their revenue. When demand is inelastic, an increase in price will lead to an increase in total revenue. For example, on this diagram, imagine that: P1 = £50 P2 = £100 Q1 = 60 units

Q2 = 45 units

The company knows that the product is price inelastic. Therefore, by increasing the price, they can increase their total revenue: At P1Q1, their total revenue is £50 * 60 = £3000. At P2Q2, even though they’ve doubled the price and demand has decreased, their total revenue is £100 * 45 = £4500. Therefore, by increasing the price, they’ve managed to increase their total revenue, and therefore increase its profits.

When demand is elastic, a DECREASE in price will lead to an INCREASE in total revenue. On this diagram, imagine that: P1 = £102 P2 = £72 Q1 = 70 units

Q2 = 35 units

The company knows that the product is price elastic. This means that if price decreases slightly, demand should increase quite a lot. Therefore, by decreasing the price, they can increase their total revenue: At P1Q1, their total revenue is £102 * 35 = £3570 At P2Q2, their total revenue is £72 * 70 = £5040 This time, by decreasing the price, the company has managed to increase their total revenue, and therefore increase their profits. Therefore, even having the basic knowledge of whether or not their products are price elastic or inelastic can help companies maximise their profits. HOW IS INCOME ELASTICITY OF DEMAND USED? Over time, real disposable incomes tend to rise. Therefore, companies that produce goods or services with a high, positive income elasticity of demand (normal or superior goods) can expect to do well in the future. This is because if incomes rise over time, then technically the demand for such goods should increase by a greater proportion, which means a lot of revenue for the company. On the other hand, companies that produce goods or services that have a negative income elasticity of demand (i.e. inferior goods) may face trouble in the future if incomes rise, as this means that demand for their products should fall over time. One way of preventing this is to positively advertise the product as being a superior good. For example, ‘Spam’ meat was at one time considered an inferior good, which would have been bad news for the company. As a result of heavily marketing the product, however, it is now considered a normal good. In the UK, as living standards have risen, there has been huge growth in products such as overseas holidays, designer clothes, dental implants, medical operations, etc. This suggests that these products and companies are likely to have good prospects for the future as incomes continue to rise.

On the flipside, however, the disadvantage to selling goods that have a high income elasticity of demand is that if income suddenly falls (as a result of recession, loss of consumer confidence, uncertain economic prospects, etc.), the demand for these products is likely to fall greatly. Imagine that a product like caviar has a YED value of 3.5. This means that if average income rises by 5%, demand for caviar should increase by 17.5%. However, if recession strikes and average income decreases by 10%, the demand for caviar will take a massive hit (as much as a 35% decrease). HOW IS CROSS ELASTICITY OF DEMAND USED? Estimates of cross elasticity of demand are very important to companies operating in a highly competitive market. If companies are operating in a market where there are close substitutes to their own products, they need to know how a change in the price of their own product might affect the demand of their own and their rivals’ goods. When companies know that there is a high cross elasticity of demand for their product, they are likely to reduce their own prices, thereby increasing demand for their products while at the same time decreasing demand for their rivals’ products. This can be seen with low-cost airlines that fly identical routes but are in close competition with one another; well-known brands of nearly identical products (i.e. Coca-Cola and Pepsi, or Epson and Canon printers); other commodities such as sugar or gold that come from different places but are virtually the same. It would be foolish for companies to increase prices in such a market, as there are many substitutes for consumers to buy instead. Since it usually takes time for consumers to alter their spending habits, once they’ve decided to go with a different company, it may take time (or a significant reduction in price) to entice those consumers back. HOW IS PRICE ELASTICITY OF SUPPLY USED? Price elasticity of supply isn’t as useful to businesses because they themselves will know how much stock they have and how much more they can produce. However, businesses will generally try and make their supply as elastic as possible, so that if prices rise, they can increase their profits by supplying more onto the market. As a result of having a high price elasticity of supply, it is then easier for companies to move resources away from this product if prices begin to fall, and allocate more resources towards other products.