Introduction to Economics Elasticities KEY TERMS

Introduction to Economics Elasticities

KEY TERMS ¡ PεD – Price Elasticity of Demand ¡ elastic ; inelastic ; unit elastic ¡ percentage change ¡ consumer expenditure ¡ YεD – Income Elasticity of Demand ¡ positive income elasticity ; negative income elasticity ; zero income elasticity ¡ CεD – Cross Elasticity of Demand ¡ PεS – Price Elasticity of Supply

Four types ¡ Price elasticity of demand l ¡ Price elasticity of supply l ¡ The responsiveness of quantity supplied to a change in price Income elasticity of demand l ¡ The responsiveness of quantity demanded to a change in price The responsiveness of quantity demanded to a change in the (real) income of consumers Cross elasticity of demand l The responsiveness of quantity demanded of one good to a change in price of another good.

Demand ¡ What happens when the price of a good rises? ……………………. ¡ By how much?

Price elasticity of demand ¡ PED - A measure of the responsiveness of the quantity demanded to a change in price of that good ¡ Formula ¡ % change in Quantity Demanded % change in Price Pε D = % Δ Q D ÷ % Δ P P of oil increases by 40% → Qd↓ by 10%. PεD = ? P of beans increases by 10% → Qd↓ by 20%. PεD = ?

Market supply and demand S 2 S 1 b Price P 2 c P 3 a P 1 D' D Q 3 O fig Q 2 Q 1 Quantity

Using proportionate/percentage measures ¡ We can compare quantity changes with monetary changes ¡ We can work out the size of price and quantity changes l l l If the price of goods increases by 50 pence – how large an increase is this for: (a) beans; (b) champagne

Remember ¡ The shape of demand curves is (generally) l d_ _ _ d - s_ _ _ g ¡ There is an i_ _ _ e relationship between P and Qd ¡ Therefore, calculating PεD produces a negative figure Note: the negative sign is ignored by economists

PED values Perfectly inelastic ¡ Inelastic (between 0 and -1) ¡ Unit elasticity (-1) ¡ Elastic ¡ Perfectly elastic ¡

How elastic is elastic? – match the elasticity with its definitions 1. Elastic Inelastic Unit elasticity a. The % change in quantity demanded is exactly the same as the percentage change in price b. The % change in quantity demanded is greater than the % change in price c. The % change in quantity demanded is smaller than the % change in price. 2. 3.

Pause for Thought ¡ Why will the price elasticity of demand for a particular brand of a product (eg BP, Shell, Texaco) be greater than that for the product in general (eg petrol)? ¡ Is this difference the result of a difference in the size of the income effect or the substitution effect?

Discussion ¡ Think of examples of goods where the % ∆ in Qd is > the % ∆ in P. the % ∆ in Qd is < the % ∆ in P

Determinants of PED Number close substitutes ¡ Proportion (%) of a consumer’s income spent on the product ¡ Time period following a Price Change ¡ Habit ¡

Why do we care about different PED values? ¡ It tells us about total consumer expenditure (TE = P x Q). ¡ TE is the same as total revenue (TR = P x Q) so we can predict how changes in the price of a good will affect the TR earned by producers from the sale of that good.

TE/TR ¡ Elastic l If P ↑ Q ↓ a lot so TR ↓ l If P ↓ Q ↑ a lot so TR ↑

Relatively elastic demand

Relatively inelastic demand

SPECIAL CASES

P Perfectly inelastic demand (Pe. D = 0) D b P 2 a P 1 Q 1 O fig Q

SPECIAL CASES How elastic is elastic? – delete one ¡ Perfectly inelastic l PεD is 0 l Demand curve is vertical ¡ The quantity demanded does/does not change when the price changes

P Perfectly elastic demand (Pe. D = ¥) a b Q 1 Q 2 P 1 O fig D Q

How elastic is elastic? – delete one ¡ Perfectly elastic l PεD is ∞ [infinite] l Demand curve is horizontal ¡ As you move back and along the curve, there is a change/no change in the quantity demanded but a change/no change in the price.

Unit Elasticity of Demand IF %∆P =%∆Qd What will the demand curve look like?

Unit Elasticity of Demand IF %∆P =%∆Qd What will the demand curve look like?

PED and Consumer Expenditure Elastic – when a small change in price has a larger effect on quantity demanded ¡ Inelastic – when a large change in price has a smaller effect on quantity demanded ¡ PED and demand curves ¡ l l Low PED (inelastic) shown by a steeper curve High PED (elastic) shown by a flatter curve

The effect of advertising Producers seek to: ¡ Increase demand (shift the curve to the right) by l l ¡ Bringing product to people’s attention Increasing people’s desire for the product Make demand less elastic by l l Creating greater brand loyalty Fostering belief that competitors’ products are inferior

Limited competition ¡ Where other suppliers aren’t accessible, prices can be increased significantly, as in the case of: l l l Wine in restaurants (even if food prices are reasonable) Food and drink on trains, planes, motorways Fuel on motorways

Supply What happens to quantity supplied when the price of a good rises? ……………………. ¡ The next question is… by how much? ¡ The shape of supply curves (generally) l u_ _ _ d - s_ _ _ g ¡ There is a p_ _ _ _ e relationship between P and Qs ¡ So the PεS figure is ……………… ¡

Price elasticity of supply PES ¡ Definition - Responsiveness of quantity supplied to a change in price ¡ Formula % change in Quantity Supplied % change in price ¡ Pε s = % Δ Q s ÷ % Δ P ¡

Determinants of PES The amount that cost rises as output rises ¡ Time period ¡

Income elasticity of demand YED ¡ Definition - The responsiveness of quantity demanded to a change in the (real) income of consumers ¡ Formula % change in Quantity Demanded % change in Income ¡

YED – why is it useful? ¡ It allows us to determine: l l ¡ whether a good is a normal or inferior good; and measure how intensely the demand for the good responds to changes in income The key determinant of YεD is the degree of necessity of the good [see textbook - Table 3. 2, p 72]

YεD l Formula % ∆ in Qd % ∆ in Y Example Real income increases by 10%, Qd for cars increases by 25% YεD = ?

Understanding YED values ¡ Positive income elasticity l ¡ Negative income elasticity l ¡ As real income increases, demand for goods increases (called NORMAL goods) As real income increases, demand for the good decreases (called INFERIOR goods) Zero income elasticity l As real income increases, demand for the good does not change Note: plus / minus signs are important

Cross Elasticity of Demand - CεD ¡ The effect of the change in one good’s price on the quantity demanded of the other good. ¡ Formula: l CεD between goods ‘a’ and ‘b’ = % ∆ in QDa % ∆ in Pb

CεD ¡ When two goods are substitutes – CεD is positive l [eg a rise in P of good ‘a’ increases demand for good ‘b’] ¡ If they are close substitutes – CεD is positive and large ¡ If they are not close – CεD is positive and small

CεD ¡ When two goods are complements – CεD is negative l [eg a rise in P of good ‘a’ decreases demand for Good ‘b’] ¡ If the CεD is only slightly below zero, the goods are weak complements ¡ If the CεD is very negative, the goods are strong complements.

CεD ¡ THEREFORE the PLUS or MINUS SIGN is VERY IMPORTANT ¡ BECAUSE it tells us whether the two goods are substitutes or complements ¡ SO if it is stated that the CεD between two goods is: -0. 3 what might you conclude as to their relationship?

Cross elasticity of demand Substitute – increase in Price of good B will increase demand for good A (positive CED) ¡ Complement – increase in price of good B will decrease demand for good A (negative CED) ¡ Determined by closeness of substitute or complement – closer = greater effect ¡