ELASTICITY

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Elasticity

  • Elasticity measures the degree of responsiveness of one variable to changes in another.

Economists make use of four types of elasticity:

  • Price Elasticity of Demand (PED)
  • Cross Elasticity of Demand (XED)
  • Income Elasticity of Demand (YED)
  • Price Elasticity of Supply (PES)
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Price Elasticity of Demand (PED)

  • Price elasticity of demand (PED) measures the degree of responsiveness of the quantity demanded of a good or service to changes in its price.

PED can be calculated using the following formula:

(http://upload.wikimedia.org/math/0/1/6/016abe0d0054a749f400bb865c10c636.png)

where: 

  • ΔQd is the change in the quantity demanded
  • ΔP is the change in the price
  • P is the original price
  • Q is the orginal quantity demanded


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PED (cont.)

  • If the values of PED are negative, this is because the gradient of a demand curve is downward sloping.
  • The PED of a good or service between any two points on its demand curve will be different depending upon whether prices are rising or falling.
  • This is because, for the syllabus, PED is calculated in simplified form.
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PED

  • The value of PED ranges from 0 to ∞ assuming no negative signs. 

If the value obtained  is:

  • 0, good/service is turned perfectly inelastic and the quantity demanded of it does not change with changes in its price.
  • 0-1. good/service is turned inelastic and there will be a small change in the Qd and it will change to a smaller percentage
  • 1, good/service has unit elasticity Qd and P will be changing by nothing.
  • 1-, good/service is turned elastic and its Qd changes by a larger percentage than the % change in its price.
  • , good/service is turned perfectly elastic. Households are prepared to buy all they can at one price and nothing at all at a higher/lower price.
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Perfectly Inelastic

"i" for (perfectly) inelastic:

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Inelastic

inelastic demand curve:


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Unit Elasticity

"u" for unit elasticity:



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Elastic

elastic demand curve:


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Perfectly Elastic

"e" for elastic:

  • PED along a perfectly inelastic demand curve is 0 along its entire length
  • PED along the demand curve of unit elasticity is 1 along its entire length.
  • PED along a perfectly elastic demand curve is ∞ along its entire length.
  • PED along a straight line inelastic/elastic curve is ∞ to 1 to 0.
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The Determinance of PED

1. Number and closeness of substitutes

  • The more substitutes there are for a good/service the more elastic its PED.
  • The more better the substitutes, the more elastic their PED
  • Goods/services with no/few substitutes will have an inelastic PED.

2. The necessity of a good/service and how widely it is defined

  • If a good/service is a necessity it will have an inelastic PED
  • What is a necessity, depends on how widely a good/service is defined
  • e.g. Food is a necessity and is priced inelastic but a Big Mac meal is NOT a necessity and will be priced elastic.
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The Determinance of PED (cont.)

  • What is a necessity will vary from consumer to consumer. i.e addiction to drugs, alcohol and cigarettes results in them being priced very inelastic.

3. The proportion of income spent on a good/service

  • The greater the proportion of their income households spend on a good/service, the more inelastic its PED.

4. The time period under consideration

  • The PED for some goods/services can change from being inelastic to being elastic overtime. This is because as the goods/services prices rise, consumers may be able to switch to cheaper substitutes.
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Applications of PED

Firms and/or governments use the concept of PED to calculate how a firms total revenue will change given a change in the price of a good/service.

Economists use this to explain why primary products and secondary products have different PEDs.

  • Primary products are agricultural goods and comodities, e.g iron, oil etc. Secondary products are manufactured goods. 
  • Because primary products tend to be necessities with no/few substitutes they are more price inelastic.
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Applications of PED (cont.)

Governments use PED to work out which goods/services to put indirect taxes on to maximise government revenue.

  • Indirect taxes such as VAT are placed on products and lead to prices of goods/services rising.
  • If a government wants to maximise its revenue from an indirect tax such as VAT, it will put the tax on products that are priced inelastic.
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Cross Price Elasticity of Demand (XED)

  • XED measures the degree of responsiveness of the demand for a good/service to changes in the price of another good/service.

XED can be calculated using the following formula:

(http://www.mbs.edu/home/jgans/mecon/value/Segment%203_3_files/image026.gif)

%= Old - New / Old * 100

The value of XED varies from  to + . If the value obtained is either:

  • NEGATIVE: The two products are compliments.
  • POSITIVE: The two products are substitutes.
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Cross Price Elasticity of Demand (XED) (cont.)

  • The higher the negative value, the closer the relationship between the two compliments and the more the demand curve for one will shift, given a change in the price of the other.
  • The higher the positive value, the closer the relationship between the two substitutes and the more the demand curve of one will shift given a change in the price of the other.
  • For any two products, a positive answer is more likely than a negative answer because pairs of goods and services are more likely to be substitutes than compliments.
  • The concept of XED  is relevant for firms because they need to be aware of how the demand for their goods/services is likely to change given a change in the prices of other goods/services in order to adopt appropriate strategies.
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Income Elasticity of Demand (YED)

  • YED measures the degree of responsiveness of the demand of a good/service to changes in households' income.

YED can be calculated using the following formula:

(http://www.mbs.edu/home/jgans/mecon/value/Segment%203_3_files/image027.gif)

The value of YED can range from - to + . If the value obtained is:

  • NEGATIVE: the good/service is an inferior good.
  • POSITIVE: the good/service is a normal good.
  • The bigger the negative number, the more the demand curve for an inferior good will shift to the left, given an increase in households' income.
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Income Elasticity of Demand (YED) (cont.)

  • The bigger the positive number, the more the demand curve for a normal good will shift to the right, given and increase in households' income. 
  • The majority of goods and services will have a positive YED because most goods and services are normal.

Concentrating on the positive value, it can be said that when the value of YED is:

1. 0, good/service is turned perfectly inelastic with respect to income, and the demand for it does not change with income.

2. 0-1, a good/service is turned income inelastic and the demand for it changes by a smaller percentage than that of the income.

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YED

3. 1, good/service has an income elasticity of demand equal to unit elasticity and the demand for it changes by the same proportion of the change in income.

4. 1-, good/service is turned income elastic and the demand for it changes by a greater percentage than the percentage in income.

  • Income elastic goods/services will tend to be necessities.
  • Income inelastic goods/services will tend to be luxuries/superior goods.
  • Therefore, necessities will have a YED of less than 1 while luxuries will have a YED of more than 1.
  • Most goods/services will have a YED of less than 1 because most goods/services aren't necessities.
  • This also means that all inferior goods are necessities because their YED is less than 1.
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Applications of YED

  • The YED of primary products will tend to be more inelastic than secondary or tertiary because primary products have no/few substitutes.
  • This has implication for both firms and an economy as a whole because as households get richer, they will tend to spend a greater proportion of their income, first, on secondary products, and second, on tertiary products.
  • Therefore, what firms produce will change over time and governments must ensure that there is a balance between the production sectors so that the economy can continue to grow.
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