- 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)
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:
- 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
- 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.
- 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.
"i" for (perfectly) inelastic:
inelastic demand curve:
"u" for unit elasticity:
elastic demand curve:
"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.
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.
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.
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.
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.
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:
%= 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.
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.
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:
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.
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.
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.
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.