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# Economics is fundamentally based on the logic of cause and effect.

## Its most benefits can be seen

in the explanation of how a change in one variable leads to a change in another. For example, in 2010
almost two million new cars were registered in the UK, with 1.8% more than in 2009. Crucially for 2011,
due to the end of the Car Scrappage Incentive Scheme, the new car market registered its worst year for at
least a decade with a fall of 4.4% (CAR Magazine). The concepts of elasticity extend the logic of
economics by measuring the sensitivity of one thing to another (Bannock and Baxter et al., 2003, p. 116).
As an illustration, in car market, the government decision to end Car Scrappage Incentive Scheme and cut
the subvention of 1,000 lead to a reduction in purchases. The purpose of this essay is to examine
economic factors that affect the elasticities for new cars. After first defining different concepts of
elasticities, the essay will explain them. Finally, it will apply them to the new car market.
In order to increase the profits, private and public sector are naturally interested in what affects
demand, in economic terms, the desire for a particular good or service (Bannock and Baxter et al., 2003,
p. 91). There are several concepts of elasticity which analyse how people respond to changes and how
their desire fluctuates in time. One concept is the price elasticity of demand and it represents the
responsiveness of the quantity demanded to a change in the price of the product (Bamford & Grant
2008, p. 42). It can be calculated by dividing the percentage change in the quantity demanded by the
correspondent percentage change in its price (Begg and Fischer et al., 2008, p. 48). Gillespie (2011: 5657) states that PED is likely to be a negative number because in most cases price reduces the quantity
demanded. This means that the quantity demanded and the change in price move in opposite directions.
On the other hand, a positive answer means that variables move in the same direction and both increase or
decrease. Regarding the value of the operation, the size of the answer shows how inelastic or elastic the
demand is in relation to price. Begg (2009 :62) exemplifies that if demand is elastic which means that the
value is greater than 1, a 1% price cut raises the quantity by more that 1% and vice versa. The diagram
below illustrates how a Porsche demand will decrease because it is a high percent of income, and so the
higher price will put people off. Assuming that the brand increases the price from P1 to P2 the quantity
demanded will decrease from Q1 to Q2 more than the price increases.
Price elastic demand
Price

P2
P1

Q2

Q1

Quantity

## Source: Based on (Gillespie, 2011, p. 57).

Conversely when the value is lower than 1, demand is inelastic. The diagram below gives an
example of how , a price cut from P1 to P2 leads to a rise in quantity from Q1 to Q2 with a lower value
than the price is cut.
Price inelastic demand
Price
P1
P2

Quantity
Q1 Q2
Source: Based on (Mankiw and Taylor, 2008, p. 100).
Gillespie (2011: 58) explains that unitary price elasticity of demand appears when a product has a
PED equal to one. At completely opposite poles stays perfectly inelastic demand and perfectly elastic
demand. The former is equal to zero, which means that the price changes does not affect the quantity
demanded and the latter is infinite, which means that the price has a limitless effect on the quantity
demanded.
The price elasticity of demand in car market can be determined by the relationship established
between the firm and costumers (Gillespie, 2011, p. 70). For example, Ferrari Owners' Club has 2,900
members across the UK. Some of them are so enthusiastic of this brand that would never buy a
Lamborghini (Ferrari.com, 2013). The most influencing determinant is the availability of close substitutes
(Mankiw and Taylor, 2008, p. 95). For instance, due to the congestion in some urban road, networks
people choose public transportation in favour of cars.
Another concept is the income elasticity of demand. Nicholson (2008: 127) defines this type of
elasticity as the percentage change in the quantity demanded of a good in response to a 1 percent change
in income. Sloman and Sutcliffe (2003: 54) give the formula for YED as being the proportionate change
in demand divided by the proportionate change in income. Products with a positive income elasticity of
demand are known as normal goods. In this case, income is direct proportional with demand. On the
other hand, inferior goods are products with negative income elasticity of demand and their income is
indirect proportional with demand (Gillespie, 2011, p. 70). Begg (2009: 67) explains that not only inferior
goods are necessities but also normal goods whose income elasticity of demand lies between one and zero
make part of this category. If the value of the YED is greater than 1, the product is classified as a luxury.
Taking into account the differences of YED the diagram situated on the next page shows how a normal
and a luxury good shifts the demand curve outward from D to D and respectively D. In addition, it
illustrates how income reduces demand from D to D for an inferior good.

## Income elasticity and shifts in demand

Price

D
D
D
D
Quantity (units)
Source: Based on (Gillespie, 2011, p. 72)
With attention to car market, as countries develop and get richer, the first thing people want to
buy is a car. The income elasticity of demand for cars has been estimated to be around 2. In 1949, the
worlds most populous economy had 1800 cars. Presently, that figure is 20 million. Surprisingly, between
2002 and 2003 the car market has tripled. While in 1970 a worker had to save for a year to buy a bicycle,
incomes are now so high that people have to save only one year to buy a car (Begg and Fischer et al.,
2008, p. 58).
A further concept is the cross-price elasticity of demand. Mankiw and Taylor (2008: 104) state
that its role is to measure how the quality demanded of one good changes as the price of another good
changes. The formula for measuring cross elasticity of demand for good X is the percentage change in
quantity demanded of good X divided by the percentage change in price of another good Y (Anderton,
2008, p. 75). If two goods in question are substitutes, the XED is positive because the price of one good
and the quantity demanded of the other good are moving in the same direction (Nicholson, 2008, p 128).
For example, the XED for changes in the price of Mercedes-Benz on Lexus might be 0.1.Each 1
percentage point increase in the price Mercedes-Benz results of a 0.1 percentage point increase in the
demand for Lexus because those brands are seen as substitutes by consumers.The diagram below
illustrates how both the price of one item and the quantity demanded for its substitute increase.
Price of brands Cross price elasticity of demand: Substitutes
P2
P1

Q1

Q2

## Source: Based on (Tragakes, 2012, p. 59)

Quantity

Correspondingly, if the XED is negative, products are complements. In this case, an increase in
the price of one product leads to a decline in the quantity demanded of the other (Gillespie, 2011, p. 73).
In particular, an increase in the price of carbon fibre used in the production of auto body parts leads to a
fall in demand of a complement such a sport car. The diagram below explains how an increase in the price
from P1 to P2 of a good B leads to a decrease in quantity demanded for a good A which is the
complement of B from Q1 to Q2.
Cross price elasticity of demand: Complements
Price

P2
P1

Q2
Q1
Quantity
Source: Based on (Tragakes, 2012, p. 59)
The fourth concept is the price elasticity of supply. When price changes there is not only a change
in the quantity demanded, but also a change in the quantity supplied. To clarify, there is a change in the
quantity of a good or service available for sale at any specified price or cost of inputs (Bannock and
Baxter et al., 2003, p. 372). Sloman and Sutcliffe (2003 :53) states that PES measures how much the
quantity supplied responds to changes in price. PES is computed by economists as the percentage change
in the quantity supplied divided by the percentage change in the price (Mankiw and Taylor, 2008, p. 105).
Begg and Fischer et al. (2008 : 59) explains that PES is always positive because supply curves are sloped
upwards. PES is reflected in the appearance of the supply curve. In the extreme case of a zero elasticity,
supply is perfectly inelastic. At the opposite extreme stays the supply that is perfectly elastic. In this case,
producers are prepared to supply any amount at any given price. If the result of the operation is between
zero and one the PES is considered inelastic and there is less than a proportionate response in supply to a
change in price. The diagram below shows how an increase in price leads to a lower increase in quantity
supplied.
Supply inelastic
Price
P2

P1

Q1 Q2
Quantity
Source: (Mankiw and Taylor, 2008, p. 106)

Furthermore if the percentage change in quantity supplied is equal with percentage change in
price the elasticity is unitary. Finally, if the result lies between one and infinity, there is a more than
proportionate response in supply to a change in price and PES is considered elastic (Anderton, 2008, p.
75). The diagram below shows how a rise from P1 to P2 leads to a higher rise of quantity supplied from
Q1 to Q2.
Supply elastic
Price
P2
P1

Q1
Q2
Quantity
Source: Based on (Mankiw and Taylor, 2008, p. 106)
In fact, if an auto manufacturer has only one factory producing a type of vehicle. Assuming that
there is a price increase and the company wants to increase production. The factory can hire more workers
and increase production only if it is producing far fewer vehicles than is capable of. On the other hand, if
the factory is at full production, the company cannot build a second factory because this would make the
supply of more vehicles more inelastic.
There are some determinants of elasticity of supply in car market. Anderton (2008: 76) notes that
in the availability of producer substitutes can influence it. For example, one model of a car can easily
substitute another model in the same rage because the car manufacturer can conveniently switch resources
on its production line. Another determinant is the length and complexity of production. Auto manufacture
is a multi-stage process that requires skilled labour, specialized equipment and a large supplier's network
(Samuelson and Nordhaus, 2001).
To summarize, price elasticity of demand shows to producer when to push up or lower the price if
the demand for the product is inelastic and respectively elastic. Income elasticity of demand is useful in
explaining whether is the right time to promote a certain type of good. Cross elasticity of supply shows
the producer if it is the right time to promote a substitute. A conclusion can be drawn that concepts of
elasticities are effective for increasing sales. However, on their own are not effective because they do not
show the actual cause and effect. Moreover, in reality many factors are changing at the same time. As a
result, concepts of elasticity may be misleading.

References
Anderton, A. 2008. Economics. Harlow [England]: Pearson Education.
Bannock, G., Baxter, R. and Davis, E. 2003. The Penguin dictionary of economics. London:
Penguin Books.
Begg, D. 2009. Foundations of economics. 4th ed. New York: McGraw Hill Education.
Begg, D., Fischer, S. and Dornbusch, R. 2008. Economics. Maidenhead: McGraw-Hill Higher
Education.
Ferrari.com. 2013. Ferrari Owners' Club of Great Britain. [online] Available at:
http://www.ferrari.com/English/Community/OwnersClubs/Pages/FOC_Club_Great_Britain.
aspx [Accessed: 17 Nov 2013].
Gillespie, A. 2011. Foundations of economics. Oxford: Oxford University Press.
Mankiw, N. and Taylor, M. 2008. Economics. South- Western, Cengage learning.
Nicholson, W. 2008. Intermediate microeconomics. London: South-Western Cengage Learning.
Samuelson, P. and Nordhaus, W. 2001. Economics. 17th ed. McGraw-Hill Inc..
Sloman, J. and Sutcliffe, M. 2003. Economics. 5th ed. Harlow, England: Prentice Hall Financial
Times.
Tragakes, E. 2012. Economics for the IB Diploma. 2nd ed. Cambridge: Cambridge University Press.