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1.2 – Elasticity

Price Elasticity of Demand (PED)
Price Elasticity of Demand and Its Determinants
Price elasticity is a measure of how responsive the demand is to change in price. If demand
is very elastic, then it is easily influenced by price. On the other hand, if demand is inelastic,
then changing the price will have little effect on demand: the demand is less sensitive to
price.
The price elasticity of demand for any given demand curve can be calculated according to
the equation:
=



When doing these calculations, it is important to note that, although the calculated value is
usually negative, it is treated as a positive number. The absolute value is used instead of the
negative number.
Values can be compared using the following measures: if the absolute value is between 0
and 1, the demand is said to be inelastic, as changes in price have only a minor effect on
demand. On the other hand, values above 1 indicate that the demand is elastic. When the
value is exactly equal to 1, this is called unit elastic demand. This means that a change is
price by one percent corresponds to a change in demand by one percent.
When the value is equal to 0, the demand is known as perfectly inelastic. Changing the price
would have no effect on demand. Likewise, when the value is ∞, the demand is perfectly
elastic. A price change would cause an infinite change in demand.




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The determinants of PED are:
 Degree of necessity - i.e. is it addictive? a basic need? Food items like bread and milk
would be largely inelastic because they are necessary to life.
 The proportion of income spent on the purchase - expensive items like cars or
houses cost a high proportion of income, making the demand for them more elastic
 Number and closeness of substitutes - if there is a large number of similar products
on the market, demand becomes more elastic. The greater the similarity of the
products, the more likely consumers are to switch after a price change.
 Timeframe between measurements - to accurately determine price elasticity,
sufficient time must be allowed to measure the proportion of the market that stops
purchasing the product. For example, if the price of insurance increased, consumers
would need time to transfer to another company before the impact of the price
change would be seen. Some products are inelastic in the short-term, but very
elastic in the long-term.
It is important to realise that PED varies along the demand
curve and is not represented by the slope of the curve.
Instead, PED is an arc that touches the straight-line demand
curve. At lower prices, the gradient of the arc approaches 0
and at higher prices the gradient approaches ∞.
The gradient of the two lines are equal only at the point
where they touch. The gradient of the PED curve is
constantly changing as price changes.







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Applications of Price Elasticity of Demand
Role of PED for Firms
Businesses use PED to determine the effect of price changes on their total revenues. This is
crucial for their decision making - would it be worth it to increase the price of their product,
or would it have too much of a negative effect on demand? Their revenue is represented by
the area under the demand curve.
= ×
Firms will sell their product at the price that maximises their revenue. They must consider
PED in order to compare the revenue at different prices.
Role of PED for Governments
PED can be used by governments to predict the effect of implementing taxes. They will
compare the elasticity of different products and tax the most
inelastic ones.
Incidence of Taxation
This is the question of whether producers or consumers pay the
cost of taxes. If a product is price inelastic, the producers can pass
on the cost of the tax to the consumers without much effect on
demand. Consumers wear the cost of the tax.
Looking at the graph on the right, it can be seen that a price
increase for a price inelastic product only causes a small decrease
in demand
On the other hand, if the product is price elastic, the
producers must absorb the cost of the tax, since the increase
in price causes demand to fall, thereby decreasing the
producer’s revenue.
The graph, left, shows that increasing the price of a price
elastic product would cause a large decrease in demand.

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Note that on these two graphs, the price changes due to a shift of the corresponding supply
curve, as below. The shift in the supply curve is caused by the change in the costs of
production as a result of the tax.




Generalising Elasticity
Primary commodities, including raw materials, are usually price inelastic because they are
necessary for life: things like food products or sources of energy.
Conversely, manufactured products tend to be price elastic because there are more
alternative products available from other suppliers.

Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand and Its Determinants
This is the responsiveness of the quantity demanded of a good to the price of another good.
It indicates the relationship between two related products when there is a shift in the
demand curve. This is mainly used for products that compete with each other - i.e. if the
price of Y chips goes up, how does the demand for X chips change? It is calculated using the
equation:
=



In the chips example, X chips are considered a substitute to Y chips if the
demand for X increases as the price of Y increases, leading to a positive XED.
By definition, substitute goods have a positive value of XED.
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Another type of related products is complementary products - these are products that are
dependent on each other. An example of this is CD players and CDs: you only buy a CD
player if the price of CDs is affordable. If the price of CDs goes up, then the demand for CD
players would go down, leading to a negative XED. Therefore, by definition, complementary
goods have a negative value of XED.
However, the XED alone does not determine whether goods are substitutes or
complements. For these relationships to exist, the products must be closely related. You
could calculate the XED for hairspray and pillows, but it would not give any useful data,
since the goods are not actually related. Hence, the absolute value of XED depends on how
closely related the products are.

Applications of Cross Price Elasticity of Demand
XED is useful for supermarkets, as it allows them to see whether increasing prices to
maximise their profits may have a negative effect on sales for complementary goods.
Competitors can also test whether a price increase would cause too many customers to
switch to substitute goods. This way, they can be aware of effects on sales and revenue
before making price decisions. Furthermore, if their rival businesses change their prices,
they can predict how much this will affect their sales.
Income Elasticity of Demand (YED)
Income Elasticity of Demand and Its Determinants
This calculation is used to show how dependent the demand for a product is on the income
of consumers. Therefore, it assesses the shift in the demand curve that results when income
increases or decreases. It is calculated using the equation:
=



Normally, when income increases, people can afford to purchase higher quantities of a
given good. As a result, the definition of normal goods is items with positive YED - that is,
the demand increases as income increases.
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On the other hand, some goods are cheaper, low quality substitutes to more expensive
items. While low income causes the demand for these goods to increase, when income is
high, the luxury of purchasing more expensive items can be afforded. Therefore, the
definition of inferior goods is items with negative YED - that is, as income increases, the
demand for the item decreases.
When the YED is greater than 1, a product is income elastic. This means that the product is a
luxury good, as consumers will purchase it based on their income. On the other hand, a
product with YED les than 1 is income inelastic. This means the product is a necessity good,
since consumers must continue to buy it even when income is low.
Applications of Income Elasticity of Demand
For the economy, income elasticity can be used to determine which products to produce.
Since primary products have a very low YED, the demand will be relatively constant despite
any changes in income. Manufactured products will have a higher YED, so demand is higher
once the average income increases. Services have an even higher YED, which means that
any decrease in income will have a significant impact on demand.
In a growing economy, firms will try to avoid producing inferior goods. Those producing
necessity products know that demand will not change when income changes. It can also be
useful for firms to monitor income in other countries, as this may indicate new markets for
normal goods.
Furthermore, when the economy develops, a country tends to shift from primary to
secondary and tertiary production. For primary sector businesses, the demand for goods will
be relatively constant. However, with this change of sectors, more elastic products will be
purchased. Firms in the secondary or tertiary sector will see higher demand for their goods.
Therefore, YED is a crucial consideration in business decision-making.



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Price Elasticity of Supply (PES)
Price Elasticity of Supply and Determinants
Producers use increases in price as indicators that more of a good should be supplied. The
price elasticity of supply is the measure of the responsiveness of the quantity supplied of a
particular good to a change in its price. It is calculated according to the formula:
=



PES > 1 - Supply is elastic (usually manufactured goods)
PES < 1 - Supply is inelastic (usually primary products)
PES = 1 - Unit elastic supply
PES = 0 - No response to prices; the supply curve is vertical and perfectly inelastic
PES = ∞ - Perfectly elastic supply; horizontal supply curve
The PES always has a positive value.
PES is determined by factors including:
Time - The faster the goods can be produced, the more
elastic the supply is in response to changes in demand.
This also relates to the time it takes to train people to
produce the goods. While there is always a delay
between the change in price and the change in supply,
this delay may be longer from some products than for
others.

Mobility of Factors of Production - Elasticity is higher if the factors of production can be
moved easily. A firm might have to buy new machinery or train staff.
Unused Capacity - This means that it is easy to increase production if there is a shift in
demand. A supplier might not be producing the maximum amount, so there is room for
them to increase production if the price increases. If there is a lot of unused capacity, the
PES will be higher.
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Ability to Store Stock - If stock can be stored easily, then the supply is more elastic in
relation to the demand. Many food products deteriorate quickly, whilst other non-
perishables can be stored for extended periods of time. Supply for perishable items is more
inelastic.
Number of Competitors - If there are fewer barriers to entry for new competitors, then
more firms can enter the market to meet increasing demand.
Number of Suppler Substitutes - A firm might be able to product multiple types of product.
When the price of one decreases, the supplier is able to switch to producing the other. If
they have a large number of substitutes that are closely related, the supply is more elastic.

Applications of Price Elasticity of Supply
Primary commodities often require large amounts of time to produce, such as crops and
minerals. As a result, a change in demand will see a delay in the response of the suppliers.
On the other hand, manufacturers can easily change their supply by altering the hours of
the workers or the output from machinery. This makes the PES of manufactured goods
higher.

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