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Overview

Globalisation and Business Enterprise

• Concept of elasticity
• Various types of elasticity
• Total revenue and elasticity
• Tax revenue and elasticity

• Reading: Stewart & Moodie, Economic Concepts and


Applications, Third edition, Chapter 4.
1 © AUT Faculty of Business 2008
The concept of elasticity
Globalisation and Business Enterprise

• Elasticity is the term used in economics to explain the


sensitivity of one variable to changes in another
variable.

• Elasticity is useful for business decision-making (e.g.


pricing, marketing) and policy making.

2 2 © AUT Faculty of Business 2008


Price elasticity
Globalisation and Business Enterprise

• Price elasticity measures the sensitivity of the dependent


variable in terms of the independent variable. For example:
the size of a corn harvest (dependent) and the amount of
rain (independent).
• It is calculated as the ratio of the percentage change in the
dependent variable if the independent variable was to
change by 1%.
Ep = percentage change in dependent variable
percentage change in independent variable

3 3 © AUT Faculty of Business 2008


Four types of elasticity
Globalisation and Business Enterprise

1. Price elasticity of demand


2. Cross elasticity of demand
3. Income elasticity of demand
4. Price elasticity of supply

For the purpose of this course we will focus on the


first three types of elasticity.

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Price elasticity of demand
Globalisation and Business Enterprise

• Price elasticity of demand measures the sensitivity of


quantity demanded by consumers to changes in price.
• It is calculated as the ratio of the percentage change
in quantity demanded of a product to a percentage
change in the price of the that product.
• The formula for price elasticity of demand is:
Ed = percentage change in quantity demanded
percentage change in price

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Numerical example
Globalisation and Business Enterprise

• A rock group increases ticket prices from $25 to $30,


and the number of seats sold falls from 20 000 to 10
000 as a result. The point elasticity of demand at a
price of $30 would be:

∆Q P
×
∆P Q
10000 30
= ×
− 5 10000
=− 2000 ×0.003
=− 6
6 6 © AUT Faculty of Business 2008
Point elasticity of demand
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• This numerical example’s answer is known as point


elasticity of demand seeing as the answer is
calculated for a specific price and quantity.
• Thus, in calculating the elasticity of a product at a
specific price and quantity you can use the formula

∆Q P
×
∆P Q

7 7 © AUT Faculty of Business 2008


Arc elasticity
Globalisation and Business Enterprise

• However, if you want to calculate the elasticity


between to prices you have to calculate what is known
as arc elasticity.
• To calculate arc elasticity the average of both
quantities and prices are used as the basis for
calculating the percentage change.
• Formula used for this is:

∆Q ΣP
×
∆P ΣQ
8 © AUT Faculty of Business 2008
Demand Curves and Elasticity
Globalisation and Business Enterprise

Elasticity is a measure of the


degree of responsiveness of
one variable (here, revenue) to
changes in another (here,
price).

Total Revenue = Price x


Quantity

Price elasticity of demand


measures changes in total
revenue as prices change.
9 © AUT Faculty of Business 2008
Perfect elastic demand (Ed=∞)
Globalisation and Business Enterprise

• Perfect elastic demand indicates that consumers will


purchase any amount of a product at a specific fixed
price.
• If the demand for a product is perfect elastic,
producers will not be able to increase their total
revenue by increasing the price seeing as soon as
they increase the price, the quantity demanded will fall
to zero.

10 © AUT Faculty of Business 2008


Elastic demand (∞>Ed>1)
Globalisation and Business Enterprise

• Elastic demand indicates that the percentage change in


quantity demanded is greater than the percentage change in
price.
• This means consumers are sensitive to the price change.
• If the producer increased the price by let’s say 1%, he will
loose 2% in terms of quantity demanded for his product.
• But if the producer decreased the price by 1%, he will gain
2% in terms of quantity demanded. Thus increasing his total
revenue.

11 11 © AUT Faculty of Business 2008


Unit elastic (Ed=1)
Globalisation and Business Enterprise

• Unit elasticity means that the percentage change in


quantity demanded will be equal to the percentage
change in price.
• This means if the producer increased the price by 1%,
he will loose 1% in terms of the quantity demanded.
• If the price decreased by 1%, he will gain 1% in the
quantity demanded.
• This means that it does not matter what price strategy
he follows, his total revenue will remain the same.

12 © AUT Faculty of Business 2008


Inelastic demand (0<Ed<1)
Globalisation and Business Enterprise

• Inelastic demand is a condition in which the


percentage change in the quantity demanded is
smaller than the percentage change in the price.
• This means consumers are not sensitive to the price
change.
• If the producer increased his price 1%, he will loose
0.5% in terms of quantity demanded.
• Thus, by increasing his price, he will loose clients but
he will still increase his total revenue.

13 © AUT Faculty of Business 2008


Perfect inelastic (Ed=0)
Globalisation and Business Enterprise

• Perfect inelastic demand means that consumers will


purchase a fixed quantity of the product regardless of
the price.
• This means that the producer can increase his price to
whatever level he pleases, just as long as his product
does not have satisfactory substitutes.

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Determinants of Elasticity
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i. The availability of substitutes - if there are plenty of


good substitutes available consumers can easily
switch to that good or service when the price of the
one they are using increases.
ii. The extent to which the good is a necessity - a
necessity tends to be purchased despite price
increases.
iii.The proportion of income spent on the good - if only a
small proportion of income is spent on a good or
service it will be less sensitive to price changes than
big ticket items. So a high price change for a low cost
item may have little effect on demand, while a low
price change on a higher price item may have a larger
15 effect.
© AUT Faculty of Business 2008
Elasticity and Revenue Analysis
Globalisation and Business Enterprise

(i) Elastic Demand - if total revenue decreases from $50 to


$30 when the price of the good increases, demand for the
good is elastic.
Elastic Demand
Price ($)

Revenue gain
$10
Revenue loss
$5
Demand

3 10 Quantity

16 © AUT Faculty of Business 2008


Elasticity and Revenue Analysis
Globalisation and Business Enterprise

cont..
(ii) Inelastic Demand - if total revenue increases from $50 to
$60 when the price of the good increases, demand for the
good is inelastic.
Inelastic Demand
Price

Revenue gain

$10
Revenue loss
$5
Demand

6 10 Quantity
17 © AUT Faculty of Business 2008
What is cross-elasticity of
Globalisation and Business Enterprise

demand?
• The ratio of the percentage change in quantity demanded of a good to a given
percentage change in price of another good:
• Cross elasticity calculations reveal whether goods are substitutes or
complements in use.
• When your answer is positive it means that a rise in the price of let’s say lamb will
lead to an increase in the quantity demanded of beef – substitutes.
• When your answer is negative it means that a rise in the price of let’s say cars will
lead to a decrease in the quantity demanded of petrol – complements.

Ed = % change in quantity demanded of good A


% change in price of good B
18 18 © AUT Faculty of Business 2008
What is income elasticity of
Globalisation and Business Enterprise

demand?
• The concept of income elasticity of demand relates the quantity
demanded of any good or service to a change in income.

% ∆Q
ey =
%∆
• If income increases and quantity Y
demanded increases
normal good (such as luxury - and necessity goods).
• If income increases and quantity demanded decreases
inferior good (such as low quality clothing and food).

19 © AUT Faculty of Business 2008


Elasticity and indirect tax
Globalisation and Business Enterprise

• With an indirect tax on products it is assumed that the


seller should pay the tax to the Inland Revenue
Service but they will try to pass at least some of the
tax burden on to the consumer through price
increases.
• There is no necessity that the incidence be equally
shared and by how much the supplier can increase
the price without effecting quantity demanded to much
will depend on the elasticity of the product.

20 © AUT Faculty of Business 2008


Tax and inelastic demand
Globalisation and Business Enterprise

P
S1
S
2.70
2.00 Tax = $1 per can

78 Q
Incidence on buyer
21 Incidence on seller
© AUT Faculty of Business 2008
Tax and elastic demand
Globalisation and Business Enterprise

P S1
S

450 Tax = $180 per mobile


400 phone
D

Q
70 100

Incidence on buyer
Incidence on seller
22 © AUT Faculty of Business 2008