A really simple presentation on the three demand elsticities. Hope you find it useful!

Published on: **Mar 4, 2016**

- 1. Price, Income and Cross Elasticity
- 2. Elasticity – the concept <ul><li>The responsiveness of one variable to changes in another </li></ul><ul><li>When price rises, what happens to demand? </li></ul><ul><li>Demand falls </li></ul><ul><li>BUT! </li></ul><ul><li>How much does demand fall? </li></ul>
- 3. Elasticity – the concept <ul><li>If price rises by 10% - what happens to demand? </li></ul><ul><li>We know demand will fall </li></ul><ul><li>By more than 10%? </li></ul><ul><li>By less than 10%? </li></ul><ul><li>Elasticity measures the extent to which demand will change </li></ul>
- 4. Elasticity <ul><li>4 basic types used: </li></ul><ul><li>Price elasticity of demand </li></ul><ul><li>Price elasticity of supply </li></ul><ul><li>Income elasticity of demand </li></ul><ul><li>Cross elasticity </li></ul>
- 5. Elasticity <ul><li>Price Elasticity of Demand </li></ul><ul><ul><li>The responsiveness of demand to changes in price </li></ul></ul><ul><ul><li>Where % change in demand is greater than % change in price – elastic </li></ul></ul><ul><ul><li>Where % change in demand is less than % change in price - inelastic </li></ul></ul>
- 6. Elasticity The Formula: Ped = % Change in Quantity Demanded ___________________________ % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)
- 7. Elasticity Price (£) Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
- 8. Elasticity Price Quantity Demanded (000s) D The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5 100 Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. Total Revenue
- 9. Elasticity Price Quantity Demanded (000s) D If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. £5 100 £3 140 Total Revenue
- 10. Elasticity Price (£) Quantity Demanded 10 D 5 5 6 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall Producer decides to lower price to attract sales Not a good move!
- 11. Elasticity Price (£) Quantity Demanded D 10 5 20 Producer decides to reduce price to increase sales 7 % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
- 12. Elasticity <ul><li>If demand is price elastic: </li></ul><ul><li>Increasing price would reduce TR (%Δ Qd > % Δ P) </li></ul><ul><li>Reducing price would increase TR </li></ul><ul><li>(%Δ Qd > % Δ P) </li></ul><ul><li>If demand is price inelastic: </li></ul><ul><li>Increasing price would increase TR </li></ul><ul><li>(%Δ Qd < % Δ P) </li></ul><ul><li>Reducing price would reduce TR (%Δ Qd < % Δ P) </li></ul>
- 13. Elasticity <ul><li>Income Elasticity of Demand: </li></ul><ul><ul><li>The responsiveness of demand to changes in incomes </li></ul></ul><ul><li>Normal Good – demand rises as income rises and vice versa </li></ul><ul><li>Inferior Good – demand falls as income rises and vice versa </li></ul>
- 14. Elasticity <ul><li>Income Elasticity of Demand: </li></ul><ul><li>A positive sign denotes a normal good </li></ul><ul><li>A negative sign denotes an inferior good </li></ul>
- 15. Elasticity <ul><li>For example: </li></ul><ul><li>Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8% </li></ul><ul><li>Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2% </li></ul><ul><li>Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8% </li></ul><ul><li>Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3% </li></ul>
- 16. Elasticity <ul><li>Cross Elasticity: </li></ul><ul><li>The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement </li></ul>Xed = % Δ Qd of good t __________________ % Δ Price of good y
- 17. Elasticity <ul><li>Goods which are complements : </li></ul><ul><ul><li>Cross Elasticity will have negative sign (inverse relationship between the two) </li></ul></ul><ul><li>Goods which are substitutes : </li></ul><ul><ul><li>Cross Elasticity will have a positive sign (positive relationship between the two) </li></ul></ul>
- 18. Elasticity <ul><li>Price Elasticity of Supply: </li></ul><ul><ul><li>The responsiveness of supply to changes in price </li></ul></ul><ul><ul><li>If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price </li></ul></ul><ul><ul><li>If Pes is elastic – supply can react quickly to changes in price </li></ul></ul>Pes = % Δ Quantity Supplied ____________________ % Δ Price
- 19. Determinants of Elasticity <ul><li>Time period – the longer the time under consideration the more elastic a good is likely to be </li></ul><ul><li>Number and closeness of substitutes – the greater the number of substitutes, the more elastic </li></ul><ul><li>The proportion of income taken up by the product – the smaller the proportion the more inelastic </li></ul><ul><li>Luxury or Necessity - for example, addictive drugs </li></ul>
- 20. Importance of Elasticity <ul><li>Relationship between changes in price and total revenue </li></ul><ul><li>Importance in determining what goods to tax (tax revenue) </li></ul><ul><li>Importance in analysing time lags in production </li></ul><ul><li>Influences the behaviour of a firm </li></ul>