• • • • Concept of Elasticity

8/14/2019 Concept of Elasticity

1/22

AUT Faculty of Business 2008

Globalisationan

dBusiness

Enterprise

1

Overview

Concept of elasticity

Various types of elasticity

Total revenue and elasticity

Tax revenue and elasticity

Reading: Stewart & Moodie, Economic Concepts andApplications, Third edition, Chapter 4.


2/22


Globalisationan

dBusiness

Enterprise

2 2

The concept of elasticity

Elasticity is the term used in economics to explain thesensitivity of one variable to changes in anothervariable.

Elasticity is useful for business decision-making (e.g.pricing, marketing) and policy making.


3/22


Globalisationan

dBusiness

Enterprise

3 3

Price elasticity

Price elasticity measures the sensitivity of the dependentvariable 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 tochange by 1%.

Ep = percentage change in dependent variable

percentage change in independent variable


4/22


Globa

lisationan

dBusiness

Enterprise

4

Four types of elasticity

1. Price elasticity of demand

2. Cross elasticity of demand

3. Income elasticity of demand4. Price elasticity of supply

For the purpose of this course we will focus on the

first three types of elasticity.


5/22


Globa

lisationan

dBusiness

Enterprise

5

Price elasticity of demand

Price elasticity of demand measures the sensitivity ofquantity 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 percentagechange 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


6/22


Globa

lisationan

dBusiness

Enterprise

6 6

Numerical example

A rock group increases ticket prices from $25 to $30,and the number of seats sold falls from 20 000 to 10000 as a result. The point elasticity of demand at a

price of $30 would be:

6

003.02000

10000

30

5

10000

=

=

=

Q

P

P

Q


7/22 AUT Faculty of Business 2008

Globa

lisationan

dBusiness

Enterprise

7 7

Point elasticity of demand

This numerical examples answer is known as pointelasticity of demand seeing as the answer iscalculated for a specific price and quantity.

Thus, in calculating the elasticity of a product at aspecific price and quantity you can use the formula

Q

P

P

Q



Globa

lisationan

dBusiness

Enterprise

8

Arc elasticity

However, if you want to calculate the elasticitybetween to prices you have to calculate what is knownas arc elasticity.

To calculate arc elasticity the average of bothquantities and prices are used as the basis forcalculating the percentage change.

Formula used for this is:

Q

P

P

Q



Globa

lisationan

dBusiness

Enterprise

9

Demand Curves and Elasticity

Elasticity is a measure of thedegree of responsiveness ofone variable (here, revenue) tochanges in another (here,price).

Total Revenue = Price xQuantity

Price elasticity of demandmeasures changes in totalrevenue as prices change.



Globa

lisationandBusiness

Enterprise

10

Perfect elastic demand (Ed=)

Perfect elastic demand indicates that consumers willpurchase any amount of a product at a specific fixedprice.

If the demand for a product is perfect elastic,producers will not be able to increase their totalrevenue by increasing the price seeing as soon asthey increase the price, the quantity demanded will fall

to zero.



Globa

lisationandBusiness

Enterprise

11 11

Elastic demand (>Ed>1)

Elastic demand indicates that the percentage change inquantity demanded is greater than the percentage change inprice.

This means consumers are sensitive to the price change. If the producer increased the price by lets 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 totalrevenue.



Globa

lisationandBusiness

Enterprise

12

Unit elastic (Ed=1)

Unit elasticity means that the percentage change inquantity demanded will be equal to the percentagechange 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 thequantity demanded.

This means that it does not matter what price strategyhe follows, his total revenue will remain the same.



Globa

lisationandBusiness

Enterprise

13

Inelastic demand (0


14/22


Globa

lisationandBusiness

Enterprise

14

Perfect inelastic (Ed=0)

Perfect inelastic demand means that consumers willpurchase a fixed quantity of the product regardless ofthe price.

This means that the producer can increase his price towhatever level he pleases, just as long as his productdoes not have satisfactory substitutes.


15/22


Globa

lisationandBusiness

Enterprise

15

i. The availability of substitutes - if there are plenty ofgood substitutes available consumers can easilyswitch to that good or service when the price of theone they are using increases.

ii. The extent to which the good is a necessity - anecessity tends to be purchased despite priceincreases.

iii.The proportion of income spent on the good - if only asmall proportion of income is spent on a good or

service it will be less sensitive to price changes thanbig ticket items. So a high price change for a low costitem may have little effect on demand, while a lowprice change on a higher price item may have a larger

effect.

Determinants of Elasticity


16/22


Globa

lisationandBusiness

Enterprise

16

(i) Elastic Demand - if total revenue decreases from $50 to$30 when the price of the good increases, demand for thegood is elastic.

Elasticity and Revenue Analysis

Price ($)

Elastic Demand

Quantity

$10

$5

103

Demand

Revenue gain

Revenue loss


17/22


Globa

lisationandBusiness

Enterprise

17

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

Inelastic Demand

Price

Quantity

$10

$5

106

Demand

Revenue gain

Revenue loss

Elasticity and Revenue Analysiscont..


18/22


Globa

lisationandBusiness

Enterprise

18 18

What is cross-elasticity ofdemand?

The ratio of the percentage change in quantity demanded of a good to a givenpercentage change in price of another good:

Cross elasticity calculations reveal whether goods are substitutes orcomplements in use.

When your answer is positive it means that a rise in the price of lets say lamb willlead to an increase in the quantity demanded of beef substitutes.

When your answer is negative it means that a rise in the price of lets say cars willlead to a decrease in the quantity demanded of petrol complements.

% change in quantity demanded of good A

% change in price of good B

Ed =


19/22


Globa

lisationandBusiness

Enterprise

19

What is income elasticity ofdemand?

The concept of income elasticity of demand relates the quantitydemanded of any good or service to a change in income.

If income increases and quantity demanded increasesnormal good (such as luxury - and necessity goods).

If income increases and quantity demanded decreases

inferior good (such as low quality clothing and food).

YQey

=%

%


20/22


Globa

lisationandBusiness

Enterprise

20

Elasticity and indirect tax

With an indirect tax on products it is assumed that theseller should pay the tax to the Inland RevenueService but they will try to pass at least some of the

tax burden on to the consumer through priceincreases.

There is no necessity that the incidence be equallyshared and by how much the supplier can increase

the price without effecting quantity demanded to muchwill depend on the elasticity of the product.


21/22


Globa

lisationandBusiness

Enterprise

21

Tax and inelastic demand

S1

S

D

P

Q

2.70

2.00

7 8

Tax = $1 per can

Incidence on buyer

Incidence on seller


22/22


Globa

lisationandBusiness

Enterprise

22

Tax and elastic demand

D

S

S1P

Q

450400

70 100

Incidence on buyerIncidence on seller

Tax = $180 per mobilephone

Documents

• • • • Concept of Elasticity