Elasticity

Elasticity is the measure of the responsiveness of one variable to changes in another variable that determines it. The price elasticity of demand for a good is a measure of the responsiveness of the quantity demanded of that good to changes in its price.

Price elasticity of demand (ε) is equal to the percentage change in quantity demanded that results from a 1% change in its prince:

                                    e = % change in quantity demanded

                                                   % change in price

Factors affecting Price Elasticity of Demand:

• Substitution Possibilities

Price elasticity of demand is generally higher for products with close substitutes readily available. For example, salt is an inelastic product because it has no close substitutes, even if the price changes a lot, people will still buy it since there are no other substitute possibilities.

• Budget Share

Price elasticity of demand is generally higher for products/services with a large share of the budget in terms of high cost or frequent usage, because if the prices of these products rise, there is greater incentive to switch to a substitute.

•   Time

Price elasticity of demand for any good is higher in general for long term items than short terms items. For example, if you bought an air conditioner and then the price of electricity went up, it is unlikely you will replace it straight away for a more efficient model, rather wait until it breaks

Graphical Interpretation of Price Elasticity

The formula for price elasticity can be rearranged to incorporate the demand curve. The price elasticity of demand at any point along a demand curve is the ratio of price to quantity at that point, multiplied by the gradient (absolute value) at that point:

Note:

• Price elasticity decreases along the demand curve
• Price elasticity is greater for curves with greater gradient

We can also apply the 3 cases of elasticity to the graph of a demand curve.

• Midpoint has unit elasticity
• Top half is elastic
• Bottom half is inelastic

Special Cases

• Perfectly elastic demand (e= ¥) : when the price elasticity of demand is infinite at every point along a horizontal demand curve. This means that even the slightest increase in price results in the consumers completely abandoning the product in favour of substitutes
• Perfectly inelastic demand (e= 0) : when price elasticity of demand is zero at every point along a vertical demand curve. This means that consumers will not, or cannot, switch to substitutes even if the prices increase significantly

Elasticity and Total Expenditure

Total expenditure is the total amount of money spent, i.e. the number of units bought multiplied by the price each unit was sold. Since all the money spent goes towards the seller of that product, then the total revenue must be equal to the total expenditure

                   Total expenditure = P * Q = Total revenue

 For a straight line demand curve, the total expenditure curve has a maximum at the midpoint where it corresponds to unit elasticity.

Elasticity determines whether increase in price will increase or decrease total expenditure:

• If e > 1, changes in price is always in OPPOSITE direction to change in total expenditure
• If e < 1, changes in price is always in SAME direction to change in total expenditure
• If e = 1, changes in price has NO EFFECT on total expenditure

Cross-Price Elasticity of Demand

The cross-price elasticity of demand is the percentage change of the quantity demanded of a good in response to a 1% change in the price of ANOTHER good:

• Positive Value: means the two goods are substitutes, as price increase in the good B will increase the demand of good A, since people abandon B for A as a substitute
• Negative Value: means the two goods are compliments, as price increase in good B will decrease the demand for good A, since both needs to be used together

Income Elasticity of Demand

The income elasticity of demand is the percentage change of the quantity demanded of a good in response to a 1% change in income:

• Positive Value: means the good is a normal good, since as income increase people can afford more of it and thus demand for more. If it the value is very small, i.e. <1, then the good is an essential good. g. people won't buy THAT much more bread even when their income increases
• Negative Value: means the good is an inferior good, since as income increase people abandon it for better products

Price Elasticity of Supply

Price elasticity of supply (ε) is equal to the percentage change in quantity supplied that occurs in response to a 1% change in price. It has the exact same formula as price elasticity of demand:

Similarly, the price elasticity of supply can have 3 values:

• Elastic if e > 1, i.e. a small % change in price will lead to a larger % change in supply.
• Inelastic if e < 1 , i.e. a large % change in price only leads to a small % change in supply
• Unit elastic when i.e = 1this occurs when the supply curve goes through the origin, i.e. any % change in price results in an equal % change in supply

There are also two special cases:

• Perfectly Inelastic Supply

Supply is perfectly inelastic with respect to price when e = 0 meaning supply is always fixed and won't be affected by any % change in price. For example, lakefront properties may fluctuate in price but the amount of land available is always the same.

•  Perfectly Elastic Supply

Supply is perfectly elastic with respect to price when e =¥ meaning no matter how much supply is produced, the price for each unit is always the same. So whenever additional units of good can be produced at the same cost it has been using so far, the supply is perfectly elastic. For example, if a cup of lemonade cost 20 cents and no matter how many cups are made the cost is the same, then the marginal cost of lemonade is always 20 cents.

Factors affecting Price Elasticity of Supply:

• Flexibility of Inputs

The supply of a good is elastic if it is easy to lure additional inputs away from production of other goods, i.e. the relative ease of acquiring additional inputs. For example, making lemonade requires minimum skill so if the price of lemonade increases it is easy to convert many workers in other fields to lemonade production to significantly increase supply. However, even if the salary of brain surgery rose significantly, supply of brain surgeons will not increase, at least in the short run, as it requires specialised training

§  Mobility of Inputs

The supply of a good is elastic if it the inputs can be easily transported from one site to another, so that an increase in the price of one product in one market will attract inputs from other markets, thereby increasing supply. For example, supply in entertainment industry is relatively elastic because entertainers are willing to travel for gigs.

§  Ability to Produce Substitute Inputs

The supply of a good is elastic if technology can overcome limitations imposed by inputs that are fixed in supply. For example, raw diamonds have limited supply so even if their prices go up, not much more supply is available. But new technology creating synthetic diamonds is able to make diamonds more elastic

§  Time

Price elasticity of a good is higher in the long term than short term, due to the time it takes for producers to respond to an increase in price by switching from one activity to another, building new factors, or training more skilled workers