Economic Issues: An Introduction Outcome One: Elasticity

Learning Objective Learn the meaning of elasticity of demand. Examine what determines the elasticity of demand. Apply the concept of elasticity to different goods. 2

I should be able to: Calculate the price elasticity of demand. Distinguish between the price elasticity of demand for necessities and luxuries. Demonstrate the impact of the price elasticity of demand on total revenue. 3

Elasticity The elasticity is a measure of the sensitivity of one variable to a change in another. How much does the quantity demanded change if the price of a good increases or decreases? 4

Demand 5 Inverse relationship between demand and price. This relationship allows us, in most cases, to state the direction of change. Price Q2 Q1 Quantity P2 P1 A B D

Demand elasticity Now we want to measure the extent to which demand is affected by a change in price. This will vary from one market to another. 6

Demand sensitivity Demand sensitivity describes how consumer demand reacts to changes in price. Factors that affect sensitivity of demand: –Necessity of good/service –Substitutes –Addictiveness 7

Price elasticity of demand Which of the following has the lowest price sensitivity? Sugar Cigarettes Cinema tickets 8

Price elasticity of demand: definition Measures the responsiveness of demand to a change in price a. If demand is relatively unresponsive to a change in price, it is said to be inelastic. b. If demand is relatively responsive to a change in price, it is said to be elastic. 9

Elastic Vs. Inelastic Elastic Demand Usually luxury products Products that have a lot of substitutes E.G. Technology, Tourism, Clothes, Games, Nights out, Cinema Inelastic Demand Usually necessity products Products which have no substitutes. When prices change you can’t switch to another similar product Addictive E.G. Cigarettes, Alcohol, Rent, Petrol, Energy, Transport, Basic foods 10

Elasticity of demand and total revenue Awareness of elasticity is of great importance to suppliers. The responsiveness of demand to a change in price will affect the total revenue collected by suppliers at different prices. 11

Calculating total revenue Total Revenue = Selling price X quantity demanded Example A firm sells 200 jumpers. The selling price of one jumper is £5. What is the total revenue collected by the firm? Answer: £5 X 200 = £

Calculating elasticity: change in total revenue Economists calculate the change in total revenue by… Calculating the value of total revenue: a. before, and b. after the change in price 13

14 Price (£) Quantity D Example One A decrease in price from £10 to £8 causes quantity demanded to increase from 50 to 80. Calculate the total revenue: a. before the price decrease? b. after the price decrease?

Example 1: Answers a. Before the price decrease: Total revenue = £10 X 50 = £500 b. After the price decrease: Total revenue = £8 X 80 = £640 15

16 Example Two Price (£) Quantity D An increase in price from £6 to £9 causes quantity demanded to fall from 100 to 90. Calculate the total revenue: a.before the price increase? b. after the price increase?

Example 2: Answers a. Before the price increase: Total revenue = £6 X 100 = £600 b. After the price increase: Total revenue = £9 X 90 = £810 17

18 Price (£) Quantity D Example OneIn example one, when demand is elastic and price is reduced, total revenue rises from 500 to 640.

19 Example Two Price (£) Quantity D In example two, when demand is Inelastic and price is raised, total revenue rises from 600 to 810.

Calculating price elasticity using TR Method Calculating the change in total revenue is another way to determine price elasticity of demand: If price and total revenue change in the same direction: demand is inelastic. If price and total revenue change in different directions: demand is elastic. 20

21 These examples show that: a.When demand is elastic it will benefit the supplier to reduce the price because total revenue will rise as a result. b.When demand is inelastic it will benefit the supplier to increase the price because total revenue will rise as a result.

Income elasticity of demand Measures the responsiveness of Demand to a change in income. How much does income changes affect consumption of different goods? 22

Income Elasticity Income Elastic Demand Demand is related to income changes When income increases – demand for these products will also increase. When income falls – demand for these goods will also fall. Known as normal goods Income Inelastic Demand Demand unrelated to income changes When income increases – there is no real change in consumption of these products. When income falls – there is no real change in demand for these products Goods you have to buy regardless of your income. 23

Income Elasticity Income Elastic Demand Usually luxury products – Goods you will buy more of if your income rises – Goods you can go without if your income falls E.G Holidays, Clothes, Technology, Games, Cars, Nights out Certain products (known as Inferior goods) fall as incomes rise – people can now afford better versions of these products. Usually budget items. Income Inelastic Demand Usually necessity products – Goods you must continue to buy regardless of your income as they are essentials – Changes in income will not make you buy significantly more of these products as you are already purchasing what you need E.G Bills, Rent, Electricity, Medicine, Transport, Petrol 24

Business knowledge Knowledge of these changes are useful in predicting future Demand in the service sector. Cruises, for example, may benefit from increased incomes as it’s a service with a high income elasticity. 25