Elasticity

Price elasticity of demand Elasticity is not a word you would expect to hear in Economics. Something is elastic when it changes its shape quite easily. A piece of metal should not be elastic. However some metals eg aluminium can be bent more than others and are therefore elastic. So what does this have to do with Economics?

Price Elasticity of Demand is a measure of how responsive demand is to a change in price. If a price change leads to a bigger change in quantity demanded, we would consider the good to be responsive to a price change: therefore elastic. If, however, a similar price change leads to a much smaller change in demand, then the demand is inelastic.

inelastic elastic

Shopkeepers and other businesses have to know what the PED for their good or service is. Without this information, they will not be able to accurately set their price at a level which earns them the most revenue.

To calculate a value for price elasticity of demand, we use the formula: percentage change quantity demanded percentage change in price

Bananas R4 per kg 80 kg per day. Price drop to R3.20 per kg Number of kg’s he sells rises from 80 to 112 kg

percentage change quantity demanded percentage change in price STEP 1: PED = percentage change quantity demanded percentage change in price STEP 2: PED = +32 / 80 X 100/1 -80c / 400c X 100/1 STEP 3: PED = +40 % -20% = 2 EFFECT ON REVENUE: Original revenue: 80 kg x R4 per Kg = R320 per day New revenue: 112 kg x R3.20 per Kg = R358.40 per day

When calculating the PED, the answer will always have a minus sign (-) in front of the number. This is because there is an inverse relationship between the Q demanded and price. This minus sign does not mean that the number is negative. So do not confuse – 2 with a number which is less than 1! The number and the sign must be viewed separately.

In the greengrocer example, the PED for bananas was – 2 In the greengrocer example, the PED for bananas was – 2. As the number was more than 1, it meant that PED was elastic and that a decrease in price would result in a proportionately bigger increase in quantity demanded. For this reason, the greengrocer should never increase his price. If he increased his price by 10 %, it would result in a 20 % decrease in quantity demanded and therefore less revenue

Types of PED: There are five types of PED and they can be represented in the following ways: 1. Perfectly inelastic

2. Perfectly elastic 1. The value of PED is 0 and demand is entirely unresponsive to price changes. To improve revenue, always increase price, never decrease. 2. Also known as infinite elasticity, the value is more than 1 into infinity. Demand is exceptionally responsive to a change in price.

3. Relatively elastic

4. Relatively inelastic

3. The value is more than 1 but less than infinity 3. The value is more than 1 but less than infinity. The demand is responsive to a change in price. To improve revenue, always decrease price, never increase. 4. The value is less than 1 but more than 0. Demand is very unresponsive to changes in price. To improve revenue, increase price only.

5. Unitary elasticity The value is 1 – no more and no less. The responsiveness of demand is proportionate or equal to the change in price. Price changes have no effect on revenue.

Factors influencing the Price elasticity of demand Every product has a different PED. The reasons for this are due to the following variables: The proportion of income spent on the product Time Availability of substitute products Addictive and irreplaceable products.

Price elasticity of Supply Price elasticity of supply (PES) measures the responsiveness of supply to a change in price. The formula for calculating PES is: PRICE ELASTICITY OF SUPPLY = percentage change quantity supplied percentage change in price

Factors influencing the PES: Number of suppliers in the market Where only a few suppliers of a product exist, price increases are not followed by large increases in the quantity supplied. Time taken to produce the product Agricultural produce which requires sun, rain and a germination period as well as products which require complicated technology eg locating oil, will result in the output being less responsive to changes in price.

Other elasticities: income elasticity and cross price elasticity of demand The demand for goods and services is affected by numerous factors in addition to the price of the product itself. Some goods are so luxurious that their demand rises and falls as the general level of income rises and falls. Other goods have their demand being affected by the demand for substitutes and complementary goods.

Income elasticity of demand (YED): YED measures the responsiveness of demand to a change in income. The formula is as follows: YED = percentage change quantity demanded percentage change in income

When the economy is experiencing prosperity and employment is high, the number of people earning an income rises. This increase in the general income level results in certain types of goods rising in proportion (by the same amount) or even disproportionately (by a bigger or smaller amount). A supermarket which stocks two very similar types of goods will find the following changes in demand for these goods when incomes rise.

Cross price elasticity of demand (CPED) The following formula is used to determine whether goods are substitutes or complements. Substitutes  CPED = % change quantity demanded of Good A % change in price of Good B When goods are in competition with each other, their respective demand is affected by the price of each others goods. This is the case with substitutes eg Coke and Pepsi or Toyota and Ford. the fact that the answer is preceded by a plus (+) sign = substitute

Complements Another type of demand relationship is when two goods are used together or in conjunction with each other. As complementary goods need to be used together to achieve the maximum utility, their demand will be affected by changes in the price of each. When the CPED for two products is preceded by a minus (-) sign, the goods in question are complements.