1. Price, Income and Cross Elasticity

2. Elasticity – the concept
The responsiveness of one variable to changes in another
When price rises, what happens to demand?
Demand falls
BUT!
How much does demand fall?

3. Elasticity – the concept
If price rises by 10% - what happens to demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which demand will change

4. Elasticity 4 basic types used: Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity

5. Elasticity Price Elasticity of Demand
The responsiveness of demand to changes in price
Where % change in demand is greater than % change in price – elastic
Where % change in demand is less than % change in price - inelastic

6. Elasticity The Formula: % Change in Quantity Demanded
___________________________
Ped =
% 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.
Quantity Demanded

8. Elasticity Total Revenue Price £5 D 100 Quantity Demanded (000s)
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.
The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5
Total Revenue D
100
Quantity Demanded (000s)

9. Elasticity D Total Revenue Price £5 £3 100 140
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 £3
Total Revenue D
100
140
Quantity Demanded (000s)

10. Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20%
Producer decides to lower price to attract sales 10
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall 5
Not a good move! D 5 6
Quantity Demanded

11. Elasticity Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises 10
Good Move! 7 D 5 20
Quantity Demanded

12. Elasticity If demand is price elastic:
Increasing price would reduce TR (%Δ Qd > % Δ P)
Reducing price would increase TR
(%Δ Qd > % Δ P)
If demand is price inelastic:
Increasing price would increase TR
(%Δ Qd < % Δ P)
Reducing price would reduce TR (%Δ Qd < % Δ P)

13. Elasticity Income Elasticity of Demand:
The responsiveness of demand to changes in incomes
Normal Good – demand rises as income rises and vice versa
Inferior Good – demand falls as income rises and vice versa

14. Elasticity Income Elasticity of Demand:
A positive sign denotes a normal good
A negative sign denotes an inferior good

15. Elasticity For example:
Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8%
Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%
Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%
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%
This slide has a ten second gap in between each example to allow the teacher to explain how the figures have been calculated. This gap can be increased or reduced as appropriate using the custom animation tool.

16. Elasticity Cross Elasticity:
The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y

17. Elasticity Goods which are complements: Goods which are substitutes:
Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive relationship between the two)

18. Elasticity Price Elasticity of Supply:
The responsiveness of supply to changes in price
If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price
If Pes is elastic – supply can react quickly to changes in price
% Δ Quantity Supplied
____________________
Pes =
% Δ Price

19. Determinants of Elasticity
Time period – the longer the time under consideration the more elastic a good is likely to be
Number and closeness of substitutes – the greater the number of substitutes, the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Luxury or Necessity - for example, addictive drugs

20. Importance of Elasticity
Relationship between changes in price and total revenue
Importance in determining what goods to tax (tax revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course.