Elasticity in Economics
- In general terms, elasticity refers to the responsiveness of one variable to the change in the other.
- There are three elasticities of demand to consider
- Price elasticity of demand PED
- Cross elasticity of demand XED
- Income elasticity of demand YED
Price elasticity of Demand (PED)
- Price elasticity of demand is the measure of responsiveness of demand to changes in price.
- There can be either elastic, inelastic or rarely unitary demand.
- Price elasticity of Demand (PED) = the percentage change in quantity demanded of the product (QD) divided by percentage change in the price of the product (P)
- This equation can be written as PED = %ΔQD/%ΔP
- ΔP = new price - old price
- ΔD = new quantity demanded - old quantity demanded \
- %ΔP = ΔP/old price
- %ΔD = ΔD/old quantity demanded
- Example:
The price of a magazine falls from $5 to $4.5 and the QD increases from 200,000 to 230,000
%ΔQD = ΔQD/QD x 100% = 15%
%ΔP = ΔP/P x 100% = -10%
PED = %ΔQD/%ΔP = -1.5 = 1.5 (the negative is omitted for PED) - The output of the PED calculation is negative due to the inverse relationship between price and demand. An increase in one of the variables results in a decrease of the other.
- However, the negative is omitted for simplicity.
Range Values of PED
Theoretical Values
- Generally values below 1 mean that the demand is inelastic while values over 1 mean that demand is elastic.
- A demand curve with an elasticity of 0 generally isn't possible.
- This is because the demand would always be the same, no matter the price or supply.
- The curve for demand appears as a straight vertical line.
- A demand curve with an elasticity of infinite would mean that only at one point there would be infinite demand, and no demand at all for any other price level.
- The curve for demand would appear as a straight horizontal line.
Elastic Demand
- A certain % change in P leads to a greater % change in QD due to elasticity.
- This occurs if PED > 1.
Inelastic Demand
- A certain % change in price leads to a smaller % change in quantity demanded.
- This occurs if 0 < PED < 1.
Unit Elastic Demand
- If a product has unit elastics demand, changes in the price are proportional but opposite changes in QD.
- For example a 10% decrease in price leads to a 10% decrease in demand.
- This occurs when PED = 1.
- While profit is still unknown, revenue remains the same.
Determinants of PED
- Different products will have different values for PED which there are number of determinants.
1. The Number of Closeness of Substitutes
- Different products have different amounts of substitutes.
- Products with less substitutes will be more inelastic compared to those with more substitutes.
- The defined good has a lot to do with the elasticity. The more specific the good, the more elastic it is, as it has more substitutes.
- For example food is a very inelastic product because there are no alternatives.
- However meat is comparatively more elastic product, as if meat is too expensive people will eat vegetarian food instead.
- Beef is comparatively more elastic as people can switch to eating other meats if beef is more expensive, and vice versa.
- Fray Bentos corned beef is the most elastic out of the listed examples, as if the price were to be raised, then people would switch to alternative brands.
2. Necessity of Product
- Some products such as toilet paper are necessities.
- For example if you have the buy toilet paper and napkins but both face a rise in price, you're likely to keep buying toilet paper but lay off napkins due to toilet paper being more necessary.
- Some products have addictive properties which means that they're very inelastic.
- People are willing pay for these products even if they cost more.
3. Proportion of Income Spent on Goods
- Goods that cost very little and thus constitute a small portion of a person's income tend to have inelastic demand.
- The opposite applies for more expensive goods, which tend to have more elastic demand.
- For example, if the price of coffee increases from $1.50 to $1.65, the price increase is so minimal that you'll likely still buy the same amount of coffee. However, if you were thinking of buying a car which costs $10000 and the price increases by $1000, you will likely look into another car. The demand for the car decreases more relative to the decrease in demand for coffee, even though the percentage increase in price was the same.
4. Time Period Considered
- When their price is changed, some products might be very inelastic at first but become more elastic later on.
- This is because it takes time for people to switch between products.
- For example if the price of iPhones rises by a lot, many users won't immediately switch to Android phones. However, as people change their habits more people might be willing to make the switch, making iPhones more elastic.
Inelastic Goods
- Inelastic goods are products whose demand doesn't change much with changes in price.
Note: A product isn't elastic or inelastic, instead, we say the product has elastic or inelastic demand. This small distinction can save or cost you a lot of points in exams!
- Inelastic goods are generally broad ranges of products or very necessary products such as food or medicine.
- The percentage change in the quantity of a good or service is less than the percentage change in its price.
- They have an elasticity coefficient less than 1.
Elastic Goods
- Products whose demand changes a lot with changes in price are called elastic products.
- They can be products of a specific brand or luxury goods for example.
- Their quantity demanded decreases significantly compared to changes in price unless they are Veblen goods.
- The percentage change in quantity demanded of a good or service is more than the percentage change in its price.
- They have an elasticity coefficient greater than 1.
- Elastic products tend to have the following features:
- Many substitutes
- Luxury goods
- Large portion of income
- Non-Addictive
- Plenty of time to decide, not urgent to purchase.
Unitary Elastic Goods
- The percentage change in quantity demanded is equal to the percentage change in price.
- This rarely ever occurs in real life or in economic models.
- The elasticity coefficient is exactly 1.
- %ΔQD = %ΔP
Uses of PED
- Knowing PED can be essential for guidance in making choices for firms and governments.
- Firms can use PED to determine the effects of their pricing decisions on quantity demanded and on total revenue.
- For example a firm selling insulin medications might want to increase their price if they know that their product is inelastic, as it would lead to an increase in total revenue.
- For governments, they need to be aware of the consequences on various economic variables that are caused by the imposition of indirect taxes (taxes that affect the price of products).
- For example, if the government wants to increase the taxes imposed on a certain product. However, if that product is elastic, then the resulting increase in price from the sales tax would cause a large decrease on demand. This might actually end up reducing the tax revenue the government earns from said product.
- Imposing taxes on an elastic good might also increase unemployment, due to the large drop in the workers demanded for the production of the good.
- Governments might prefer imposing taxes on inelastic products, as the small change in demand would result in an increase in tax revenue and likely not a large increase in unemployment.
PED of Primary Commodities and Manufactured Products
- Primary commodities are raw materials, such as cotton or coffee beans.
- Primary commodities tend to be inelastic as many manufacturers require them, meaning they have a high necessity.
- Additionally as primary commodities tend to have a wide range of uses, their substitutes are harder to come across.
- A increase in price results in a small decrease in demand, as the manufacturers that process the good don't have many substitutes for it. An decrease in price doesn't result in a large increase in demand, as most manufacturers have already set production quotas or aren't willing or able to make the accommodations for processing more materials due to marginal costs.
- Manufacturers process primary commodities into manufactured goods, which tend to be elastic.
- This is because they usually are produced and sold by various manufacturers and firms meaning they have many substitutes.
Effect of PED on the Demand Curve
- Did you know you can tell whether a product is elastic or inelastic just from a glance at the demand curve? It's true!
- The price elasticity of demand of a good affects the gradient of the curve.
Note: While elasticity affects the gradient of the demand curve, it is not a measure of the gradient. You can tell whether a good is inelastic or elastic based on the gradient, but you cannot calculate the gradient by using the elasticity coefficient or vice versa.
- Products with inelastic demand will have a steeper curve.
- Products with elastic demand will less of a slope.
- Lastly, products with unitary elastic demand, will have a curve at a 45 degree angle to either axis.
Change of PED Along the Demand Curve
Warning: You are entering HL territory!
- While the slope of the demand curve can show the elasticity, elasticity also varies depending on the point you are on in the curve.
- PED equals 1 when moving to the middle point of the curve.
- Moving along any two points in the upper half of the curve yields a PED coefficient greater than 1.
- Moving along any two points in the lower half of the curve yields a PED coefficient less than 1.
- This means a product is more elastic with higher prices and more inelastic with lower prices.
Image Sources
https://www.coursesidekick.com/economics/study-guides/boundless-economics/price-elasticity-of-demand
https://www.intelligenteconomist.com/price-elasticity-of-demand/