Elasticity

Elasticity is a central concept in economics, and is applied in many situations. Basic demand and supply
analysis tell us that economic variables, like price, income and demand, are causally related. Elasticity
can provide important information about the strength or weakness of such relationships.

Elasticity refers to the responsiveness of one economic variable, such as quantity demanded, to a
change in another variable, such as price.

Types of elasticity

There are four types of elasticity, each one measuring the relationship between two significant
economic variables. They are:

Price elasticity of demand (PED), which measures the responsiveness of the quantity demanded to a
change in price. PED can be measured over a price range, called arc elasticity, or at one point,
called point elasticity. Price Elasticity of Demand = % Change in Quantity Demanded / % Change in
Price

The following equation enables PED to be calculated.

% change in quantity demanded% change in price

We can use this equation to calculate the effect of price changes on quantity demanded, and on
the revenue received by firms before and after any price change.

For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls
from 500,000 to 250,000, the PED will be:- 50+20=(-) 2.5

The negative sign indicates that P and Q are inversely related, which we would expect for most
price/demand relationships. This is significant because the newspaper supplier can calculate or estimate
how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x
500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The key
benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If
quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’.

PED can also be:

 Less than one, which means PED is inelastic.

 Greater than one, which is elastic.

 Zero (0), which is perfectly inelastic.

 Infinite (∞), which is perfectly elastic.

PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to
right. PED = 1 at the midpoint of a linear demand curve.

PED and revenue

There is a precise mathematical connection between PED and a firm’s revenue.

There are three ‘types’ of revenue:

1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).

2. Average revenue (AR), which is found by dividing total revenue by quantity sold (TR/Q). Consider
these figures and calculate Total, Marginal and Average Revenue.

3. Marginal revenue (MR), which is defined as the revenue from selling one extra unit. This is
calculated by finding the change in TR from selling one more unit.
 PRICE (£) Qd TR MR AR

10 1      

9 2      

8 3      

7 4      

6 5      

5 6      

4 7      

3 8      

2 9      

1 10      

Answer

Study the patterns of numbers and see if you can analyse the relationships between the three measures
of revenue – then answer the following:

1. How are price and average revenue connected?

2. What happens to total revenue as output increases?

3. What is the connection between total revenue and marginal revenue?

4. How are marginal revenue and average revenue connected?

When TR is at a maximum, MR = zero, and PED = 1.

1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P.

2. A curve plotting AR (=P) against Q is also a firm’s demand curve.

3. TR increases, reaches a peak and decreases.

Why does a firm want to know PED?

There are several reasons why firms gather information about the PED of its products. A firm will know
much more about its internal operations and product costs than it will about its external environment.
Therefore, gathering data on how consumers respond to changes in price can help reduce risk and
uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price.

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total
revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will
lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to
£10,800.

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate.
Price discrimination is a policy of charging consumers different prices for the same product. If demand is
elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.

Non-pricing policy
When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce
elasticity.

Determinants of PED

There are several reasons why consumers may respond elastically or inelastically to a price change,
including:

The number and ‘closeness’ of substitutes

A unique and desirable product is likely to exhibit an inelastic demand with respect to price.

The degree of necessity of the good

A necessity like bread will be demanded inelastically with respect to price.

Whether the good is habit forming

Consumers are also relatively insensitive to changes in the price of habitually demanded products.

The proportion of consumer income which is spent on the good

The PED for a daily newspaper is likely to be much lower than that for a new car!

Whether consumers are loyal to the brand

Brand loyalty reduces sensitivity to price changes and reduces PED.

Life cycle of product

PED will vary according to where the product is in its life cycle. When new products are launched, there
are often very few competitors and PED is relatively inelastic. As other firms launch similar products, the
wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become
very responsive to price, hence discounting is extremely common.

Price elasticity of supply (PES), which measures the responsiveness of the quantity supplied to a change
in price.

% change in quantity supplied% change in price

While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to
infinite, perfectly elastic.

A firm’s market price increases from £1 to £1.10, and its supply increases from 10m to 12.5m. PES is:

+ 25+10=(+) 2.5

The positive sign reflects the fact that higher prices will act an incentive to supply more. Because the
coefficient is greater than one, PES is elastic and the firm is responsive to changes in price. This will give
it a competitive advantage over its rivals.

Extreme cases
There are three extreme cases of PES.

1. Perfectly elastic, where supply is infinite at any one price.

2. Perfectly inelastic, where only one quantity can be supplied.

3. Unit elasticity, which graphically is shown as a linear supply curve coming from the origin.

Determinants of PES

How firms respond to changes in market conditions, especially price, is an important consideration for
the firm itself, and to an understanding of how markets work.

The key considerations are:

1. Are resource inputs readily available?

2. Are factors mobile - are workers prepared to move to where they are needed?

3. Can finished products be easily stored, and are there existing stocks?

4. Is production running at full capacity?

5. How long and complex is the production cycle or production process?

What is the most desirable PES for a firm?

Improving PES

Because a high PES is desirable, it may be necessary for firms to undertake actions that improve their
speed of response to changes in market conditions. Examples of these actions include:

1. Creating spare capacity

2. Using the latest technology

3. Keeping sufficient stocks

4. Developing better storage systems

5. Prolonging the shelf life of products

6. Developing better distribution systems

7. Providing training for workers

8. Having flexible workers who can do a range of jobs

9. Locating production near to the market

10. Allowing inward migration of labour if there is a labour shortage

Cross elasticity of demand (XED), which measures the responsiveness of the quantity demanded of one
good, good X, to a change in the price  of another good, good Y.

Cross elasticity of demand

Cross elasticity of demand (XED) is the responsiveness of demand for one product to a change in the
price of another product. Many products are related, and XED indicates just how they are related.

The following equation enables XED to be calculated.

% change in quantity demanded (good A)% change in price (good B)

Substitutes

When XED is positive, the related goods are substitutes. For example, if the price of Coca Cola increases
from 50p to 60p per can, and the demand for Pepsi Cola increases from 1m to 2m per year, the XED
between the two products is:

+100+20=(+) 5.0

The positive sign means that the two goods are substitutes, and because the coefficient is greater than
one, they are regarded as close substitutes.

Complements
When XED is negative, the goods are complementary products. The equation is the same as for
substitutes.

For example, if the price of Cinema Tickets increases from £5.00 to £7.50, and the demand for Popcorn
decreases from 1000 tubs to 700, the XED between the two products will be:

- 30+ 50=(-) 0.6

The negative sign means that the two goods are complements, and the coefficient is less than one,
indicating that they are not particularly complementary.

Why does a firm want to know XED?

1. Knowing the XED of its own and other related products enables the firm to map out its market.
Mapping allows a firm to calculate how many rivals it has, and how close they are. It also allows
the firm to measure how important its complementary products are to its own products.

2. This knowledge allows the firm to develop strategies to reduce its exposure to the risks
associated with price changes by other firms, such as a rise in the price of a complement or a fall
in the price of a substitute.

3. Risks can be reduced in a number of ways, including adopting the following strategies:

Horizontal integration

Horizontal integration usually means merging with a rival, such as the merger of brewing

Vertical integration

Vertical integration means merging with a complement producer, such as a record producer merging
with or taking over a record store, or radio station.

Alliances and collusion

Joint alliances with competitors can also take place, such as Sony-Ericssoncombining resources to create
mobile phones.

Collusion is also a possibility. For example, firms may enter into price fixing agreements so that they
avoid having to fight a price war. This is more likely to occur in oligopolistic markets, where there are
only a few competitors.

Income elasticity of demand (YED), which measures the responsiveness of the quantity demanded to a
change in consumer incomes.
Income is an important determinant of consumer demand, and YED shows precisely the extent to which
changes in income lead to changes in demand. YED can be calculated using the following equation:

% change in quantity demanded% change in income

Normal goods

When the equation gives a positive result, the good is a normal good. A normal good is one where
demand is directly proportional to income. For example, if, following an increase in income from
£40,000 to £50,000, an individual consumer buys 40 DVD films per year, instead of 20, then the
coefficient is:

+ 100+ 25=(+) 4.0

The positive sign means that the good is a normal good, and because the coefficient is greater than one,
demand for the good responds more than proportionately to a change in income. This indicates the
good is not a necessity like food, and would be considered a relative luxury for this individual.

Inferior goods

When YED is negative, the good is classified as inferior. For example, if, following an increase in income
from £40,000 to £50,000, a consumer buys 180 loaves of bread per year instead of 200, then the YED is:

- 10+ 25=(-) 0.4

The negative sign means that the good is inferior, and, because the coefficient is less than one, demand
for the good does not respond significantly to a change in income. This indicates that the good is not
particularly inferior compared with a good which has a YED of  > (-)1.

The sign and the number provide different information about the relationship between income and
demand. Income elasticity of demand can also be illustrated byEngel curves.

Why does a firm want to know YED?

There several reasons why a firm would want to know YED, including the following:

Sales forecasting

A firm can forecast the impact of a change in income on sales volume (Q), and sales revenue (P x Q).

For example, a hypothetical car manufacturer has calculated that YED with respect to its luxury car is (+)
3.8, and it has also undertaken research to discover that consumer incomes will rise by 2% next year. It
can now predict the impact of this change.

Exercise

Using the YED equation, calculate the effect on sales.

The same producer sells a small car with a YED of (-) 5.  Using the YED equation, and assuming income
also increases by 2%, calculate the effect on sales. 

Answers 

Pricing policy
Knowing YED helps the firm decide whether to raise or lower price following a change in consumer
incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the
reduction in demand.

Diversification

Firms can diversify and offer a range of goods with different YEDs to spread the risks associated with
changes in the level of national income. For example, a car manufacturer may produce cars with a range
of YED values, so that sales are stabilised as the economy grows and declines.

YED and the business cycle

Changes in real national income tend to be cyclical. The demand for normal goods increases when the
economy is expanding, but decreases when the economy is contracting. Conversely, the demand for
inferior goods is counter-cyclical.

The higher the positive value for YED, the greater the effect of a change in national income on consumer
demand.