hl2 economics review of elasticity an introduction to elasticity

HL2 ECONOMICS REVIEW OF ELASTICITY

An Introduction to Elasticity

SUPPLY & DEMAND

• Businesses supply to a market and consumers demand a product.

• Both parties will be strongly affected by price• If the price increases, businesses will have an

incentive to increase production to gain from the higher prices on offer.

• Conversely higher prices are likely to reduce demand for a product as consumers choose not to purchase it or buy a cheaper substitute instead.

SUPPLY & DEMAND

• Market forces work to push the price to an equilibrium level that satisfies customers and producers of goods and services.

• Eg: Suppose the price is too high: the plan of gaining a high price will incentivize lots of production by businesses, but they will be left with excess stock as there will be insufficient demand at the higher price

• The business with leftover stock will then drop the price until they have managed to sell off all their excess stock – where the price has fallen to where demand equals supply.

• This is known as the “invisible hand” of the market and was first discussed by Adam Smith, a Scottish economist in the 18th century.

SUPPLY & DEMAND

• Other parts of the marketing mix will also affect supply and demand

• An effective advertising campaign would be likely to increase demand for a product at any price level, which would be likely to push equilibrium prices up.

• Supply shortages can also lead to prices increasing beyond the recommended retail price.

SUPPLY & DEMAND

Case Study-Nintendo Wii Consoles – 2007• Nintendo Wii consoles were in very short supply in

Europe in late 2008 due to huge demand for the product.

• In the run up to Christmas 2007, some people who managed to get hold of consoles managed to sell then to other customers on auction sites such as eBay at significantly higher prices than consoles would sell in the shops.

• The market forces were pushing the price to its true equilibrium, despite the shops only selling the consoles at the lower recommended retail price.

ELASTICITY Price Elasticity of Demand (PED)

• PED measures how sensitive the quantity demanded is to changes in the price.

• You would expect the demand for most goods to fall as the price increases, but PED measures how much of a fall is likely.

• It is important to distinguish between elastic and inelastic demand.


Formula for PED:% change in quantity demanded% change in price

How do we calculate the % change???Change in QuantityOriginal Quantity ________________ (divided by)

Change in PriceOriginal Price

PED Example

• The price of a popular chocolate bar increases from $3 to $4 per bar.

• The quantity demanded per week falls from 10000 bars to 9000 bars.

• Calculate the PED.Change in Quantity = 1000Original Quantity 10000 = .1 .1__ .333 = .3Change in Price = 1 = .3333 Original Price 3

What does this number mean ? – the product is inelastic.What does inelastic mean? Read on!


Elastic Demand• A small change in prices results in a relatively

larger change in the quantity demanded.• Eg: If the price of a textbook increases by 10%

and as result demands fall by 30%, demand is said to be elastic.

• Demand is price elastic if the value calculated is more than 1. Therefore using our formula:

30 / 10 = 3


Inelastic Demand• A relatively large change in price, led to a smaller

change in the quantity demanded. • If the price of a product increases by 10% and demand

only falls by 1%, then demand is said to be inelastic. • The same is of course true, for price drops, leading to a

rise in demand. • Demand is inelastic if the figure calculated is less than

1. Therefore using our formula: 1/10 = .1 • Our chocolate bar was an example of an inelastic good.


Unitary Elasticity • If PED is exactly 1, this is know as unitary

elasticity, which means that a change in price will lead to an identical change in quantity demanded.


The Importance of PED for Business• It is useful for business to look at PED when

deciding whether or not to change the price.• Revenue (price x quantity) will be affected by

any change in price, but how it is affected depends on whether a product is elastic or inelastic.


PED is Inelastic (less than 1) = Business Can Increase Revenue by Increasing Price

• They will lose some revenue from quantity demanded, but will gain more revenue from the higher prices, as demand changes less than proportionally to the change in price.


PED is Elastic (Greater than 1) =Businesses Can Increase Revenue by Lowering Prices

They will lose some revenue from the lower prices, but will gain more revenue from the higher quantity demanded, as demand changes more than proportionally to the change in price

This means that businesses must be careful to interpret their sales data correctly before making decisions on price changes.

PED EXERCISES (1)

American Airlines (AA) decides to increase its airfares on the Caracas to Miami route from $400 one way to $600 one way during December and January. Weekly demands for the seats at this price level falls from 10000 per week to 9000 per week.• Calculate the Price Elasticity of Demand (PED)• Explain what the number means – are airfares on

this route at this time elastic or inelastic??• From a revenue perspective was this a wise and

smart decision for AA.

PED EXERCISE (2)

APPLE decides to decrease the selling price of its basic IPAD from $499 to $399. Weekly demand in a specific market increases from 10,000 units to 11,000 units. • Calculate the Price Elasticity of Demand • Explain what this number means• From a revenue perspective, was this a wise/

smart decision for APPLE.

ELASTICITYIncome Elasticity of Demand (YED)

• YED measures the change in demand for a product if there is a change in consumers income.


Formula:% Change in Quantity Demanded% Change in Income

How do we calculate the % change???Change in QuantityOriginal Quantity ________________ (divided by)

Change in IncomeOriginal Income


Elastic Income Demand• If demand is more than proportionally affected by

a change in income it is elastic.• If incomes rises by 5% and demand increases by

20% it clearly is elastic. • Income elastic goods are known as luxury goods. • Expense jewelry is a good example – demand will

be significantly affected by changes in income.


• You would expect most goods to have a positive relationship to income with demand rising as income rises.

• After all, if you have more money you will spend more. However, we need to distinguish between two different types of goods:

Normal Goods Inferior Goods


Normal Goods• Normal goods which will have a positive YED, because

more is demanded as income rises – both the top and bottom of the calculation will have the same size.

Inferior Goods• Demand actually falls as income rises.• The best examples are the low cost value ranges

stocked by most supermarkets. • As income rises, instead of customers buying more of

these products, they may choose to swap to a higher quality or brand alternative.


Inferior Goods• These products are extremely popular in times of

recession and when incomes are falling, but are quickly abandoned once incomes and employment start to rise.

• The success of low cost chains across Europe such as Lidl and Aldi will increase as the global economy tips into a recession.

• As demand falls when income rises, the top and bottom of the equation will have different signs and therefore have a negative YED.

Income Elasticity of Demand (YED)Exercise

The average middle income salary increases from $50,000 to $70,000. The amount spent by these consumers on restaurant meals (fine dining) increases from $80 per week to $150.• Calculate the YED.• Explain the meaning of the number.• Are restaurant meals a normal or an inferior

good? Why?

ELASTICITY Cross Elasticity of Demand (XED)

• XED is a measure of responsiveness of change in the demand of one product to the change in the price of another (a complement or a substitute).


The formula is: % Change in Quantity Demanded of Product A% Change in the Price of Product B

How do we calculate the % change???Change in Quantity AOriginal Quantity A________________ (divided by)

Change in Price of Product BOriginal Price of Product B


Substitutes • Products that can replace each other

(substitutes) will have a positive XED – the price of butter goes up, demand for margarine will increase as some people choose to swap to the option that has become relatively cheaper.


Complements• Products that are linked (complements) have a

negative XED – as the price of airfares increases, the demand for hotels in resort locations may go down.


No Relationship Between Goods• Goods with no relationship will have an XED of

zero – for example if the price of cars increases, demand for cheese will remain unchanged.


What does the number mean?• The higher the number calculated, the stronger

relationship between the products, whether a complement or a substitute.

Examples• Coke and Pepsi are likely to have a very high, positive

XED as they are very close substitutes. • Coke and Spirit will still have a positive XED, but it is

likely to be lower, as Spirit is alternative soft drink, but not quite as close a match as another Cola.

Cross Elasticity of Demand (XED)Exercise

The number of subscribers to Super Cable increases from 10,000 per month in September to 11,000 per month in October. During October Direct TV decided to increase the cost of platinum TV package (all channels) from $60 per month to $80 per month.• Calculate XED• Explain the meaning of the number.

hl2 economics review of elasticity an introduction to elasticity

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