Notes: Grade 12

The law of demand states that theres an inverse relationship between price and quantity demanded but this is not sufficient. We know that when price falls the quantity demanded increases but not by how much or by what percentage. Firms need to know when they change prices by a given percentage by what percentage will quantity demanded change. To answer this question, Economists have developed a concept known as Elasticity of Demand. The elasticity concept represents the percentage change in one variable versus the percentage change in another variable. Elucidating, the concept of elasticity relates to the responsiveness of one variable (A) to a percentage change in another variable (B). Price Elasticity of Demand (PED) measures how responsive is the quantity demanded of one product to a change in the price of that product, ceteris paribus.

Example 1: The price of a product falls from $40 to $30 and the quantity demanded increases from 100 to 150 units. Calculate the PED.

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When the elasticity formula is applied we obtain a coefficient of elasticity. If the calculated coefficient is: i. Greater than unit (1), demand is said to be elastic. When demand is elastic the percentage change in quantity demanded is greater than the percentage change in price. In other words, the quantity demanded is very responsiveness to a one percent change in price.

ii.

Less than one, demand is considered inelastic.

When demand is inelastic the percentage change in quantity demanded is less than the percentage change in price. In other words, the quantity demanded is not very responsiveness to a one percent change in price.

iii.

Equal to one, demand is said to unitary-elastic (unit elastic).

Note that the negative sign on the price elasticity of demand is indicative of a negative (or inverse) relationship between price and quantity demanded, that is, as price goes up, the quantity demanded goes down. Conventionally, economists refer to PED in absolute terms by ignoring the negative sign on the coefficient.

GRAPHICALLY Price Elastic - PED > 1 A 1 per cent change in price will cause a greater than 1% change in quantity demanded. Price
P2

P1

Q2

Q1

Quantity

The figure above shows a fairly elastic demand curve where the PED is greater than 1 but less than infinity. Here demand is elastic as the percentage change in Q is greater than the

percentage change in P. The increase in price from P1 to P2 causes a decrease in quantity demanded from Q1 to Q2.

Price Inelastic PED < 1 A 1 per cent change in price will cause a less than 1% change in quantity demanded.

Price

P2 P1

D Q2 Q1

Quantity

The figure above shows a fairly inelastic demand curve where the PED is less than 1. The increase in price from P1 to P2 causes a decrease in quantity demanded from Q1 to Q2. Here demand is inelastic as the percentage change in Q is less than the percentage change in P. Goods that are necessities also exhibit the characteristics of price inequality. Special Cases I. Price Perfect Elasticity

P*

Q1

Q2

Q3

Q4

Quantity

Perfectly Elastic demand indicated that or below the market price, P*, an infinite amount of the product will be purchased but above that price none will be purchased. When there is an increase in the price, the quantity demanded would fall from such a large amount to zero. Considering the demand curve above, assume that P* is equal to $10. Then above that price of $10 no one would be willing to purchase any of this product. However, if price were to fall, to say $9, they would buy all that is available. The relative change in demand here yields the following:

II. Price

Perfect inelasticity

P4 P3 P2 P1

Quantity

Demand being perfectly inelastic indicates that regardless of the price limit the same quantity will be purchased. An example of this is insulin which is used to treat Diabetes - in this case the patient purchases a dose of insulin regardless of the price. In this case the calculated PED will be equal to zero.1

Note that the PED of demand takes on mathematical values from 0 to

Calculation: In this case, an increase in the price of insulin from $10 to $11 yields the following:

Factors affecting Elasticity of Demand 1. The number of substitutes a product has. The less substitutes the less elastic the demand 2. The percentage of consumers income that is spent on the product. The higher the share of consumers income that is spent on the product the more elastic will be the demand. On the other hand, if it accounts for a small share of the consumers income it will be more inelastic. 3. Time In the short run horizon, possibly weeks or months, people may find it harder to change their spending pattern (hence not very responsive to a change in price). However, if the price of a product goes up and stays up, then over time people will find way of adapting or adjusting (find substitutes, for example), so PED is likely to become more elastic over time. 4. Whether the item is a luxury or necessity Necessity Price elasticity of demand will tend to be inelastic as one person cannot do without it. Luxury The individual can do without consuming this product. 5. The extent to which the productive is addictive The more addictive the product, the more inelastic will be its elasticity of demand. 6. Number of uses The more uses the product has the more elastic its elasticity of demand. 7. How broadly/narrowly the product is defined If the product is broadly defined it will be inelastic but if it is narrowly defined the demand will tend to be elastic.

Price Elasticity of Demand and Total Revenue

Where P is Price and Q is quantity. If a firms product demand is elastic the firm can increase its total revenue by reducing prices. If the firm increases its prices, it total revenue will fall. If the demand is inelastic, then the firm can increase its total revenue by increasing prices, if the firm were to reduce its prices its total revenue will decrease. If the demand is unitary elastic a price increase/reduction will leave total revenue unchanged.

Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the demand of a product to a change in income. It is merely the ratio of the percentage change in demand to the percentage change in income.

Note that unlike in the case of the PED, the sign of the coefficients whether negative (-) or (+) is very important in our analysis and interpretation. Scenarios and Explanations A. say +2.5

Then in situation A. demand is income elastic. This means that a 1% increase (decrease) in income (Y) will lead to a 2.5% increase (reduction) in demand for that product. The positive sign (+) indicated that as income increases the demand for the product increases. This is called a normal good. B. say +1

This is unitary elastic demand as a 1% change (increase/decrease) in income leads to a 1% change (increase/decrease) in demand. This product is a normal good as indicated by the positive sign on its coefficient. C. say +0.8

This is income inelastic as a 1% change in income will lead to a 0.8% change in demand. Analogously, a 1% decrease in income leads to a 0.8% decrease in demand. This product is a normal good.

All products having a negative income elasticity sign are called inferior goods. Scenarios and Explanations A. This means that a 1% increase (decrease) in income will lead to a 1.9% decrease (increase) in the demand. Note also that the demand for this product is also income elastic. B. This means that a 1% increase (decrease) in income will lead to a 1% decrease (increase) in the demand. Note also that the product has unitary income elasticity. C. This means that a 1% increase (decrease) in income will lead to a 0.6% decrease (increase) in the demand. Note also that the demand for this product is income inelastic.

Special Case

This means that income is perfectly income unitary elastic. This means that a 1% increase in income leads to a 0% increase in the products demand. For example Salt, if a persons income increases then the amount of salt that they purchase tends to remain the same.

Note: Normal goods are those which as income increases (decrease), the demand increase (decrease). In other words, there is a positive relation between the changes in income and the changes in demand. These normal goods can be income elastic, inelastic or unitary elastic. Those goods that have a positive income elastic demand are called luxury goods.

Income Elasticity and the firm When income has increased the demand for all normal goods will increase. Where demand is: i. Income elastic by definition, the percentage change in demand is greater than the percentage change in income. Firms selling these normal goods that are elastic will their sales increasing and ceteris paribus, will expand production. ii. Firms selling a normal good that is income unitary elastic will experience an increase in demand by the same percentage at which income has increased. Therefore the firms revenue will increase by the same percentage as the increase in income. iii. Firms selling a product that is income inelastic will experience an increase in demand or revenue but by a smaller percentage than the increase in income. For all inferior goods an increase in income will lead to a decrease in demand. Firms selling an inferior good that is also elastic will fair-off worse because by definition the percentage change in demand is greater than the change in income. The firms revenue would decrease substantially.

 The firm selling an inferior good that is unitary elastic will experience a fall in demand equal to the increase in income. Firms selling an inferior good that is inelastic will not fair off so badly since by definition the percentage change in demand is less than the increase in income.

Cross Elasticity of Demand

Cross elasticity of demand measures how responsive is the demand of one product (A) to a change in the price of another product (B).

E.g.: The price of beef has increased from $40 to $50 per lbs and the quantity demanded for pork has increase from 20 to 30 lbs.

The cross elasticity of demand coefficient is 0.8. This means that demand is inelastic and that the two (2) products are substitutes since they have a positive (+) coefficient of elasticity. If the price of beef had fallen then the quantity demanded for pork would have also fallen. This negative price change and negative change in quantity demanded would yield the positive coefficient as in our example above. When the coefficient of the XED is negative (-) the two products are complementary goods (complements). That is, an increase in the price of one will lead to a decrease in the quantity demanded of the other and vice versa. When the XED = 0, it means that a change in the price of one product will have no effect on the quantity demanded of the other. This means that the two products are non-related.

The importance of knowledge of cross elasticity to managers of firms Foreword Many companies are concerned with the impact that rival pricing strategies will have, ceteris paribus, on the demand for their product. Recall that substitutes are characterized by a positive XED: the higher the numerical value, the greater the degree of substitutability between these alternatives in the eyes of the consumer. In such cases there is a high degree of interdependence between suppliers, and the dangers of a rival cutting price are likely to be very significant indeed. Companies are increasingly concerned with the trying to get consumers to buy not just one of their products but a whole range of complementary ones, for example computer printers and the print cartridges. XED will identify those products that are most complementary and help a company introduce a pricing structure that generates more revenue. For instance, market research may indicate that families spend most money at the cinema when special deals are offered on ticket prices, even though the PED for ticket prices is low. In this case for example, the high negative cross elasticity between ticket prices and the demand for food, such as ice cream and popcorn, means that, although the revenue from ticket sales may fall, this may be compensated for by increased sales of food. This points to the need for a more sophisticated pricing structure within the cinema looking at the relationships between the demand for all products and services offered. Extracted from Economics for CAPE- Colin Bamford & Narissa Mohammed Major issues: whether the products are substitutes/complements A. Substitutes: (+) (Assuming a price increase)

Once the two products are substitutes and the price of the other has increased, then the firm selling the product whose price has remained unchanged will stand to benefit in terms of increased sales. Assuming that: XED > 1 The demand here is cross elastic. The percentage increase in sales will be greater than the percentage increase in the rival product. This would offer the best case scenario for the firm.

 XED = 1 The demand here is cross unitary elastic. The percentage increase in demand or sales would be equal to the percentage increase in demand or sales would be equal to the percentage increase in the price of the related products. When XED < 1 The demand here is cross inelastic. The percentage increase in demand or sales would be less than the percentage increase in the price of the related products.

B. Complements: (+)

(Assuming a price increase)

If two products are complements and the price of one has increased the demand for both will decrease. XED > -1 When two products are complements and demand is cross elastic, the percentage fall in demand will be greater than the percentage increase in the price of the related goods. XED < -1 Here the XED is negative and inelastic. The percentage fall in demand will be less than the percentage increase in the price of the complementary good. XED = -1 The percentage fall in demand is equal to the percentage increase in the price of the complementary good.