Chapter 8: Price Elasticity, Income Elasticity, and Cross Elasticity of Demand PDF

## Chapter 8: Price Elasticity, Income Elasticity, and Cross Elasticity of Demand ### Learning Intentions - Define the meaning of price elasticity, income elasticity, and cross elasticity of demand (PED, YED, XED). - Use formulas to calculate price elasticity, income elasticity, and cross elastic...

## Chapter 8: Price Elasticity, Income Elasticity, and Cross Elasticity of Demand ### Learning Intentions - Define the meaning of price elasticity, income elasticity, and cross elasticity of demand (PED, YED, XED). - Use formulas to calculate price elasticity, income elasticity, and cross elasticity of demand. - Explain the importance of relative percentage changes, the size and sign of the coefficient in relation to price elasticity, income elasticity, and cross elasticity of demand. - Describe elasticity values: perfectly elastic, (highly) elastic, unitary elasticity, (highly) inelastic, perfectly inelastic. - Explain the variation in price elasticity of demand along the length of a straight-line demand curve. - Analyze the factors that affect price, income, and cross elasticity of demand. - Analyze the relationship between price elasticity of demand and total expenditure on a product. - Discuss how price, income, and cross elasticity of demand can affect decision-making. ### Economics in Context: India's Jet Airways Grounded In 2019, the aviation industry in Asia experienced soaring growth, particularly in India. Competition is fierce with low fares on internal routes and heavy losses due to low fares and competition from Indian Railways. In 2019, Jet Airways, the second-largest airline in India, was the latest casualty in a series of airline failures. The abrupt stoppage of domestic and international routes had a significant impact on the livelihoods of 23,000 workers and those employed in support services. ### 8.1 What Do Economists Mean by Elasticity? Understanding the general direction of any change in price and its effect on the quantity demanded or supplied isn’t enough. When analyzing these changes, it's crucial to consider the extent of any change in price and its effect on the quantity demanded and supplied. For example, a small change in the price of rice may have a minor impact on quantity demanded, whereas a small change in the price of tea, which has close substitutes, may have a much larger effect. The same goes for income changes; there may be little effect on the demand for some products and a much greater effect on the demand for others. **Elasticity** measures the responsiveness of one variable to a change in another variable. It's used to measure how much quantity demanded for a product changes after a change in another variable, such as the price or income. The extent of any change is important. If a small change in price or income produces a bigger change in the quantity demanded, the relationship between price/income and quantity demanded is **elastic**. If a large change in price or income produces only a small change in the quantity demanded, the relationship is **inelastic**. These definitions and examples highlight how firms respond to changes in the market. Businesses need to understand how the quantity demanded for a good or product responds not only to a change in its price but also to a change in the income of consumers or the prices of substitutes and complements. ###### Key Concept Links: Margin and Decision-making, Time The concept of elasticity deals with **change** in the market, particularly how individuals, firms, and governments make choices after that change has occurred. The source of change is usually over time and is due to changes in the factors that determine (affect) the demand for products, such as their prices, incomes, or the prices of competitors' products. ### 8.2 Price Elasticity of Demand **Price elasticity of demand (PED)** measures the responsiveness of quantity demanded for a product following a change in its price. In other words, PED describes how quantity demanded is affected by a change in a product's price, assuming all other factors remain unchanged. If demand is **price elastic**, then a small change in price will result in a relatively larger change in quantity demanded. If demand is **price inelastic**, then there is a large change in price and a far smaller change in quantity demanded. PED can be calculated by dividing the percentage change in quantity demanded by the percentage change in price. PED = (Percentage change in quantity demanded)/(Percentage change in price) For example, assume product A and B are both priced at $100 and have demand of 1,000 units per month. An increase in price to $105 results in a quantity demanded decrease of 990 for product A and 900 for product B. - Product A: a decrease of 10 units from 1,000 to 990. - Product B: a decrease of 100 units from 1,000 to 900. Using these values in the PED equation, we can calculate the price elasticity of demand. - Product A: PED = (-0.2)/(0.05) = -4 - Product B: PED = (-2.0)/(0.05) = -40 Both results are negative because of the inverse relationship between price and quantity demanded. As the price goes up, the quantity demanded goes down (and vice versa), but economists typically refer to PED in absolute terms by ignoring the negative sign. In the case of **product A**, the numerical value, 4, is less than 1, indicating that demand is **price inelastic** or *relatively* unresponsive to price changes. The 5% increase in price resulted in a *much* smaller change in quantity demanded. In the case of **product B**, the numerical value of 40 is greater than 1, indicating that demand is **price elastic** or *highly* responsive to price changes. The same 5% price change resulted in a *much* bigger change in quantity demanded. **It's accepted practice to ignore the minus sign when considering estimates of price elasticity of demand.** #### Special PED Values PED values range from 0 to infinity. - **Perfectly inelastic demand** (PED = 0) occurs when consumers are willing and able to buy the same amount of a product regardless of the price charged. The quantity demanded is unresponsive to any change in price. - **Perfectly elastic demand** (PED = infinity) occurs when consumers aren’t willing to buy any of a product at a particular price, but they will buy anything available at a lower price. The relative change in quantity demanded is infinite, since the original demand was zero. - **Unit elasticity** (PED = 1) occurs when the increase in price *exactly* matches the fall in quantity demanded. The specific price range is important. For example, if a product goes from $1 to 1.05 and quantity demanded decreases from 10,000 to 9,500, the PED will equal 1 over that range of prices. *** **Factors Affecting Price Elasticity of Demand** There are three main factors that affect the price elasticity of demand for a product: * **Availability and attractiveness of substitutes.** The greater the number of substitutes available in a market and the more closely substitutable those products are, the more likely it is that consumers will switch away from the product when its price goes up (or towards the product if its price falls). For example, there are many substitutes for canned cola, iced tea, and fruit juices. A small change in price could lead to large changes in what consumers purchase. * **Relative Expense of the Product.** A rise in price reduces the purchasing power of a person’s income and their ability to pay for a product. The larger the proportion of income that price represents, the larger the impact on income due to a change in the product's price. A 10% increase in the price of a flight to Pakistan will have a bigger impact than a 10% rise in the price of a bus trip into town. The greater the relative proportion of income accounted for by a product, the higher the PED. * **Time Period.** In the short run, consumers may find it difficult to change their spending habits. However, in the long run, if the price of a product goes up and stays up, then over time consumers will find ways of adapting and adjusting, so the PED of a product is likely to increase over time. In other words, it changes from being price inelastic to price elastic as consumers look at what else is available in the market. **PED and a Downward-Sloping Linear Demand Curve:** PED is not the same throughout the entire length of the demand curve. - When prices are high and the quantity demanded is low, a large change in price will not be a large percentage change. The percentage change in quantity demanded will be higher, resulting in demand being price elastic on the upper part of the demand curve. - The reverse applies and explains why PED is inelastic in the lower portion of the demand curve. ### 8.3 Income Elasticity of Demand **Income elasticity of demand (YED)** measures the responsiveness of the quantity demanded for a product following a change in income. In simpler terms, YED describes how quantity demanded is affected by a change in a consumer’s income, assuming all other factors remain unchanged. YED = (Percentage change in quantity demanded)/(Percentage change in income) When demand is *responsive* to an income change, the percentage change in quantity demanded will be greater than the percentage change in income. This leads to an income elastic outcome with a YED value greater than 1. When demand is not responsive to an income change, the quantity demanded is income inelastic and has a value of less than 1. #### The Classification of Goods in Relation to Income YED is used to classify goods based on how the quantity demanded changes in relation to changes in individual incomes. This classification is based on the size and sign of the YED. There are four types of goods based on their YED: * **Normal Good:** The quantity demanded increases as income increases. Most products are normal goods. In China and India, the demand for chicken meat has increased as incomes have increased for many households. In developing economies especially, the demand for cars increases as incomes increase. Smartphones are also now often considered normal goods. Normal goods have a positive YED value between 0 and 1. * **Inferior Good:** The quantity demanded decreases as income increases (and increases as income decreases). As income increases consumers use their increased incomes to buy better quality goods to replace inferior substitutes. Typical examples of inferior goods are poor quality rice and packet noodles. Inferior goods have a negative YED. * **Necessity Good:** This is a type of normal good where the quantity demanded is unlikely to change when income changes. These products are often considered staple foodstuffs such as rice, flour, and pulses. Necessity goods have a positive YED value close to zero. * **Superior or Luxury Good:** Superior goods have a positive YED value greater than 1. The quantity demanded is *responsive* to changes in income. The higher the size of the YED, the greater the change in quantity demanded. Examples of superior goods are designer clothes and jewelry, latest tech devices, and motorcycles in low-income economies. The YED is helpful to understand consumer behavior and demand for various goods and services across different income levels. For example, rice might be a necessity good for a low-income family, but a normal good for a middle-income family. ### 8.4 Cross Elasticity of Demand **Cross elasticity of demand (XED)** measures the responsiveness of the quantity demanded for one product following a change in price for another product. In other words, XED describes how the quantity demanded of one product is affected by a change in the price of a related product, assuming all other factors remain unchanged. XED can be elastic or inelastic. - **Cross elastic demand:** If the quantity demanded for one product responds more than proportionately to a change in the price of another product. The XED value is greater than 1. - **Cross inelastic demand:** If the quantity demanded for one product responds *less* than proportionately to a change in the price of another product. The XED value is less than 1. The sign of the XED (positive or negative) is important because it indicates the relationship between the two goods. * **Positive XED:** This indicates that the two goods are *substitutes*. An increase in the price of one good causes an increase in the quantity demanded of the other good. For example, an increase in the price of Coca Cola will likely lead to an increase in the demand for Pepsi Cola, a close branded alternative. * **Negative XED:** This indicates that the two goods are *complements* or jointly demanded. An increase in the price of one product causes a decrease in demand for another product (whose price has remained unchanged). A rise in the price of a smartphone contract may result in less demand for apps and internet surfing. Another example is, an increase in the price of cinema tickets may lead to a fall in the quantity of popcorn demanded by cinema goers. Calculating XED is helpful to understand the relationship between goods and how consumers might respond to changes in prices, potentially influencing demand for substitutes and complements. **Examples of XED Calculations:** 1. *Substitute products:* Suppose the average market price of a standard type of personal computer is $1,000 and current sales are 100 units per day. If following a 2% decrease in the price of laptop computers (a substitute product), demand for PCs falls from 100 units to 96 units per day at the original price, the XED calculation becomes: XED = (4% fall in demand for PCs) / (2% decrease in price of laptops) = +2. The positive sign indicates that the two products are substitutes. The size indicates that they are reasonably close substitutes, meaning that a change in the price of one has a significant impact on the demand for the other. 2. *Complementary products:* Suppose the average price of software (a complement) falls by 5%. If this encourages extra sales of PCs so that demand for PCs rises to 101 per day at the original price, the XED calculation becomes: XED = (1% increase in sales of PCs) / (5% fall in price of software) = -0.2. The negative sign indicates that the two products are complements, meaning that a change in the price of one has a negative effect on the demand for the other. The small numerical value indicates that the relationship between the two products is weak. ### 8.5 How Price, Income, and Cross Elasticities of Demand Can Affect Decision-making Understanding PED, YED, and XED is crucial for economic decision-making. These elasticity measures help to explain important market phenomena, predict the impact of price changes on consumer expenditure and sales revenue and forecast the effects of changes in indirect taxes on government income. #### Price Elasticity of Demand (PED) PED is important for understanding: * **Price variations in a market:** This includes understanding why prices of certain products vary, particularly in the case of sports tickets, rail travel (peak vs. off-peak pricing), airline tickets, and restaurant meals. * **Impact of changing prices on consumer expenditure and sales revenue:** Businesses can use PED to determine how much of a price change to implement without drastically affecting quantity demanded and revenue. * **Effects of changes in indirect taxes on government income:** Understanding the PED of certain products helps governments predict how much revenue they can generate from indirect taxes, like excise taxes on tobacco and alcohol. #### Relationship Between PED and Total Expenditure on a Product PED helps to understand how total spending, or total revenue, for a firm will change as the price rises or falls. Total expenditure is calculated as price (**P**) multiplied by quantity(**Q**) and can be used to predict how a price increase or decrease will affect a firm's revenue. - **When demand is price inelastic**, a business can raise prices to increase its revenue because consumers will be relatively unresponsive to price changes. - **When demand is price elastic**, a business should decrease prices to increase the quantity demanded and therefore revenue. Increasing prices would significantly decrease sales and revenue. #### Income Elasticity of Demand (YED) YED provides information on how the quantity demanded varies with a change in income. It is potentially important for firms and governments for forecasting the future demand for goods and services. - If the YED for a normal good is greater than 1, then we can expect demand to grow more quickly than consumer incomes. This is typically the case in times of sustained economic growth. During a recession, firms producing these types of product suffer reduced demand. - If the YED is negative, in the case of inferior goods, firms producing these can expect their sales to decline when the economy is doing well. At a time of recession, though, demand for their product is likely to increase. #### Cross Elasticity of Demand (XED) Many firms are concerned about competitors' pricing strategies and the impact they may have on their own product demand. Knowledge of XED helps predict the impact of competitors’ price changes on demand for their own products, particularly for substitute products. The higher the XED, the more likely it is that consumers will switch to the cheaper substitute, leading to a high degree of interdependence between suppliers. The size of the XED is also important. If a firm has an XED of 1.5 with another related product, this indicates that a 10% decrease in price is likely to cause a 15% decrease in the quantity demanded of its own product. An even higher XED would lead to an even greater increase in the quantity demanded. Firms are increasingly trying to get consumers to buy a whole range of complementary products, such as computer printers and cartridges from the same manufacturer. XED helps identify these products and introduce a pricing structure that generates more revenue. #### Market Research Estimating elasticity values can be challenging. Market research can be used to gather data and provide reasonable estimates for PED, YED, and XED. ## Chapter 9: Price Elasticity of Supply ### Learning Intentions - Define the meaning of price elasticity of supply (PES). - Calculate price elasticity of supply using the formula. - Explain the significance of the relative percentage changes, the size and sign of the coefficient of price elasticity of supply. - Analyze the factors affecting price elasticity of supply. - Discuss how price elasticity of supply is related to the speed and ease with which businesses react to changed market conditions. ### Economics in Context: Supply of Cashew Nuts from Tanzania Tanzania is the world's largest producer of cashew nuts. They are a valuable source of export revenue and a significant source of income for many farmers. Demand for cashew nuts is high in many parts of the world, especially in Asian countries. Supply, though, is unpredictable, dependent on weather and the extent to which farmers increase their plantings. ### 9.1 Price Elasticity of Supply **Price elasticity of supply (PES)** measures the responsiveness of quantity supplied of a product following a change in the price of the product. In simpler terms, it describes how quantity supplied is affected by a change in a product's price, assuming all other factors remain unchanged. PES is always positive because the supply curve (usually) slopes upwards. - **Price elastic supply** occurs when the numerical value of PES is greater than 1. The quantity supplied responds more than proportionately to a change in its price. - **Price inelastic supply** occurs when the numerical value of PES is less than 1. The quantity supplied is proportionally less than the change in price. *Example:* Imagine two garment manufacturers in Bangladesh, both selling their garments for $10 each and supplying 100 garments a day. A celebrity liking the garments leads to an increase in demand, prompting both manufacturers to raise their price to $12. Producer A can now supply 110 units a day, while Producer B can supply 140 units a day. Using the PES formula: PES = (Percentage change in quantity supplied) / (Percentage change in price) - Producer A: PES = ((10 / 100) * 100%) / ((2 / 10) * 100%) = (10 / 20) = 0.5 - Producer B: PES = ((40 / 100) * 100%) / ((2 / 10) * 100%) = (40 / 20) = 2.0 Producer A’s supply is price inelastic (PES = 0.5 ), and Producer B’s supply is price elastic (PES = 2.0). **Factors Influencing Price Elasticity of Supply** The key to understanding PES is **supply flexibility**. The more flexible businesses and industries are in their operations, the more elastic the supply tends to be. There are three main influences on PES: * **Availability of Stocks:** The ease with which businesses can accumulate or reduce stocks of goods influences PES. Firms can meet variations in demand by changing their output rather than changing the price of the product. The more easily manufacturers can build up stocks, the higher the PES. Firms that provide services are often unable to build up stocks, and in many cases, the product is perishable. For example, if an airline or hotel seat or room is not sold, revenue is lost. Their supply is fixed in the short run. Another example is a football stadium, where the supply curve will have a PES of zero since capacity in the stadium is limited to the number of seats available. * **Time Period:** The ease with which producers are able to increase production is also relevant. Businesses and industries with spare productive capacity tend to have a higher PES in the short run. However, shortages of critical factor inputs (skilled workers, components, fuel) will often lead to an inelastic PES. This is particularly true with most agricultural products, where it takes time to alter the type of crops produced. It can often take a whole growing season for producers to switch from a poor-performing to a more saleable crop. * **Productive Capacity:** Over time, firms may increase their available productive capacity by investing in more capital equipment, often taking advantage of technological advances. Equally, over time, more businesses can enter or leave an industry, increasing the flexibility of supply. ### 9.3 Implications of PES for the Ways in Which Businesses React to Changing Market Conditions Knowledge of PES is essential for understanding how quickly and easily businesses can respond to changing market conditions. PES helps explain why businesses respond differently to changes in demand in the short run and the long run. - The PES for agricultural products is usually more price inelastic in the short run than the PES for manufactured goods. - In the longer term, if the increase in demand is expected to persist, the business can be expanded to increase productive capacity—this takes time. - The situation in agricultural markets is different. The market supply, nationally and internationally, is more price inelastic than for manufactured goods. It’s also more volatile, influenced by external forces like natural disasters, climate change, health scares, and trade barriers. The stability of global markets is also affected by changes in demand for manufactured goods and agricultural products. The impact of changes in demand is usually greater in agricultural markets than in markets for manufactured goods. When the PES is inelastic, any change in demand has a big impact on prices, influencing farmers’ incomes. When PES is more price elastic, changes in demand have a smaller impact on prices. The impact of PES on the effectiveness of business strategies and government policies is significant. Understanding PES is crucial for effective decision-making across various sectors of the economy.