Introduction to Economics - Elasticity of Demand (PDF)

University of Trinidad and Tobago Bioscience, Agriculture and Food Technology Diploma in Agriculture Introduction Economics ECOS 1004 Lecture 2.1. Demand and Suppl...

University of Trinidad and Tobago Bioscience, Agriculture and Food Technology Diploma in Agriculture Introduction Economics ECOS 1004 Lecture 2.1. Demand and Supply a. Elasticity and its effect on Total Revenue What Is Elasticity?  Elasticity is a measure of a variable's sensitivity to a change in another variable, most commonly this sensitivity is the change in quantity demanded relative to changes in other factors, such as price.  In business and economics, price elasticity refers to the degree to which individuals, consumers, or producers change their demand or the amount supplied in response to price or income changes. How Elasticity Works  When the value of elasticity is greater than 1.0, it suggests that the demand for the good or service is more than proportionally affected by the change in its price.  A value that is less than 1.0 suggests that the demand is relatively insensitive to price, or inelastic.  Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.  If elasticity = 0, then it is said to be 'perfectly' inelastic, meaning its demand will remain unchanged at any price. There are probably no real-world examples of perfectly inelastic goods.  The only thing close to a perfectly inelastic good would be air and water, which no one controls.  Elasticity is an economic concept used to measure the change in the aggregate quantity demanded of a good or service in relation to price movements of that good or service. A product is considered to be elastic if the quantity demand of the product changes more than proportionally when its price increases or decreases. Conversely, a product is considered to be inelastic if the quantity demand of the product changes very little when its price fluctuates. Types of Elasticity Elasticity of Demand 1 The quantity demanded of a good or service depends on multiple factors, such as  price,  income, and  preference. Whenever there is a change in these variables, it causes a change in the quantity demanded of the good or service. Price elasticity of demand is an economic measure of the sensitivity of demand relative to a change in price. The measure of the change in the quantity demanded due to the change in the price of a good or service is known as price elasticity of demand. Income Elasticity  Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in real income of consumers who buy this good, keeping all other things constant.  The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income. With income elasticity of demand, you can tell if a particular good represents a necessity or a luxury. Cross Elasticity  The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price for another good changes.  Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good. Price Elasticity of Supply  Price elasticity of supply measures the responsiveness to the supply of a good or service after a change in its market price.  According to basic economic theory, the supply of a good will increase when its price rises. Conversely, the supply of a good will decrease when its price decreases. Factors Affecting Demand Elasticity There are three main factors that influence a good’s price elasticity of demand. 1. Availability of Substitutes 2 In general, the more good substitutes there are, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people, in this case, might not willingly give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes. 2. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to get to work or drive for a number of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks. 3. Time The third influential factor is time. For instance, if the price of cigarettes goes up to $2 per pack, someone with a nicotine addiction with very few available substitutes will most likely continue buying their daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that person who smokes cigarettes finds that they cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price of cigarettes for that consumer becomes elastic in the long run. The Importance of Price Elasticity in Business Understanding whether or not the goods or services of a business are elastic is integral to the success of the company. Companies with high elasticity ultimately compete with other businesses on price and are required to have a high volume of sales transactions to remain solvent. Firms that are inelastic, on the other hand, have goods and services that are must-haves and enjoy the luxury of setting higher prices. Beyond prices, the elasticity of a good or service directly affects the customer retention rates of a company. Businesses often strive to sell goods or services that have inelastic demand; doing so means that customers will remain loyal and continue to purchase the good or service even in the face of a price increase. 3 Examples of Elasticity There are a number of real-world examples of elasticity we interact with on a daily basis. One interesting modern-day example of the price elasticity of demand many people take part in even if they don't realize it is the case of Uber's surge pricing. As you might know, Uber uses a "surge pricing" algorithm during times when there is an above-average amount of users requesting rides in the same geographic area. The company applies a price multiplier which allows Uber to equilibrate supply and demand in real-time. The COVID-19 pandemic has also shone a spotlight on the price elasticity of demand through its impact on a number of industries. For example, a number of outbreaks of the coronavirus in meat processing facilities across the US, in addition to the slowdown in international trade, led to a domestic meat shortage, causing import prices to rise 16% in May 2020, the largest increase on record since 1993 Another extraordinary example of COVID-19's impact on elasticity arose in the oil industry. Although oil is generally very inelastic, meaning demand has a little impact on the price per barrel, because of a historic drop in global demand for oil during March and April, along with increased supply and a shortage of storage space, on April 20, 2020, crude petroleum actually traded at a negative price in the intraday futures market. In response to this dramatic drop in demand, OPEC+ members elected to cut production by 9.7 million barrels per day through the end of June, the largest production cut ever.2 What Is Meant by Elasticity in Economics? Elasticity refers to the measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Goods that are elastic see their demand respond rapidly to changes in factors like price or supply. Inelastic goods, on the other hand, retain their demand even when prices rise sharply (e.g., gasoline or food). Are Luxury Good Elastic? Luxury goods often have a high price elasticity of demand because they are sensitive to price changes. If prices rise, people quickly stop buying them and wait for prices to drop. What Are the 4 Types of Elasticity? Four types of elasticity are demand elasticity, income elasticity, cross elasticity, and price elasticity. What Is Price Elasticity? 4 Price elasticity measures how much the supply or demand of a product changes based on a given change in price. What Is the Elasticity of Demand Formula? The elasticity of demand can be calculated by dividing the percentage change in the quantity demanded of a good or service by the percentage change in price. It reflects how demand for a good or service changes as its quantity or price varies. The Bottom Line Understanding whether a good or service is elastic or inelastic, and what other products could be tied to a good's elasticity can help consumers make informed decisions when they are deciding if or when to make a purchase. When the coefficient of PED < 1, then a rise in price will increase total revenue. For example, if PED = -0.3, this means demand is price inelastic When the coefficient of PED > 1, then a price fall will increase total revenue. For example, if PED = -2.5, this means demand is price elastic When the coefficient of PED = 1, then demand is unitary elastic. This means a price change will leave total revenue unchanged When demand is price inelastic, consumers are less sensitive to the price being charged. They have a lot of consumer surplus which businesses can possibly extract into extra revenue – perhaps as a result of price discrimination. 5  KEY TAKEAWAYS  Elasticity is an economic measure of how sensitive one economic factor is to changes in another.  For example, changes in supply or demand to the change in price, or changes in demand to changes in income.  If demand for a good or service is relatively static even when the price changes, demand is said to be inelastic, and its coefficient of elasticity is less than 1.0.  Examples of elastic goods include clothing or electronics, while inelastic goods are items like food and prescription drugs.  Cross elasticity measures the change in demand for one good given price changes in a different, related good. 6