· The term on the top is the slope of the demand curve, while the term on the bottom is the slope of the ray from the origin to the point on the curve where you are measuring elasticity.

· As price and quantity demanded are inversely related the equation is always negative, but we tend to ignore the negative sign and report a whole number.

· Elastic demand (h > 1):

o A subsidy leads to an outward shift in supply, prices fall leading to a large increase in quantity demanded (%Dq > %Dp).

o If price fell by 10% and quantity demanded rose by 50%, the elasticity would be equal to 5, an unusually high number for elasticity

o Perfectly elastic (h = ¥): infinite change in quantity demanded (%Dq = ¥)

· Inelastic demand: (h < 1):

o A subsidy leads to an outward shift in supply, prices fall but there is only a small increase in quantity demanded (%Dq < %Dp)

o If price fell by 10% and quantity demanded rose by only 5%, elasticity is equal to 0.5.

o Perfectly inelastic (h = 0): no change in quantity demanded (%Dq = 0)

· Unit elastic demand (h = 1): if the responsiveness is about the same as the change in price, then the measure will be equal to (minus) one (%Dq = %Dp)...

Arc Elasticity

· Arc elasticity measures the elasticity over a segment of the curve.

· The slope is taken from the the chord over that arc of the curve. As there are two points, the slope of the ray is determined by an average: the average quantity over the average price.

Point Elasticity

· Point elasticity measures the responsiveness of quantity to price at a particular point on the demand curve.

· The slope is given by the tangent to that point, and is often measured as dq/dp, which is determined by calculus.

· The slope of the ray is given by: q/p, the p and q corresponding to that point are used (rather than average p and q over an arc of the curve).

Elasticity Along a Straight Line

· Elasticity along a straight line demand curve varies from zero at the quantity axis to infinity at the price axis.

· In the figure:

o Below the midpoint of a straight line demand curve, E₃, elasticity is less than one and the firm wants to raise price to increase TR.

o Above the midpoint, E₂, elasticity is greater than one and the firm wants to lower price to increase TR.

o At the midpoint, E₁, elasticity is equal to one.

· For the straight demand curve, the ranges of elasticity are given by the formula:

· For the curved demand curve, EF is the distance from the point where the tangent intersects the x axis to the tangency point divided by the distance from the tangency point to the intersection with the y axis.

o For a hyperbola, the point of tangency will always be the midpoint of a straight line and therefore, the elasticity is always equal to one along the curve.

· Where there are two straight line demand curves of the same slope, the one furthest from the origin is less elastic at each price than the closer one.

· Where two demand curves of different slopes intersect, the elasticities are different because the slopes are different at that point.

Factors Influencing Demand

· Substitutes: if there are many substitutes available, consumers can easily switch to other goods if prices rise.

· Time: it may be difficult to find substitutes in the short run so demand is likely to be less elastic in the short run than in the long run.

· Demand within product groups tends to be fairly elastic:

o The demand for gas versus electricity or gas versus diesel is fairly elastic.

o However, for energy as a whole, demand tends to be very inelastic because there are no substitutes for hydrocarbons.

· Size of item in budget: if consumers spend only a small amount on the item (such as matches for lighting candles) relative to their budget, it is likely to be inelastic: not sensitive to price changes

· Addiction: some goods are habit forming and tend to be price inelastic: coffee.

2.2.2 Cross Elasticity of Demand

· Responsiveness of demand to changes in prices of other goods:

· Complementary goods:

o Quantity demanded increases when the price of the complement falls.

o If the price of gas fell to 10 cents a litre, sales of cars would increase.

· Substitute goods:

o Quantity demanded of one good falls when the price of the substitute falls.

o If the price of coffee rises, people tend to consume less coffee and more tea.

· Price cross elasticity tells us the relationship amongst goods:

o Bottle makers find they are in competition with producers of cans

2.2.3 Income Elasticity of Demand

· Income elasticity measures the percentage change in quantity demanded as income changes.

· Normal goods: an increase in income leads to an increase in consumption, demand shifts to the right.

o For basic or necessity goods, 0 < h < 1, quantity demanded will not increase much as income increases (income elasticity for food = 0.2)

o For luxury goods, h > 1, quantity demanded rises faster than income. For restaurant meals income elasticity is higher than for food, because of the additional restaurant service.

· Inferior goods: income elasticity is actually negative, the demand curve shifts left as income rises. As income rises, the proportion spent on food tends to fall while the proportion spent on services tends to rise.

· As economies grow, income elasticity helps determine what should be produced: firms will want to avoid producing inferior goods.

· Countries are at various stages of economic development and so have widely different income elasticities for the same products. As overseas incomes grow it may create new markets as demand shifts from inferior to normal goods.

2.2.4 Price Elasticity of Supply

· Elasticity of supply measures the responsiveness of the quantity supplied to changes in price:

· Elasticity = 0: if the supply curve is vertical, and there is no response to prices.

· Elasticity = ¥: if the supply curve is horizontal, .

· Any straight line supply curve intersecting:

o The origin has an elasticity of one: at every point along the curve, the slope of the ray (q/p) equals the slope of the line (Dq/Dp).

o The price axis is elastic.

o The quantity axis is inelastic.

Determinants of Supply Elasticity

· If costs rise only slowly as production increases, a rise in price will stimulate a large increase in quantity supplied.

· If costs of production rise rapidly as output rises, then the stimulus to production which comes from rising prices will quickly be choked off.

Capacity:

· Ease of entry: the fewer the barriers to entry, the easier for firms to enter the industry to increase supply in response to an increase in price and supply is elastic.

· Factor mobility: the easier it is to move resources into the industry, the more elastic the supply curve.

· Ease of switching: if land and labour can be shifted easily from growing one crop to another, the supply will be more elastic:

o Even if it is possible to shift inputs, if the cost of inputs rises production costs will rise rapidly as output rises and supply will be inelastic.

· Spare capacity: if there is unused capacity, it is easy to increase production if demand should start to shift out.

· Ease of storing output: if it is easy to store production, the more elastic supply response to increases in demand.

Length of time:

· Length of production period: the more quickly the good can be made, the easier to respond to an increase in price.

· Time period: over time the firm can train labour and invest in more capital equipment and supply is more elastic in its response to price increases.

o Over the longer term as cheaper inputs are substituted and new production methods incorporated into the firm, outputs will tend to increase and prices will tend to moderate.

2.2.5 Applications of concepts of elasticity

PED and the firm

· Total Revenue: is equal to P*Q.

o By estimating the effect of a price change, firms can plan the number of goods to produce and estimate their potential revenue.

· Inelastic demand: price and total revenue are positively related

o If firms cut prices by 10% but sales only increase by 5%, revenues fall

o A rise in price will not only increase revenue but will also increase profit as costs will fall because less is produced.

o The increase in the number demanded is too small to offset the drop in the price of each good sold.

§ Example: the oil industry where demand is inelastic, as prices rise, quantity demanded does not fall very much.

· Elastic demand: price and total revenue are negatively related

o If demand is elastic, a fall in price will increase revenue but not necessarily increase profit as production must increase quantity demanded increases.

o If quantity demanded increased 50% when price fell by 10%, revenues increase.

o The increase in the number demanded is more than enough to offset the fall in the price of each good sold.

· Unit elastic demand:

o Total revenue is constant regardless of changes in prices.

o The cut in prices is exactly offset by the increase in the quantity demanded, and total revenue to producers will stay the same.

Cross Elasticity

· Firms can determine the impact on sales and revenues of price changes by rivals, or when they or another industry changes the price of complements.

· During the oil crisis in the 1970s prices rose 400% in the space of three months but quantity demanded fell by less than 5% the first year.

o More energy efficient cars were bought by consumers

o Companies switched to using coal instead of oil in their furnaces.

· In the longer term, new supplies of oil were found, and the real price of oil declined as consumers switched to substitutes.

· For goods like energy it takes time to use up the stock of appliances and machinery and switch to those using energy in a more efficient manner.

Income Elasticity

· As economies grow:

o Firms will plan on producing fewer inferior goods.

o Production and purchasing of capital goods and other factors can be planned.

o Production for exports can be planned as new markets open and close.

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