Elasticities

Elasticities of Demand 

Measures the responsiveness of one variable to the change in another variable 

Price elasticity of demand (PED) Responsiveness of quantity demanded to a change in price. 

PED = % change in Q / % change in price

Elastic demand: PED > 1 Inelastic demand: PED < 1 Unitary elasticity: PED = 1

Perfectly elastic demand: any increase in price will cause demand to drop to zero. Perfectly inelastic demand: any price change won’t affect demand.

PED is always negative.

Income elasticity of demand (YED) Responsiveness of quantity demanded to a change in income

YED = % change in Q / % change in income

Normal goods: positive YED (normal luxury = high positive YED) Inferior goods: negative YED

Cross elasticity of demand (XED) Responsiveness of quantity demanded OF A to a change in price OF B

XED(A) = % change in Q (A) / % change in P (B)

Substitutes: positive XED Complements: negative XED Closer to zero = unrelated

Factors affecting the elasticity of demand:

- Availability of substitutes (the more substitutes available, the more price elastic a good is - easy to find an alternative product)

- Impact of indirect taxes (inelastic goods don’t react as much to an indirect tax)

- Percentage of income and time (the higher proportion of income spent, the more elastic - goods are more elastic in the long run)

- Type of good (Addictive goods tend to be more price inelastic)

- Impact of subsidies (if the commodity has inelastic demand, the price will drop more than quantity increases after subsidy)

Factors affecting PED:

Substitutes

Percentage of income

Luxury

Addiction

Time

PED and Revenue:

Total revenue = price x quantity

If PED is elastic, cutting prices will raise the total revenue.

If PED is inelastic, raising prices will raise the total revenue.

Price elasticity of Supply (PES) Responsiveness of quantity supplied to a change in price

PES = % change in quantity / % change in price

Elastic supply: PES > 1 Inelastic supply: 0 < PES < 1 Unitary supply: PES = 1

Firms aim for high elasticity of supply so they can react rapidly to changes in price and demand.

To increase elasticity:

• Improve technology

• Introduce flexible working patterns

• Excess production capacity

Factors affecting elasticity of supply:

- Perishable goods (perishable goods will have a more inelastic supply)

- Recessionary period (in times of high unemployment, PES is higher - larger labour pool to hire from)

- Agility (firms that are agile keep high levels of stock - increases PES)

- Time (supply is more elastic in the long run)

Factors affecting PES:

Barriers to entry

Raw materials

Inventory

Time

Spare capacity

Short Run:

• Capacity is fixed

• One or more factors of production are fixed

• Hard to increase production

• Supply = inelastic

Long run:

• All factors of production are variable

• Firms able to increase capacity

• Supply = more elastic than in the short run

Authored by Priscilla Chau.