# Elasticity

Elasticity

• We have no covered how much demand and supply changes when any factors, including price of the product changes.
• This is where the concept of elasticity comes in, which is:
• A numerical estimate
• It measures the response to a change in price or any other factors that determine the demand and supply of a product
• Elasticity explains things like:
• The price of a summer holiday in May or June is around 2/3rds of the price it is in August
• The demand for some products increases more than others when real disposable income increases
• It is often difficult for suppliers to respond quickly when there is a surge in demand for their products.

Price Elasticity of Demand (PED)

• PED measures how responsive the quantity demanded of a product is to a change in its price
• All other factors that affect demand are assumed to remain unchanged
• Mathematically, it is no more than the gradient of the demand curve
• For example, supposed a tour operator sells 5,000 holidays a month to Ibiza for a price of £400.
• When the price is increased to £440, the demand falls to 4,000 holidays per month
• So:

• This estimate of -2 indicates that the demand for holidays to Majorca is responsive to a change in the price of these holidays
• This is known as a price elastic of price sensitive situation
• The negative sign just shows that the quantity demanded has fallen as a result of the increase in price

• Not all products we buy are very responsive to a change in their price
• For example, if the price of household water were to increase by 10%, demand would hardly fall – maybe by 1%
• This would produce an estimate of PED to be -0.1
• This is price inelastic or price insensitive, meaning that the quantity demanded is not particularly responsive to a change in its price

• If PED > 1 – elastic
• If PED < 1 – inelastic
• If PED = 1 – unit PED (change in price causes a proportional change in demand)

• Variations in PED lead us to ask the question: ‘What determines the price elasticity of demand for a product or group of products?’
• There are three main determinants:
• The availability and closeness of the substitutes
• The relative exposure of the product with respect to income
• Time

• We know that a substitute is an alternative to a particular product
• In general, the greater the number of substitutes and the greater their closeness to a given product, then such a product is likely to be price elastic
• An example is baked beans
• There are many brands that are similar to each other, and so a rise in the price of one brand would result in a steep fall in demand, as more consumers would be buying other brands

• If a product takes up a very small percentage of a consumer’s income (e.g. a banana) – the doubling in price wouldn’t affect the quantity demanded that much –it’d be price inelastic
• The reverse is true
• If a product takes up a large part of a person’s income, then its demand would be more sensitive to a change in price – it’d be price elastic

• Time also plays a part, as it takes a while for consumers to change their spending habits
• As a result, they are quite likely to continue to purchase a product despite a price increase
• Over time, however, as consumers find out more about other substitutes, demand for a product is likely to become more price elastic.
• Also, where consumption of a product can be delayed (new car, new kitchen), demand for that product is likely to be price elastic.

Income Elasticity of Demand (YED)

• The sign is important, as it indicates whether there is an increase or decrease in the quantity demanded following a change in income

• Most products have a positive YED – these are called normal goods
• This means that as real disposable income increases, demand for these products will also increase
• g. holidays, wine, clothes, electronics, etc.
• The extent of the response of demand to the change in income can vary.
• Two examples are:
• Where the estimate of income elasticity of demand is < 1 –income inelastic
• Where income elasticity of demand (YED) is > 1 – income elastic

• Some goods have a very large income elasticity of demand – these are called superior goods
• Demand for them increases considerably more in relation to the change in income
• Definitive examples are hard to list, as it is subjective.
• What is a normal good for one person could be a superior good to a person on lower income

• Examples of inferior goods are own-brand supermarket products, second hand goods, coach travel, etc.
• Better substitutes are available, but for a family on low income, such alternatives are out of their reach.

Cross Elasticity of Demand (XED)

• XED is derived from what was previously stated – that the price of substitutes and complements can affect the demand for a particular product

• It measures the relationship between two different products, so the sign and size of the XED are relevant
• A positive estimate indicates that the two products are substitutes
• A negative estimate means that they are complements
• A zero estimate means that there is no particular relationship

• The size of the XED indicates the strength of the relationship between a change in the price of one product and the change in demand for another product
• Where products are good or close substitutes, the value of the XED will be higher than if they are only modest substitutes.
• Similarly, for the complements, a high value of XED is indicative of products with a high degree of complementarity.

Price Elasticity of Supply

• Price Elasticity of Supply (PES) is the supply equivalent of PED

• PES indicates how much additional supply a producer is willing to provide for the market following a change in the price of the product
• Given that the supplier wants to maximise profits, it follows that the PES will always be positive
• Obviously, if the price falls, it would be unusual for the supplier to produce more goods for the market in a free market solution

• The size of the PES is therefore very important, and can take the following values:
• Between 0 and 1
• This means that the PES is inelastic
• Supply is not very responsive to a change in the price of the product
• Greater than 1
• PES if elastic
• Producers are able to respond with a relatively large change in supply if price rises
• Equal to 1
• A change in price causes an exactly proportional change in the quantity supplied

• In practise, suppliers are not always able to respond to a change in price with the same speed as consumers
• This is because for most products, it takes time for producers to alter their production schedules in response to market need, unless they can draw upon stocks.
• For farmers, this time lag could be as much as a year – the time it takes to alter the mix of their production

• Large parts of the service sector face a rather different supply issue.
• In the long term, the supply of their products is more elastic than in the short term
• In the case of hotel or air-craft, supply is perishable as the product can’t be stored
• If a hotel room is not sold on a particular night, this represents a loss to the business.

• So there are three main factors that determine the PES of a product:
• Availability of stocks of the product
• Availability of factors of production
• Time period

• Stocks or inventory allow supplies to store products in a warehouse
• This relates to elasticity of supply as they can be quickly distributed if demand increases and henceforth price
• Equally, if price falls, goods can be stored, depending on how perishable they are
• For example, supermarkets like ASDA carry a certain amount of ‘buffer stock’, which can be released if market conditions change
• For service sector businesses like hotels, supply is infinitely inelastic since the product cannot be stored, it has to be consumed on a particular day or time period otherwise it is lost.

• With regards to the factors of production and its effect on PES, labour is usually the most available.
• Provided there is spare capacity, additional works can be used to increase output, often in a short time span
• Here, elasticity of supply is relatively elastic
• For some businesses, it is the availability of capital that determines whether a firm can increase output
• When new machinery has to be purchased and installed, the elasticity of supply will be inelastic
• The risk is that market conditions may change before any increased production can reach the market

• With regards to time, where it takes a long time for supply to be adjusted, supply will be inelastic
• In the longer term, however, supply will normally be more price elastic
• An example is travel companies – they have to reserve flights up to a year in advance for some consumers – making supply price inelastic
• The problem companies then face is if demand is low, they are left with unsold holidays
• Price will therefore have to fall in order to clear excess supply

Business Relevance of Elasticity Estimates

• Elasticity measure have considerable practical business relevance
• For example, knowledge of PED is an essential input when a firm is generating a pricing strategy which enables them to maximise sales revenue.
• But how might this data be collected and what are the general limitations of elasticity data?

• All elasticity measures require information to be collected at two separate points in time
• The formulas make this clear by indicating that ‘change’ is being measured

• The information can be collected by means of:
• Sample surveys of consumers (price and YED)
• Past records from within a company (PES)
• Competitor analysis (XED)

• Given the nature of how the data is collected, it is necessary to appreciate that:
• The data gathered will be estimates, since the data collected might be inaccurate
• Over time, there could be other factors that aren’t in the forecast that affect the demand of supply of a product
• Prices may fall due to this, which produces an unfair elasticity estimate

Use of PED

• PED is widely used by businesses when pricing their products in the market
• It is evident in the transport market where the market’s segmented on a time basis

• In applying market knowledge of PED, companies are pursuing an objective of maximising revenue
• Companies are aware that where demand is inelastic, an increase in price leads to an increase in total revenue.

• The business situation in both graphs is clearly beneficial, as revenue increases
• What is not beneficial is for a firm to reduce prises if demand is inelastic or to increase prices where demand’s elastic

Use of Income Elasticity of Demand

• In most economies, real disposable income tends to rise over time
• This is significant to businesses that produce goods and services because with a highly positive YED can expect to do well in the future
• Oppositely, firms producing goods with a negative YED might do badly
• An exception to this is where a business changes the image of a product so that YED becomes position
• Upmarket baked beans and spam are examples, as they’re not marketed as superior, but used to be inferior products

• In economies such as the UK, where living standards continue to increase, there has been a growth in markets in the service sector, such as overseas holidays, eating out and health spas.
• So these types of businesses would seem to have good business prospects in the long term
• Estimates of YED can provide a basis for forecasting market demand

• When economies force uncertain short term economic prospects, then demand for income elastic products will fall
• This is because consumers are forced to substitute their demands towards inferior goods and services
• Products with a low YED are unlikely to be affected by a rise or fall in living standards

Use of Cross Elasticity of Demand

• Estimates for XED are useful in competitive markets
• Where there are close substitutes, and hence a high positive XED with other products, then the firm are likely to cut prices to increase market share
• This occurs in practise between:
• Low cost airlines, train and bus companies on identical routes
• Well known brands of identical grocery or electronic products
• Products such as wine and butter that are produced in different companies but are virtually the same
• In such cases, there are close substitutes
• Increasing prices is dangerous, as you can lose market share to a rival, which is difficult to regain

• The case of compliments also has implications for firms
• This is because the price of two complimentary goods may not be close
• Here, XED will be high and negative

Use of Price Elasticity of Supply

• PES is always positive – it shows the affect of the relationship between price and quantity supplied
• In many types of business, supply is price inelastic in the short term, as it is often difficult to switch resources into a market
• An exception to this is firms that hold onto stocks in anticipation of a price rise
• In the long term, however, supply is more likely to be price elastic as resources can be re-allocated to respond to the increase in market price

• In general, firms will try to make their supply as elastic as possible, as they want to increase sales to maximise profits
• If prices are falling, an elastic supply will enable them to move resources away from such products and into alternatives where there’s a normal relationship between a change in price and the change in quantity supplied.