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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.