Define Elasticity.

Elasticity refers to the degree of responsiveness in supply or demand in

relation to changes in price. If a curve is more elastic, then small changes in
price will cause large changes in quantity consumed. If a curve is less elastic,
then it will take large changes in price to effect a change in quantity
consumed. Graphically, elasticity can be represented by the appearance of
the supply or demand curve. A more elastic curve will be horizontal, and a
less elastic curve will tilt more vertically. When talking about elasticity, the
term "flat" refers to curves that are horizontal; a "flatter" elastic curve is
closer to perfectly horizontal.

Figure %: Elastic and Inelastic Curves

At the extremes, a perfectly elastic curve will be horizontal, and a perfectly
inelastic curve will be vertical. Hint: You can use perfectly inelastic and
perfectly elastic curves to help you remember what inelastic and elastic
curves look like: an Inelastic curve is more vertical, like the letter I. An
Elastic curve is flatter, like the horizontal lines in the letter E.

Figure %: Perfectly Elastic and Perfectly Inelastic Curves

Price elasticity of demand, also called the elasticity of demand, refers to the
degree of responsiveness in demand quantity with respect to price. Consider
a case in the figure below where demand is very elastic, that is, when the
curve is almost flat. You can see that if the price changes from $.75 to $1,
the quantity decreases by a lot. There are many possible reasons for this
phenomenon. Buyers might be able to easily substitute away from the good,
so that when the price increases, they have little tolerance for the price
change. Maybe the buyers don't want the good that much, so a small change
in price has a large effect on their demand for the good.

Figure %: Elastic Demand

If demand is very inelastic, then large changes in price won't do very much
to the quantity demanded. For instance, whereas a change of 25 cents
reduced quantity by 6 units in the elastic curve in the figure above, in the
inelastic curve below, a price jump of a full dollar reduces the demand by
just 2 units. With inelastic curves, it takes a very big jump in price to change
how much demand there is in the graph below. Possible explanations for this
situation could be that the good is an essential good that is not easily
substituted for by other goods. That is, for a good with an inelastic curve,
customers really want or really need the good, and they can't get want that
good offers from anywhere else. This means that consumers will need to buy
the same amount of the good from week to week, regardless of the price.

Figure %: Inelastic Demand

Like demand, supply also has varying degrees of responsiveness to price,
which we refer to as price elasticity of supply, or the elasticity of supply. An
inelastic supplier (one with a steeper supply curve) will always supply the
same amount of goods, regardless of the price, and an elastic supplier (one
with a flatter supply curve) will change quantity supplied in response to
changes in price.

How Is Elasticity Measured?

As we have noted, elasticity can be roughly compared by looking at the relative
steepness or flatness of a supply or demand curve. Thus, it makes sense that the
formula for calculating elasticity is similar to the formula used for calculating slope.
Instead of relating the actual prices and quantities of goods, however, elasticity
shows the relationship between changes in price and quantity. To calculate the
coefficient for elasticity, divide the percent change in quantity by the percent
change in price:
Elasticity = (% Change in Quantity)/(% Change in Price)
Remember that to find percent change itself, you divide the amount of change in a
variable by the initial level of the variable:
% Change = (Amount of Change)/(Initial Level)
Another important thing to remember is that percentage changes can be positive or
negative, but elasticity is always an absolute value. That is, even when an increase
in price is paired with a decrease in quantity (as with most demand curves), the
elasticity will be positive; remember to drop any minus signs when finding your final
value for elasticity.
Let's apply this and solve for elasticity in the market for ping pong balls. When ping
pong balls cost $1 each, Alice is willing to buy 10 balls, and Joe is willing to sell 10
balls. When they cost $1.50 each, Alice is willing to buy 6 balls, and Joe is willing to
sell 20. First, let's solve for Alice's price elasticity of demand:
% Change in Quantity = (6-10)/10 = -0.4 = -40%
% Change in Price = (1.50-1)/1 = 0.5 = 50%
(-40%)/(50%) = -0.8
Take the absolute value to find elasticity.
Elasticity of Demand = 0.8
Now, we use the same process to find Joe's price elasticity of supply:
% Change in Quantity = (20-10)/10 = 1 = 100%
% Change in Price = (1.50-1)/1 = 0.5 = 50%
Elasticity of Supply = (100%)/(50%) = 2

2. Define the following types of elasticity:

a. Price Elasticity of Demand

Price elasticity of demand (PED) shows the relationship between price and
quantity demanded and provides a precise calculation of the effect of a
change in price on quantity demanded.

The following equation enables PED to be calculated.

We can use this equation to calculate the effect of price changes on quantity demanded, and on
the revenue received by firms before and after any price change.
For example, if the price of a daily newspaper increases from 1.00 to 1.20p, and the daily sales
falls from 500,000 to 250,000, the PED will be:
- 50% / + 20%
= (-) 2.5

The negative sign indicates that P and Q are inversely related, which we would expect for most
price/demand relationships. This is significant because the newspaper supplier can calculate or
estimate how revenue will be affected by the change in price. In this case, revenue at 1.00 is
500,000 (1 x 500,000) but falls to 300,000 after the price rise (1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The
key benchmark for measuring elasticity is whether the co-efficient is greater or less than
proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which
is called unit elasticity.
PED can also be:

Less than one, which means PED is inelastic.

Greater than one, which is elastic.

Zero (0), which is perfectly inelastic.

Infinite (), which is perfectly elastic.

b. Price elasticity of supply

Price elasticity of supply (PES) measures the responsiveness of quantity

supplied to a change in price. It is necessary for a firm to know how quickly,
and effectively, it can respond to changing market conditions, especially to
price changes. The following equation can be used to calculate PES.
While the coefficient for PES is positive in value, it may range from 0,
perfectly inelastic, to infinite, perfectly elastic.
Consider the following example:
A firms market price increases from 1 to 1.10, and its supply increases
from 10m to 12.5m. PES is:
+25 +10
= (+) 2.5
The positive sign reflects the fact that higher prices will act an incentive to
supply more. Because the coefficient is greater than one, PES is elastic and
the firm is responsive to changes in price. This will give it a competitive
advantage over its rivals.
Extreme cases
There are three extreme cases of PES.
1. Perfectly elastic, where supply is infinite at any one price.
2. Perfectly inelastic, where only one quantity can be supplied.
3. Unit elasticity, which graphically is shown as a linear supply curve
coming from the origin.

Determinants of PES
How firms respond to changes in market conditions, especially price, is an important
consideration for the firm itself, and to an understanding of how markets work.
The key considerations are:
1. Are resource inputs readily available?
2. Are factors mobile - are workers prepared to move to where they are needed?
3. Can finished products be easily stored, and are there existing stocks?
4. Is production running at full capacity?
5. How long and complex is the production cycle or production process?
c. Income Elasticity of Demand
Income elasticity of demand (YED) shows the effect of a change in income on
quantity demanded. Income is an important determinant of consumer demand, and
YED shows precisely the extent to which changes in income lead to changes in
demand. YED can be calculated using the following equation: Normal goods

When the equation gives a positive result, the good is a normal good. A
normal good is one where demand is directly proportional to income. For

example, if, following an increase in income from 40,000 to 50,000, an

individual consumer buys 40 DVD films per year, instead of 20, then the
coefficient is:
+100/+25
= (+) 4.0
The positive sign means that the good is a normal good, and because the
coefficient is greater than one, demand for the good responds more than
proportionately to a change in income. This indicates the good is not a
necessity like food, and would be considered a relative luxury for this
individual.
Inferior goods
When YED is negative, the good is classified as inferior. For example, if,
following an increase in income from 40,000 to 50,000, a consumer buys
180 loaves of bread per year instead of 200, then the YED is:
-10/+25
= (-) 0.4
The negative sign means that the good is inferior, and, because the
coefficient is less than one, demand for the good does not respond
significantly to a change in income. This indicates that the good is not
particularly inferior compared with a good which has a YED of > (-)1.
The sign and the number provide different information about the relationship
between income and demand. Income elasticity of demand can also be
illustrated by Engel curves.

d. Cross Price elasticity of Demand

Cross elasticity of demand (XED) is the responsiveness of demand for one

product to a change in the price of another product. Many products are
related, and XED indicates just how they are related.
The following equation enables XED to be calculated.
% change in () quantity demanded of good A % change in () price of good
B
Substitutes
When XED is positive, the related goods are substitutes. For example, if the
price of Coca Cola increases from 50p to 60p per can, and the demand for
Pepsi Cola increases from 1m to 2m per year, the XED between the two
products is:
+100/+20 = (+) 5
The positive sign means that the two goods are substitutes, and because the
coefficient is greater than one, they are regarded as close substitutes.
Complements
When XED is negative, the goods are complementary products. The equation
is the same as for substitutes.

For example, if the price of Cinema Tickets increases from 5.00 to 7.50,
and the demand for Popcorn decreases from 1000 tubs to 700, the XED
between the two products will be:
-30/+50 = (-) 0.6
The negative sign means that the two goods are complements, and the
coefficient is less than one, indicating that they are not particularly
complementary.
3. How do you determine whether a good is elastic, inelastic or unitary? Is it
applicable only to the first two types of elasticity?
Unit elastic - Describes a supply or demand curve which is perfectly responsive to
changes in price. That is, the quantity supplied or demanded changes according to
the same percentage as the change in price. A curve with an elasticity of 1 is unit
elastic. Not really any real life examples.
Inelastic- The demand for an item is relatively unaffected by the change in price. For
example, luxury items on a gasoline.
Elastic- The demand for an item/good is strongly affected by the change in price.
Ms. Fields' cookies are an example because they are not required to live and people
will buy less if the price increases and people will buy more if the price decreases.
4. How do you determine using the elasticity computation whether a good is a
luxury good or a necessity?
5. How do you determine whether a good is normal or inferior?
6. How do you determine whether two related goods are substitutes or
complements?

Income elasticity of demand measures the relationship between a change in

quantity demanded for good X and a change in real income.
The formula for calculating income elasticity is:
% Change in demand divided by the % change in income

Normal Goods

Normal goods have a positive income elasticity of demand so as

consumers' income rises more is demanded at each price i.e. there is an
outward shift of the demand curve

Normal necessities have an income elasticity of demand of between 0

and +1 for example, if income increases by 10% and the demand for fresh
fruit increases by 4% then the income elasticity is +0.4. Demand is rising less
than proportionately to income.

Luxury goods and services have an income elasticity of demand > +1 i.e.
demand rises more than proportionate to a change in income for example a
8% increase in income might lead to a 10% rise in the demand for new
kitchens. The income elasticity of demand in this example is +1.25.

Inferior Goods

Inferior goods have a negative income elasticity of demand meaning

that demand falls as income rises. Typically inferior goods or services exist
where superior goods are available if the consumer has the money to be
able to buy it. Examples include the demand for cigarettes, low-priced own
label foods in supermarkets and the demand for council-owned properties.