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Reality Check: Why and How is PED useful?
• PED on pricing decisions and total revenue
– When the demand is in the elastic portion of the D
curve, an increase in price causes a ………….in total
revenue
– When the demand is in the inelastic portion of the
D curve, an increase in price causes a …………in total
revenue
– And when the demand is unit elastic, then a change
in price……………………………………..
(continued)
• Therefore ………..total revenue is at its maximum
when price is at the point where PED =1
• BUT be careful this should NOT be confused with
maximizing profit (total revenue – total cost) as it
is possible that as TR increases so as the TC at a
faster rate
• We will elaborate on this more when we study
about the firms
Elasticities of Non-Price Determinants
• non-price determinants of demand cause a shift
in the demand curve
• What we now want to ask is by “how much” the
demand curve will shift or what is the
“responsiveness” of demand, given the change in
non-price determinants
• And this shall complete the tools (concepts) to
fully conduct D and S analysis of various market
scenarios/cases as shown in the real world
•  Page 6 of H/O Different Types of Elasticity
Income Elasticity of Demand
• Income elasticity of demand (YED) is a
measure of the responsiveness of demand to
changes in income. It involves the shift of the
demand curve. It provides us with information
on direction of change of demand given a
change in income (increase or decrease) and
on the size of the change
The Formula for Income Elasticity of Demand
OR
∆𝑄 𝑌1
.
∆𝑌 𝑄1
• NOTICE: YED has the same basic form as the formula for
PED.
Calculations
• 1) When incomes are $1000, the demand for
strawberries is 500 kilos per day. When incomes are
$1200, the demand for strawberries is 502 kilos per
day.
• What is the YED for strawberries?
• 2) When incomes rise by 5%, the demand for new cars
rises by 8% and the demand for second hand cars falls
by 1%.
• What is the YED for new cars?
• What is the YED for second-hand cars?
But again, one caveat and point of clarification
• Where YED is defined as the responsiveness of
“demand”, it is measured as % change of “quantity
demanded”
• But just like PED, YED is concerned with demand curve
shifts i.e. change or shift in demand and not quantity
demanded
• However, when we measure YED, we do so by
measuring changes in purchases of a good, hence in
“quantity demanded”, but with the understanding
that this involves a shift to a new demand curve
Two technical points:
1. The sign of YED: unlike PED, whose minus sign is
ignored through taking the absolute value, YED is either
positive or negative and the sign is very important for
its interpretation.
•
And keeping in mind, we know that there are
two key cases/types:
– Normal goods and inferior goods…
2. The value of YED: the absolute value of the YED
will demonstrate the size and extent of the “shift”
in demand
2 Key Types/Cases of YED
• 1. Normal Goods
• A positive YED (YED > 0) indicates that the good is a normal
good. When the income increases, so does the demand (the
demand curve shifts to the right). The demand and income
change in the same direction.
• e.g. most goods are normal goods such as iPhone6, new Nike
shoes, new car, etc…
• 2. Inferior Goods
• A negative YED (YED < 0) indicates that the good in question is
an inferior good. When the income increases, the demand for
the inferior good decreases (the demand curve shifts to the
left). The demand and income change in the opposite
directions.e.g. bus rides, second hand clothes, second hand
and used cars, etc
Two Types of Normal Goods:
Necessities are goods that have a YED that is positive but less
than 1 (0 < YED <1). It has income inelastic demand where a
percentage increase in income produces a smaller percentage
increase in quantity demanded e.g. food, water, clothes, shelter,
medication, etc.
– as income increases the proportion of income spent on
these goods becomes …………….
– EXAMPLE: The YED for food is estimated to be around 0.15 to 0.20 in the
OECD nations.
• This means that a 1% increase in income produces 0.15 to 0.2% increase
in spending on food
• Luxuries are usually goods that have a YED that is positive and
greater than 1 (YED > 1) e.g. travel, private education, easting
in nice restaurants, etc.
• as income increases the proportion of income spent on these
goods becomes ………………………..
Good
Demand
when Income
= $100
Proportion
of Income
Spent on
good
Demand when Proportion of
Income = $110 Income Spent
on good
A
$20
$21
B
$30
$33
C
$50
$60
YED
What happens to the proportion of income spent on a good as incomes rise, if the
good is INFERIOR?
!Point of Caution!
• As you may have noticed, what is a necessity or what is a
luxury depends on the income levels. The previous
estimates were based mainly for the OECD nations
(Organization of Economic Cooperative and Development).
These OECD nations are the clan of the 30 plus richest
nations in the world. It is like the UN for the rich nations
(www.oecd.org)
• Now, for people or nations with extremely low income
levels (less developed countries) food and clothes will be
luxuries and not necessities
‒ e.g. while YED for food is about 0.15 to 0.20 in developed or OECD
nations, it is estimated to be about 0.80 in poor nations. If you
are more interested, try visit www.worldbank.org, www.ilo.org,
www.adb.org, www.imf.org, and the various research think tanks
in Washington D.C. area!
To Graphically Summarize…as
incomes rise
• There is a relatively smaller rightward shift for necessities than
luxuries for an increase in income
How is the YED useful in the real
world?
– YED is a vital measure in signaling market opportunity
and the rate of expansion of industries for producers
• e.g. overtime as countries experience economic growth,
people’s income increases, which means growing demand for
goods and services.
• The higher the YED for a good or service, the greater the
expansion of its market is likely to be in the future.
• This is why companies are always looking at the GDP estimates
and its changes when they decide on expanding their
operations overseas e.g. Uniqlo eyeing South East Asia such as
Vietnam, Indonesia, etc.
• But on the hindsight, if the economy experiences a recession
goods with YED > 1 are the hardest hit while necessities are less
hit and demand for inferior goods increases
– ALSO NOTICE The YED for food is estimated to be around
0.15 to 0.20 in the OECD nations.
• This means that a 1% increase in income produces 0.15 to 0.2%
increase in spending on food  not very responsive!
(continued)
• YED is a also vital measure in signaling the
development of the economy (Macroeconomic
concept)
– The previous point regarding the industries generalizes
to the entire “macro” economy
– Every economy has 3 main sectors: primary
(agriculture), manufacturing, and service (banking,
insurance) and with economic growth, the relative size
of the three sectors usually change over time and this
can be explained with YED
• YED for primary sector is 0 < YED < 1 while for manufacturing
and service it is YED >1. This is because as the society’s income
rises, their demand gets more sophisticated and demand more
complex goods. They can also save and invest more and
finance the development of the manufacturing and service
sectors
(continued)
– The historical experience of both more and less
developed nations show that with economic growth,
the primary sector becomes less and less important
and gets replaced by manufacturing and services.
– In the developed world today, among the industries
experiencing the fastest growth are in the service
sector including technology and communications,
financial services, health care and medical research,
etc.
– Note: the falling share of the primary sector does not
mean its output is falling. It only says that it is
increasing more slowly than the total output (GDP)
Introducing the Cross Price Elasticity of
Demand (XED)
• Cross-price elasticity of demand (XED) is a measure
of the responsiveness of demand for one good to a
change in the price of another good. It involves the
shift of the demand curve. It provides us with
information on whether demand increases or
decreases and the size of the shift
• And keeping in mind, we know that there are two
key cases/types:
– How changes in the price of substitutes and
complements affect demand…
The Formula for Cross-Price Elasticity of Demand
•
•
OR
∆𝑄𝐴 𝑃1𝐵
.
∆𝑃𝐵 𝑄1𝐴
• As you can see, XED has the same basic form as the formula for PED.
Calculation
• When the price of good B is $4, the quantity
demanded of good A is 100 units. When the
price of good B falls to $3, the quantity
demanded of good A is 80 units.
• 1) Calculate the cross-price elasticity of
demand between A and B
• 2) Are A and B more likely to be skis and
snowboards or skis and poles?
Interpretation of XED formula
– 1. The sign of XED: unlike PED, whose minus sign is ignored
through taking the absolute value, XED is either positive or
negative and the sign is very important for its
interpretation.
• When two goods are substitutes, the cross-price
elasticity of demand for two goods is
……………………
(XED > 0).
•
The demand for one good and the price of the other good change in the same direction:
when the price of one increases, the demand for the other also increases (shifts to right)
– 2. The value of XED: the absolute value of the XED
will demonstrate the size and extent of the “shift” in
demand i.e. the degree of substitutability.
Example
• So if the price of Coke increases, the quantity demand of
Coke decreases and the demand for Pepsi increases as
consumers switch to Pepsi, resulting in a shift of the
demand curve to the right for Pepsi (vice versa)
• A study by Gasmi et al. (1992) “Econometric analysis of
collusive behavior in a soft-drink market” estimated that
the XED of Coke and Pepsi is about “+0.7”
‒ This means that a 1% increase in the price of one leads to a
0.7% increase in the demand for the other or 10% increase in
the price of one leads to a 7% increase in the demand for the
other. This is considered fairly high substitutability.
• Now, the bigger the positive value of XED, the greater
the substitutability between the two goods, the larger
the shift in the demand curves.
Graphically…
Group III2
Key Types/Cases of XED
(continued)
• 2. Complements and Degree of Complementarity
• When two goods are complements, the cross-price
elasticity of demand for two goods is ……………
•
(XED < 0).
• The demand for one good and the price of the other good change in the
opposite directions: when the price of one increases, the demand for the
other falls (shifts to left) and vice versa
• e.g. iPhone6 and …………… ; DVDs and………….;
tennis rackets and…………………………… etc.
Graphically…
• *Note/correction*: it is the horizontal shift distance!
Finally, the XED = 0 or Unrelated
Independent Goods
• Substitutes and Complements are the two key
cases for the use of XED but in real life,
majority of the goods are unrelated or
independent of each other e.g. potatoes and
……………….
• In such case, XED = 0 or close to 0 as a change
in the price of one is unlikely to affect the
demand for the other
Quick reality check…
• Why and how is the XED useful in the real
world?
– It is a vital measure and tool in determining business
pricing decisions and strategies to maximize profits
• E.g. substitutes produced by single firm e.g. Coke also
produces Sprite. Increase in sales through changing prices
can come at the expense of the sales of the other
• E.g. substitutes produced by two or rival firms e.g. Coke
and Pepsi
• E.g. complements produced by different firms has a big
incentive to collaborate (or engage in joint ventures) like
Expedia with hotels and airlines; sports clothes and
equipment; car parts and car companies; etc.
(continued)
– It is a vital measure to consider merger and acquisition
(M&A) of companies in the financial markets i.e.
companies with very similar products might be
interested to merge to eliminate competition (but
government might interfere and establish Competition
and Corporate Law)
– e.g. Starbucks buying Boulangerie Patisserie; Facebook
buying Instagram; Softbank buying Sprint…
– M&A often leads to big profits and market share..
synergies of production, cutting cost, etc.  the
evaluation and finalization of this is conducted by
investment banks e.g. Morgan Stanley, UBS, Merrill
Lynch, Goldman Sachs who manages the world’s money!
Price Elasticity of Supply
• Examines the responsiveness of firms to changes
in price
• The question now is by “how much” does the
quantity supplied change with changes in price??
• Price elasticity of supply (PES) is a measure of the
responsiveness of the quantity of a good
supplied to changes in its price. PES is calculated
along a given supply curve
• As you can see, the same principle of PED and the
formula follows the same general form as well…
Price Elasticity of Supply
OR
∆𝑄𝑠 𝑃1
.
∆𝑃 𝑄1
Example
Group VI
• Suppose the price of strawberries increases from $3 per
kg to $3.50 per kg and for this change in price the
quantity supplied increases from 1000 to 1100 tones per
season. Then the PES is calculated as follows.
• This finding implies that for a 1% increase in the price
of strawberries, quantity supplied increases by 0.59%
(vice versa). We conclude, the demand for iPhon6 is
price inelastic.
• Page 7 of H/O
Range of values and special cases
• Price Elasticity of Supply also ranges in value from zero to infinity.
• And because of the positive relationship between P and Qs, PES is
always………………..
• Supply is unit elastic when PED = 1 meaning the % change in Qs is
equal to the % change in P.
• Demand is perfectly inelastic when PED = 0 meaning the % change in
Qs is zero and it does not change no matter what % the P changes.
• e.g. agricultural products such as season’s entire harvest of fresh
produce/vegetables; the supply of Picasso paintings, seats in a
sports stadium
• Demand is perfectly elastic when PED = infinity meaning the % change
in Qs is infinite for a given % change in P. When there is change in
price, this results in an infinitely large response in the quantity
supplied (eg global supply of cars)
PES Graphs
Comparison of Entire Supply Curves
Important Technical Points and Caveats
• Just like in the case of demand,
– 1. Only when the two supply curves intersect (when
they share a price and quantity combination), it is
possible to make comparisons of PES of the entire
curve by references to the steepness of the curve…
the flatter the supply curve, the more elastic it is at
any given price
– 2. PES also varies along upward sloping straight line
supply curves. Comparison of PES should be done
only at a specific price or price range. Constant PES is
found across entire supply curves are found only for
those that go through the origin (unit elasticity) and
perfectly elastic (infinite) and inelastic (zero) supply
curves
Determinants of PES
• Length of time: the amount of time firms have to
adjust their inputs and resources to alter the
quantity supplied in response to changes in price
– Very short time – unable to respond, inelastic
– As time increases – slightly elastic e.g. hire more
workers
– In a very long time – highly elastic e.g. can hire both
labor and invest in new machines
• Mobility of factors of production (inputs and
resources): if the firms can shift the resources
easily and speedily between different products,
the greater the PES
Determinants of PES
• Spare (unused) capacity of firms: if firms have
unused capacity or resources (e.g. factories and
machines) it is relatively easy for a firm to respond
with increase in output to a change in price. The
greater the spare capacity, the more elastic
• Ability to store stocks: some firms can save and store
production and not sell it right away (if the goods are
durable). The more stock firms have, the more elastic
supply is to changes in prices
Real life example
• For the reasons described above, primary
commodities (agricultural goods) usually have
a ……………….. PES than manufactured goods
– Long time period need to respond (change
output) to changes in price e.g. farmers have long
planting season (eg cocoa trees take SEVEN years
from planting to yielding fruit)
– Limited and immobile resources e.g. land for
cultivating crops
– Long time need to apply or innovate new
technologies to increase the output per land area
e.g. new machines, new irrigation systems, etc.
Short run and long run PES estimates
for selected agricultural commodities
Therefore combining the demand and supply
elasticities………
• Price elasticity of supply for primary products is inelastic
with relatively steep slope, but there are supply shocks
• If we combine this with price inelastic demand, then this
leads to…
• High price volatility!
– High price fluctuations in prices
• But as prices change, so do the revenue/income of the
primary product producers
• An increase in supply with inelastic demand will lead to
………………….in revenue of producers
• For primary producers: they face volatility and
instability . But food is a NECESSITY for people around
the world,- may need……………………….
• UN World Food Program (WFP), UN Food and Agriculture
Organization (FAO) try to provide more stability
Elasticities: summary
• To enhance the precision of demand and
supply analysis, we introduced the concept of
Elasticities which quantified the extent of the
shift of D and S or the movements along the
curves
• 4 types were introduced
– Price Elasticity of Demand
– Income Elasticity of Demand
– Cross-Price Elasticity of Demand
– Price Elasticity of Supply
General Hints and Points on Elasticities
• Make sure to interpret it correctly. The use of percentage
change! For 1% change in xx the other changes by XX%
• The same general form and equation
– % change in QUANTITY divided by % change in P, P of other goods,
income
• The range of values and the types of goods and outcomes!
• Its determinants
• And WHY they are useful in real life: Important real life
application of these measures e.g. business price strategy and
how to maximize profits, implications in primary goods market,
and economic development
• - use to analyse the effects of indirect taxes and subsidies