Download Elasticities - GillmonBusinessStudies

ELASTICITIES
EXPLAINED
Cross Elasticity of Demand
 Cross Price Elasticity of demand measures
the responsiveness of demand for a product
to a change in the price of other related
products. We normally focus on the links
between changes in the prices of substitutes
and complements.
Formular
 Cross Price Elasticity of Demand (CPed) = %
change in the demand for Good X /% change
in the price of Good Y
 The main use of cross price elasticity
concerns changes in the prices of substitutes
and complements.
 With substitute goods such as brands of
cereal or washing powder, an increase in the
price of one good will lead to an increase in
demand for the rival product. Cross price
elasticity will be positive. In recent years, the
prices of new cars have been falling. This
should increase the demand for new cars and
reduce the demand for second hand cars and
mass transport services such as bus travel
(ceteris paribus
 With goods that are in complementary
demand such as the demand for DVD players
and DVD videos, when there is a fall in the
price of DVD players we expect to see more
DVD players bought, leading to an expansion
in market demand for DVD videos
 When there is no relationship between two
products, the cross price elasticity of demand
is zero.
 If CPEoD > 0 then the two goods are
substitutes
 If CPEoD =0 then the two goods are
independent (no relationship between the
two goods
 If CPEoD < 0 then the two goods are
complements
XED
 Cross inelastic if between +1 and – 1
 Cross elastic if > 1 and <-1
 Why does a firm want to know XED?
 Knowing the XED of its own and other related products
enables the firm to map out its market. Mapping allows a
firm to calculate how many rivals it has, and how close they
are. It also allows the firm to measure how important its
complementary products are to its own products.
 This knowledge allows the firm to develop strategies to
reduce its exposure to the risks associated with price
changes by other firms, such as a rise in the price of a
complement or a fall in the price of a substitute.
 Risks can be reduced in a number of ways, including
adopting the following strategies:
 Horizontal integration
 Horizontal integration usually means
merging with a rival, such as the merger of
pharmaceutical giants Glaxo Wellcome and
SmithKline Beecham to create
GlaxoSmithKline (GSK) in 2000. Horizontal
integration occurs when two or more firms
producing similar products merge with each
other, or where one takes over the other.
 Vertical integration
 Vertical integration means merging with a
complement producer, such as a record
producer merging with or taking over a
record store, or radio station.
 Alliances and collusion
 Joint alliances with competitors can also take
place, such as Sony-Ericsson combining
resources to create mobile phones.
 Collusionis also a possibility. For example,
firms may enter into price fixing agreements
so that they avoid having to fight a price war.
This is more likely to occur in
oligopolosticmarkets, where there are only a
few competitors.
PED
 PED is ELASTIC > 1
 PED is INELASTIC < 1
 PED is UNITARY Elastic = 1
Determinants of PED
 The availability of substitutes:
 If a product has few substitutes like salt ,
petrol it will be inelastic compared to a good
which has a lot of substitutes like pasta.
 Time : the longer the time period the more
price elastic a good becomes.
 E.g. Oil price rise in the short term remained
inelastic but over time consumers could
switch to gas or fuel efficient cars
PES
 Price elasticity of supply measures the
relationship between change in quantity
supplied and a change in price. The formula
for price elasticity of supply is:
 Percentage change in quantity supplied /
Percentage change in price
 Inelastic between 0 and 1
 Elastic between 1 and infinity
 Unitary is 1
 Perfectly inelastic is 0
 Perfectly elastic is infinity
 FACTORS THAT DETERMINE ELASTICITY
OF SUPPLY
 The elasticity of supply depends on the
following factors
 The value of price elasticity of supply is
positive, because an increase in price is likely
to increase the quantity supplied to the
market and vice versa. The elasticity of supply
depends on the following factors:
 SPARE CAPACITY
How much spare capacity a firm has - if there
is plenty of spare capacity, the firm should be
able to increase output quite quickly without
a rise in costs and therefore supply will be
elastic
 STOCKS
The level of stocks or inventories - if stocks of
raw materials, components and finished
products are high then the firm is able to
respond to a change in demand quickly by
supplying these stocks onto the market supply will be elastic
 EASE OF FACTOR SUBSTITUTION
Consider the sudden and dramatic increase in
demand for petrol canisters during the recent
fuel shortage. Could manufacturers of coolboxes or producers of other types of canister
have switched their production processes
quickly and easily to meet the high demand
for fuel containers?
 TIME PERIOD
Supply is likely to be more elastic, the longer
the time period a firm has to adjust its
production. In the short run, the firm may not
be able to change its factor inputs. In some
agricultural industries the supply is fixed and
determined by planting decisions made
months before, and climatic conditions,
which affect the production, yield.
 When supply is perfectly inelastic, a shift in
the demand curve has no effect on the
equilibrium quantity supplied onto the
market. Examples include the supply of
tickets for sports or musical venues, and the
short run supply of agricultural products
(where the yield is fixed at harvest time) the
elasticity of supply = zero when the supply
curve is vertical.
 When supply is perfectly elastic a firm can
supply any amount at the same price. This
occurs when the firm can supply at a constant
cost per unit and has no capacity limits to its
production. A change in demand alters the
equilibrium quantity but not the market
clearing price.
 When supply is relatively inelastic a change in
demand affects the price more than the
quantity supplied. The reverse is the case
when supply is relatively elastic. A change in
demand can be met without a change in
market price.
YED
 Demand is inelastic between +1 and -1
 Demand is elastic greater 1 and less than -1
 Normal goods have a positive income
elasticity of demand so as income rise more is
demand at each price level. We make a
distinction between normal necessities and
normal luxuries (both have a positive
coefficient of income elasticity).
 Necessities have an income elasticity of demand
of between 0 and +1. Demand rises with income,
but less than proportionately. Often this is
because we have a limited need to consume
additional quantities of necessary goods as our
real living standards rise. The class examples of
this would be the demand for fresh vegetables,
toothpaste and newspapers. Demand is not very
sensitive at all to fluctuations in income in this
sense total market demand is relatively stable
following changes in the wider economic
(business) cycle.
 Luxuries on the other hand are said to have an
income elasticity of demand > +1. (Demand rises
more than proportionate to a change in income).
Luxuries are items we can (and often do) manage to
do without during periods of below average income
and falling consumer confidence. When incomes are
rising strongly and consumers have the confidence
to go ahead with “big-ticket” items of spending, so
the demand for luxury goods will grow. Conversely in
a recession or economic slowdown, these items of
discretionary spending might be the first victims of
decisions by consumers to rein in their spending and
rebuild savings and household financial balance
sheets.
 Inferior Goods
Inferior goods have a negative income elasticity
of demand. Demand falls as income rises. In a
recession the demand for inferior products might
actually grow (depending on the severity of any
change in income and also the absolute coefficient of income elasticity of demand). For
example if we find that the income elasticity of
demand for cigarettes is -0.3, then a 5% fall in
the average real incomes of consumers might
lead to a 1.5% fall in the total demand for
cigarettes (ceteris paribus).
PED and Total Expenditure
 If a good is inelastic then total expenditure
will rise when price rises
 If a good is elastic then spending will fall if
price rises
PED and Total Revenue
 TR = PxQ
 Price Elastic : when a good is price elastic
then a fall in price will lead to an increase in
total revenue
 Elastic demand, price increase: total revenue
decreases
Elastic demand, price decrease: total revenue
increases
Inelastic demand, price increase: total revenue
increases
Inelastic demand, price decrease: total
revenue decreases
Unit elastic demand: total revenue does not
change