Economics: Elasticity

One of the recent topics I tried to simplify for myself were - Elasticity, and hopefully this quick explanation will be helpful:

Elasticity

(Mohr, et al., 2008-2010, p. 154) States “Elasticity is a measure of responsiveness or sensitivity. When two variables are related, one often wants to know how sensitive or responsive the dependant variable is to changes in the independent variable”

Elasticity is calculated by:

Elasticity = Percentage change in dependant variable/ percentage change in independent variable.

Price Elasticity of Demand

(Mohr, et al., 2008-2010, p. 154) States “The price elasticity of demand is the percentage change in the quantity demanded if the price of the product changes by one present”

Price elasticity of demand is calculated by:

Ep = percentage change in the quantity demanded of a product/ percentage change in the price of the product.

Example to calculate the price change in quantity:

The price of computer increases from R1000 to R2000

The initial demand was 2000 but now the demand is 1000

Ep = (New Quantity – Old Quantity) / (New Price – Old Price) * 100

Ep = (2000-1000) / (1000 - 2000) = 100%

Ep = -100% (quantity demand decreases in demand curve)

 The different categories of Price Elasticity of Demand are:

• Perfect inelastic demand
• Inelastic demand
• Elastic demand
• Unitary elastic
• Perfect Elastic Demand

Perfect inelastic demand

(Mohr, et al., 2008-2010, p. 160) States:” This shows that consumers plan to purchase a fixed amount of product, irrespective of price”

Perfect inelastic demand indicates that consumers will always purchase the product, no matter what the price. In other words: Elasticity of demand equals 0.

Inelastic demand

(Mohr, et al., 2008-2010, p. 160) States “Demand is said to be inelastic when the quantity demanded changes in response to a changing in price, but the percentage change in the quantity is less than the percentage change in the price of the product”

The demand for fuel will decrease slightly if the price of fuel increases (due to people trying to save money by taking public transport) thus the elasticity is less than 1.

 Elastic demand

(Mohr, et al., 2008-2010, p. 162)  Demand is said to be elastic when a price change leads to a proportionally greater change in the quantity demanded.

The elasticity is > 1. E.g. sweets (if price is low people will buy it; if price is high people will not purchase it anymore)

Unitary elastic

(Mohr, et al., 2008-2010, p. 162)  States “Unitary elastic occurs when the percentage change in the quantity demanded is exactly equal to the percentage change in price”

For example insulin, if there is a percentage change in quantity demanded then there will be a percentage change in price. (More people get diabetes, the cheaper the medicine).

 Perfect Elastic Demand

(Mohr, et al., 2008-2010, p. 162)  States “This curve shows that consumers are willing to purchase any quantity at a certain price, but if the price is raised only fractionally, the demanded quantity falls to zero”

For example you can purchase foreign exchange at R10 if the exchange rate it R10, but if the selling price is R11 for R10 currency then the demand drop to zero.

 The factors that determine elasticity is:

• Percentage of Income,
• Quality of product,
• Availability,
• Ease of substitution products,
• Brand Loyalty, and
• Necessity

 The following table indicates the relation between the elasticity’s, revenue and substitution products:

Elasticity	Price Elasticity of Demand	Revenue	Substitution
Elastic	Ep > 1	Increase in price results in decrease in demand with decrease in revenue	Easy replaceable
Inelastic	Ep < 1	Increase in price results in a small decrease in demand Revenue increases	Hard to Replace
Unitary elastic	Ep =1	Revenue at maximum level	Difficult to replace but not impossible
Perfect elastic	Ep = 0	Increase in price, demand drop to 0 Revenue will disappear	Easy replaceable
Perfect inelastic	Ep= infinity	Decrease of demand will lead to same decrease of price Revenue will decrease	Hard to Replace

 Demand and elasticity

Demand has a direct relationship to the elasticity of price and quantity.

The following section elaborates on the concepts of demand against elasticity against consumer’s income:

• Own-Price elasticity of Demand (Arc and point elasticity’s)
  • Definition: (Davies & Lam, 2001, p. 127) States: “A better way to measure the responsiveness of demand to changes in price”
  • Calculation: (change in quantity/change in price) * (price/quantity)
  • Revenue: Decrease in price will lead to increase in sales, thus increasing the revenue.
• Income elasticity of demand,
  • Definition: (Davies & Lam, 2001, p. 131) States: “The size and sign of the income elasticity of demand for a product depends to a great extend upon the nature of the product in question and the level of income that consumers have reached”
  • Calculation: : (change in quantity demanded/change in consumers income) * (consumers income/quantity demanded)
  • Revenue: Increase in income will lead to more spending on luxury goods, and at decreased income spending will be less on luxury goods, and ore on commodities, (increased income = increased revenue on luxury items)
• Cross price elasticity’s of demand,
  • Definition: (Davies & Lam, 2001, p. 133) States: “indicates the responsiveness of the demand for a commodity to changes in the other goods, the most important other goods to consider being close substitutes and compliments”
  • Calculation:  (change in quantity of A demanded/ change of price of B) * (price of B/ quantity of A)
  • Revenue: Revenue will increase if the price of a substitution product rises.

In essence the basic premise is that the more consumers earn, the more they will spend on goods and services.

 Supply and Elasticity

Supply has a direct impact on the elasticity with relation to the price supplied.

The following section elaborates on the concepts of supply against elasticity against consumer’s income:

• Perfectly inelastic supply (e > 0),
• Inelastic supply (e> 0 and e< 1)
• Unit elastic supply (e=1)
• Elastic supply (e>1)
• Perfectly elastic supply (e=infinity)
  Elasticity of supply is calculated by percentage change in quantity supplied/ percentage change in price
   Complementary Products
  (Wilinson, 2005, p. 96) States “Complementary products are consumed together in some way; cars and petrol are complements”
  If the price of the primary product rises then the demand for the complementary product will drop. E.g. jam is a complementary product to bread and butter, and if the price of bread and butter increases then the demand for jam will decrease. If the price of jam increases then it has no effect on bread as bread is a commodity, but the demand for jam will still decrease.
   Estimates
  When determining the demand of a product an estimate can be used to determine the future demand of a product. Estimates can be used as well around all complementary and substitution products, because not all products are priced the same, e.g. cigarettes cost different price per brand.
   How managers should respond to elasticity
  The following factors are applicable for managers in the determination of price elasticity of supply:

• Time since last price increase,
• Price expectations of customers,
• Excess capacity, and
• Availability of inputs,
• Stockpiling of inputs and outputs
  If there is an outside factor for example higher oil price or increased interest rate, then the disposable income for the consumer will be lower, and the demand for products will be lower as well.
  Managers should use elasticity to assist them in determining the correct price for their products and assist them to be able to be competitive in the market in relation to other substitution products.
  If the organisation sets the product price too high then the demand of the consumers will drop, revenues will fall, and consumers will find substitution products. Managers must then set the price to be lower than its competitors must, and the consumers will purchase more of the products.
  Bibliography
  Davies, H. & Lam, P.-L., 2001. Managerial Economics, An Analysis of Business Issues. 3rd ed. s.l.:Financial Times Prentice Hall.
  Mohr, P., Fourie, L.& associates, a., 2008-2010. Economics for South African Students. 4th ed. s.l.:Van Schaik publishers.
  Wilinson, N., 2005. Managerial Economics, A problem solving approach. 1st ed. s.l.:Cambridge University Press.