Price, and Cross Elasticity · Lesson Objectives By the end of the lesson • All of you should be able to explain and calculate price elasticity of demand • Excellent if you are

Price, Income and Cross Elasticity

Lesson ObjectivesBy the end of the lesson• All of you should be able

to explain and calculate price elasticity of demand

• Excellent if you are able to apply price elasticity to supply and demand curves

• Even better if you can analyse what determines the price elasticity of goods

In this lesson we will• Learn the meaning of

elasticity and examine the concept of price elasticity of demand

Elasticity• 4 basic types used:• Price elasticity of demand• Price elasticity of supply• Income elasticity of demand• Cross elasticity

Price Elasticity of Demand• The responsiveness of one demand to a change in price

• When price rises, what happens to demand?• Demand falls• BUT…• How much does demand fall?

P

QD

Price Elasticity of Demand• If price rises by 10% ‐ what happens to demand?

• We know demand will fall• By more than 10%?• By less than 10%?

• Elasticity measures the extent to which demand will change

Elasticity• Price Elasticity of Demand

– The responsiveness of demand to changes in price

– Where % change in demand is greater than % change in price – elastic

– Where % change in demand is less than % change in price ‐ inelastic

ElasticityThe Formula:

Ped =% Change in Quantity Demanded___________________________

% Change in Price

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic

Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Quick Activity1) Calculate the Ped of a new computer game if the price

falls from £20 to £15 and demand responds by rising from 200 units per week to 240 units per week.

2) Calculate the Ped if the price rose from £15 to £20 and demand fell from 240 to 140 units per week

Elasticity

Price

Quantity Demanded (000s)

D

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

£5

100

Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.

This value is represented by the grey

shaded rectangle.Total Revenue

ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the

increase in demand and the change therefore in total

revenue.

£5

100

£3

140

Total Revenue

Inelastic demand

Price (£)

Quantity Demanded

10

D

5

5

6

% ∆ Price = -50%

% ∆ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

Elastic Demand

Price (£)

Quantity Demanded

D

10

5 20

Producer decides to reduce price to increase sales

7

% ∆ in Price = - 30%% ∆ in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

Elasticity

• If demand is price elastic:

• Increasing price would reduce TR (%Δ Qd > % Δ P)

• Reducing price would increase TR (%Δ Qd > % Δ P)

• If demand is price inelastic:

• Increasing price would increase TR (%Δ Qd < % Δ P)

• Reducing price would reduce TR (%Δ Qd < % Δ P)







Elasticity & total revenue

Change in the market

Ped is inelastic and a firm raises its price.

Ped is elastic and a firm lowers its price.

Ped is elastic and a firm raises price.

Ped is -1.0 and the firm raises price by 4%

Ped is -0.4 and the firm raises price by 30%

Ped is -0.2 and the firm lowers price by 20%

Ped is -4.0 and the firm lowers price by 15%

What happens to total revenue?

Activity• Arrange the cards into a spectrum of price elasticity, from most elastic to most inelastic

Examples• Price elasticity of alcohol

• From the video you have just seen, create a diagram to demonstrate the effects of the proposed minimum price level of alcohol.

• Japan increases tax on cigarettes

• Effects of the rising price of petrol

Multiple Choice QuestionAn airline announces that it is ‘slashing fares on all of its flights’. Given a fare reduction of 35%, what would be the expected percentage rise in demand for those flights if the company has estimated their price elasticity of demand is ‐2.0?

A – 17.5B – 175.0C – 7.0D – 70.0



• Excellent if you are able to apply price/income elasticity to supply and demand diagrams

• Even better if you can analyse what determines the price/income elasticity of goods

In this lesson we will• Further examine the

concept of price elasticity of demand and learn about income elasticity of demand

What factors affect Ped?• Look at the example (Tuition Fees)

• What conclusions can you draw from the report?

How does PED change over time?• How has the PED of Nintendo’s Wii console changed since it was launched in 2006?

• Demonstrate using a diagram

ElasticityPrice (£)

Quantity Demanded

The demand curve can be a range of gradients each of which is associated with a

different relationship between price and the quantity

demanded.

Price Elastic or Inelastic demand?• A 10% fall in the price of Euro‐star tickets• An 20% increase in the price of the Financial Times• A taxi home from a night‐club on a Friday night• A 15% rise in car insurance premiums charged by Tesco car insurance• Motorway petrol prices rise by 5%• The price of central heating oil rises by 20%• A local leisure club decreases monthly charges by 15% in a bid to

increase the number of members

Factors that Determine Ped– (1) Number of close substitutes for a good and the uniqueness of the product in the market

– (2) Degree of necessity of consumption– (3) The % of a consumer’s income allocated to consumers’ spending on the good

– (4) The time period allowed following a price change – (5) Whether demand causes habitual consumption– (6) Peak and Off Peak Demand

Why is understanding Ped important for firms?

Discuss…

Why is understanding Ped important for firms?

• Firms can use Ped estimates to predict:– The effect of a change in price on quantity demanded– The effect of a change in price on total revenue– The likely price volatility in a market following unexpected changes in supply

– The effect of a change in indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer

– Information on the price elasticity of demand can be utilized as part of a policy of price discrimination

In an era of rising fuel prices, is the UK government right to maintain high levels of fuel

duty?

Veblen Goods

• These are goods for which demand rises as price rises

• They are linked to OSTENTATIOUS CONSUMPTION

• A record year for luxury car sales

Giffen Goods• http://www.economist.com/blogs/freeexchange/2007/07/as_price_goes_up_so_does_deman

• Read this article

• What is a giffen good?• Explain why these ‘anomalies’ in the law of demand occur

• Draw a diagram to illustrate giffen goods

Using Price Elasticity of Demand– How much tax revenue will higher “sin taxes” on cigarettes and alcohol provide?

– Why do airlines often give discounts for advance bookings?

– What happens to our demand for foreign holidays when the exchange rate appreciates?

– Why do hotels lower room‐rates at weekends and why do car rental firms charge lower prices at weekend?







Time Frame and Price Elasticity: Oil Price Shocks

• In 2008 the price of oil reached a record of nearly $150 a barrel.

• How do you think consumers responded to this?

• How might their behaviour change over time?

• Why?

Time Frame and Price Elasticity: Oil Price Shocks

– Response to higher prices was modest in the immediate period

– As time passed, people found ways to consume less petroleum and other oil products• Better mileage from their cars (switch to smaller vehicles)

• Higher spending on insulation in homes and factories

• Car pooling for commuters– Car manufacturers invested

enormous sums in more fuel efficient vehicles seeing a long term market opportunity

– Development of oil substitutes in the long run (natural gas, solar heating, nuclear energy)

Longer Term Demand for Oil –More Price Elastic

Demand for Oil

Price $ per barrel

Oil Demand

P1

P2

Q1 Q2

P3

Q3

Longer run demand is relatively more elastic if non-oil substitutes develop

D short-run

D long-run

Income Elasticity of Demand

Lesson ObjectivesBy the end of the lesson• All should be know how to

calculate and interpret income elasticity of demand, and be able to explain the difference between luxury, necessity and inferior goods

• Even better if you can explain how the cyclical nature of the economy affects the demand for goods and services

• Excellent when you can evaluate the impact of Yed on the behaviour of firms

In this lesson we will

• Learn the meaning of elasticity and examine the concept of income elasticity of demand

Income Elasticity• Income Elasticity of Demand (Yed)

– The responsiveness of demand to changes in real incomes

• What does this depend on?

• Normal Good – demand rises as income rises and vice versa

• Inferior Good – demand falls as income rises and vice versa

Different Types of Goods and their Income Elasticity

Normal Luxury

Air travel

Fine wines

Luxury chocolates

Private education

Private health care

Antique furniture

Designer clothes


Normal Luxury Normal Necessity

Air travel Fresh vegetables

Fine wines Instant coffee

Luxury chocolates Natural cheese

Private education Fruit juice

Private health care Spending on utilities

Antique furniture Shampoo / toothpaste / detergents

Designer clothes Rail travel


Normal Luxury Normal Necessity Inferior Good

Air travel Fresh vegetables Frozen vegetables

Fine wines Instant coffee Cigarettes

Luxury chocolates Natural cheese Processed cheese

Private education Fruit juice Margarine

Private health care Spending on utilities Tinned meat

Antique furniture Shampoo / toothpaste / detergents

Value “own-brand” bread

Designer clothes Rail travel Bus travel

ElasticityThe Formula:

Yed =% Change in Quantity Demanded___________________________

% Change in Real Income

If answer is between 0 and 1: the relationship is inelastic

If the answer is between 1 and infinity: the relationship is elastic

Income Elasticity of Demand

• Income Elasticity of Demand:

• A positive sign denotes a normal good• A negative sign denotes an inferior good

• Why is this?

Elasticity• For example:

• Yed = ‐ 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8%

• Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%

• Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%

• Yed = ‐ 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%

Card Sort1) Sort the cards provided into the most/least income

elastic

2) Choose one good and explain the factors that will influence its YED

Lesson ObjectivesBy the end of the lesson• All should be know how to

calculate and interpret income elasticity of demand, and be able to explain the difference between luxury, necessity and inferior goods

• Even better if you can explain how the cyclical nature of the economy affects the demand for goods and services

• Excellent when you can evaluate the impact of Yed on the behaviour of firms

In this lesson we will

• Learn the meaning of elasticity and examine the concept of income elasticity of demand

Elasticity

• Cross Elasticity:• The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement

Xed = % ∆ Qd of good t__________________

% ∆ Price of good y

Elasticity• Goods which are complements:

– Cross Elasticity will have negative sign (inverse relationship between the two)

• Goods which are substitutes:– Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity• Price Elasticity of Supply:

– The responsiveness of supply to changes in price

– If Pes is inelastic ‐ it will be difficult for suppliers to react swiftly to changes in price

– If Pes is elastic – supply can react quickly to changes in price

Pes = % ∆ Quantity Supplied____________________

% ∆ Price

What will determine elasticity?• 2 minutes to discuss...

Determinants of Elasticity• Time period – the longer the time under consideration the more

elastic a good is likely to be

• Number and closeness of substitutes – the greater the number of substitutes, the more elastic

• The proportion of income taken up by the product – the smaller the proportion the more inelastic

• Luxury or Necessity ‐ for example, addictive drugs

Importance of Elasticity• Relationship between changes in price and total revenue

• Importance in determining what goods to tax (tax revenue)

• Importance in analysing time lags in production

• Influences the behaviour of a firm

Elasticity & total revenue

Change in the market What happens to total revenue?

Ped is inelastic and a firm raises its price. Total revenue increases

Ped is elastic and a firm lowers its price. Total revenue increases

Ped is elastic and a firm raises price. Total revenue decreases

Ped is -1.5 and the firm raises price by 4% Total revenue stays the same

Ped is -0.4 and the firm raises price by 30% Total revenue increases

Ped is -0.2 and the firm lowers price by 20% Total revenue decreases

Ped is -4.0 and the firm lowers price by 15% Total revenue increases

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Price, and Cross Elasticity · Lesson Objectives By the end of the lesson • All of you should be able to explain and calculate price elasticity of demand • Excellent if you are