Economics for Managers - Notes

Elasticity: the responsiveness of demand and supply

The price elasticity of demand and its measurement
 Elasticity: A measure of how much one economic
variable—such as the quantity demanded of a product—
responds to changes in another economic variable—such
as the product’s price.
 Price elasticity of demand: The responsiveness of the
quantity demanded of a good to a change in its price.
The price elasticity of demand and its measurement
Measuring the price elasticity of demand
 Divide the percentage change in the quantity demanded of
a product by the percentage change in its price.
 Note: The price elasticity of demand is not the same as the
slope of a demand curve.
The price elasticity of demand and its measurement
Elastic demand and inelastic demand
 Elastic demand: Demand is elastic when the percentage
change in quantity demanded is greater than the
percentage change in price.
 The price elasticity is greater than 1 in absolute value.
The price elasticity of demand and its measurement
Elastic demand and inelastic demand, cont.
 Inelastic demand: Demand is inelastic when the
percentage change in quantity demanded is less than the
percentage change in price.
 The price elasticity is less than 1 in absolute value.
The price elasticity of demand and its measurement
Elastic demand and inelastic demand, cont.
 Unit-elastic demand: Demand is unit-elastic when the
percentage change in quantity demanded is equal to the
percentage change in price.
 The price elasticity is equal to 1 in absolute value.
The price elasticity of demand and its measurement
The mid-point formula
 This formula is used to ensure that the value of the price
elasticity of demand between the same two points is the
same whether the price increases or decreases.
The price elasticity of demand and its measurement
An example of calculating price elasticity
A cinema reduced the price of movie tickets from $20 to $15,
and average daily sales then increased from 5000 tickets to
7000 tickets. Calculate the price elasticity of demand using the
mid-point formula.
2000/6000
-5/17.5
= -1.17
The price elasticity of demand and its measurement
Polar cases of elasticity
 Perfectly inelastic demand: Demand is perfectly inelastic
when a change in price results in no change in quantity
demanded.
 Perfectly elastic demand: Demand is perfectly elastic
when a change in price results in an infinite change in
quantity demanded.
Solved Problem 1
Measuring the elasticity of demand
A study conducted by the Australian Medical Association
suggests that every 10 per cent increase in the price of
cigarettes is associated with a 5 per cent decrease in the
quantity of cigarettes demanded.
a) Use the figures from this study to calculate the price
elasticity of demand for cigarettes.
b) On the basis of your findings, does this suggest that
increasing the price of cigarettes will substantially decrease
smoking?

Solved Problem 1
Measuring the elasticity of demand
Solving the problem:
STEP 1: Review the material. The problem is about calculating
the price elasticity of demand, which is covered in the section
in the textbook, ‘The price elasticity of demand and its
measurement’. It is not necessary to use the mid-point formula,
as the question provides the percentage change in price and
the resulting percentage change in quantity demanded.
Solved Problem 1
Measuring the elasticity of demand
STEP 2: Answer a) using the following formula:

Solved Problem 1
Measuring the elasticity of demand
STEP 2, cont.: Insert the percentage changes from the question
into the formula. In absolute terms, this is:
0.05
Elasticity   0.5
0.10

Solved Problem 1
Measuring the elasticity of demand
STEP 3: Answer b) on the basis of the answer to a).
We find that price elasticity of demand for cigarettes in
absolute terms is less than 1, or price inelastic. This is not
unexpected. Cigarette smoking is a difficult habit to give up. An
increase in price alone is insufficient to induce many people to
break this habit.
The determinants of the price elasticity of demand
1. Availability of close substitutes
2. The length of time involved
3. Luxuries versus necessities
4. Definition of the market
5. Share of expenditure on the good in the consumer’s
budget
Making the Connection 4.1
The price elasticity of demand for breakfast cereal
What happens to the quantity demanded when the price rises
for:
– a specific brand of a variety of cereal;
– all brands of a variety of cereal;
– all cereals?
The relationship between price elasticity and total revenue
 Total revenue: The total amount of funds received by a
seller of a good or service.
  Total revenue is found by multiplying price per unit by the
number of units sold.
The relationship between price elasticity and total revenue
 When demand is price inelastic:
– A decrease in price leads to a decrease in total
revenue.
– An increase in price leads to an increase in total
revenue.
 When demand is price elastic:
– A decrease in price leads to an increase in total
revenue.
– An increase in price leads to a decrease in total
revenue.
Other demand elasticities
Cross-price elasticity of demand
 Cross-price elasticity of demand: The percentage change
in the quantity demanded of one good divided by the
percentage change in the price of another good.

Other demand elasticities

Cross-price elasticity of demand, cont.
  Cross-price elasticity will be positive when the two goods
are substitutes in consumption.
 Cross-price elasticity will be negative when the two goods
are complements in consumption.
Solved Problem 2
Cross-price elasticities
Would you expect the cross-price elasticity between the
following pairs of goods to be positive or negative? Explain
your answers.
a) Coke and Pepsi
b) DVD players and DVDs
c) Sunglasses and vegemite
Solved Problem 2
Cross-price elasticities
Solving the problem:
STEP 1: Review the material. The problem is about cross-price
elasticities of demand, so you may wish to review the section in
the textbook, ‘Cross-price elasticity of demand’.
STEP 2: Solving a). Coke and Pepsi are the classic example of
two goods which are substitutes in consumption. An increase in
the price of Coke would, therefore, lead to an increase in
demand for Pepsi, so the cross-price elasticity would be
positive.
Solved Problem 2
Cross-price elasticities
STEP 3: Solving b). DVD players and DVDs are complements in
consumption. An increase in the price of DVD players would see
a decrease in demand for DVD players, and hence a decrease in
demand for the complement—DVDs. The cross-price elasticity
between the two goods would, therefore, be negative.
Solved Problem 2
Cross-price elasticities
STEP 4: Solving c). Sunglasses and vegemite are completely
unrelated goods, therefore we would expect the cross-price
elasticity to equal zero.
Other demand elasticities
 Income elasticity of demand: A measure of the
responsiveness of quantity demanded to a change in
income.
 It is measured by the percentage change in quantity
demanded divided by the percentage change in income
(disposable income).

Making the Connection 4.3

Is wine a luxury good?
 – Price elasticity of demand of -0.82.
– Income elasticity of demand of 1.25.
Using price and income elasticity to analyse economic issues
Elasticity and the disappearing family farm
 Many agricultural products are characterised by rapid
productivity and output growth, which has led to falling
prices because:
– the demand for agricultural products is price
inelastic; and
– the income elasticity of demand for agricultural
products is low.
The price elasticity of supply and its measurement
 Price elasticity of supply: The responsiveness of the
quantity supplied to a change in price.
 It is measured by dividing the percentage change in the
quantity supplied of a product by the percentage change
in the product’s price.

The price elasticity of supply and its measurement

 The elasticity of supply will always be positive, as price and
quantity supplied move in the same direction.
  The primary determinant of the price elasticity of supply is
the amount by which production costs rise as output levels
rise.
– Other key determinants are largely based upon this.
The price elasticity of supply and its measurement
Key determinants of the price elasticity of supply
1. Length of time involved in production
2. Type of industry
3. Availability of inputs
4. Existing capacity
5. Inventories held
Making the Connection 4.4
Why are oil prices so unstable?
Why do oil prices fluctuate so much?
 Oil is relatively price inelastic in supply.
– Time taken to bring additional quantities of oil to the
market
– Limited substitutes
 OPEC
 Increases in demand
The price elasticity of supply and its measurement
Polar cases of perfectly elastic and perfectly inelastic supply
 The perfectly elastic supply curve is a horizontal line.
 The perfectly inelastic supply curve is a vertical line.
The price elasticity of supply and its measurement
Using price elasticity of supply to predict changes in price
 When demand changes, the change in price depends on
the price elasticity of supply.
Key Terms
Cross-price elasticity of Perfectly inelastic demand
demand Price elasticity of demand
Elastic demand Price elasticity of supply
Elasticity Total revenue
Income elasticity of demand Unit-elastic demand
Inelastic demand
Perfectly elastic demand

Check Your Knowledge

Q1. If you know the value of the price elasticity of demand,
then which of the following can you compute?
a. The effect of a price change on the quantity demanded
b. The responsiveness of the quantity supplied of a good to a
change in its price
c. The price elasticity of supply
 d. All of the above
Check Your Knowledge
Q1. If you know the value of the price elasticity of demand,
then which of the following can you compute?
a. The effect of a price change on the quantity demanded
b. The responsiveness of the quantity supplied of a good to a
change in its price
c. The price elasticity of supply
d. All of the above
Check Your Knowledge
Q2. How do economists avoid confusion over different units of
measurement in the calculation of elasticities?
a. By using aggregate values rather than single values
b. By using whole numbers rather than fractions
c. By using percentage changes
d. By using computer software packages
Check Your Knowledge
Q2. How do economists avoid confusion over different units of
measurement in the calculation of elasticities?
a. By using aggregate values rather than single values
b. By using whole numbers rather than fractions
 c. By using percentage changes
d. By using computer software packages
Check Your Knowledge
Q3. When demand is price inelastic, what is the relationship
between price and total revenue?
a. They move in the same direction.
b. They move in opposite directions.
c. When price changes, total revenue remains the same.
d. They are unrelated.
Check Your Knowledge
Q3. When demand is price inelastic, what is the relationship
between price and total revenue?
a. They move in the same direction.
b. They move in opposite directions.
c. When price changes, total revenue remains the same.
d. They are unrelated.
Check Your Knowledge
Q4. Fill in the blanks: If an increase in the price of a substitute
leads to ________ in quantity demanded, the cross-price
elasticity of demand is ________ .
a. an increase; positive
 b. an increase; negative
c. a decrease; positive
d. a decrease; negative
Check Your Knowledge
Q4. Fill in the blanks: If an increase in the price of a substitute
leads to ________ in quantity demanded, the cross-price
elasticity of demand is ________ .
a. an increase; positive
b. an increase; negative
c. a decrease; positive
d. a decrease; negative
Check Your Knowledge
Q5. Which of the following is likely to be most price inelastic in
supply in the short run?
a. A baker
b. A cattle farm
c. A pizza shop
d. A clothing retailer
Check Your Knowledge
Q5. Which of the following is likely to be most price inelastic in
supply in the short run?
a. A baker
b. A cattle farm
c. A pizza shop
d. A clothing retailer