ELASTICITY

-is the responsiveness or sensitivity of one variable to a change in another variable ceteris paribus.

- refers to the responsiveness of the dependent variable to changes in the independent variable.

PRICE ELASTICITY OF DEMAND

-it is the responsiveness of quantity demanded due to changes in the good’s own price.

-sometimes PED is called own price elasticity of demand to distinguish it from cross elasticity of demand.

PED=percentage change in quantity demanded

Percentage change in price

CALCUALTING PED

CALCULATING PERCENTAGE CHANGE IN QUANTITY DEMANDED

CALCULATING PERCENTAGE CHANGE IN PRICE

WHERE

Q2- CURRENT OUTPUT

Q1-ORIGINAL OUTPUT OR INITIAL OUTPUT

P2-CURRENT PRICE

P1-ORIGINAL PRICE
IMPORTANCE OF THE DEFINITION

-Elasticity is calculated using percentage changes which are relative changes not absolute changes. Thus
elasticity calculations should not be affected by price units.

-PED is a ratio called the elasticity coefficient

-Elasticity coefficient enables us to compare how consumers react to changes of different goods and
services.

- The PED is always negative which shows an inverse relationship between price and quantity
demanded.

EXAMPLE

Suppose that at a price of $100, monthly sales of bicycles in a city is 2000. The price rose to $101 and
the quantity of bicycles falls to 1990. Calculate the PED

Leave space for calculations

PED ALONG A STRAIGHT LINE DEMAND CURVE

-The PED falls along the demand curve

-This is because as price decrease, consumer become less responsive to price changes

Price of X Quantity demanded of X

6 0
5 5
4 10
3 15
2 20
1 25
0 30

Question

Calculate PED

(i). Price decreases from $5 to $4

(ii). $4 to $3

(iii). $2 to $1

DIFFERENT CATEGORIES OF PED

There are 5 categories of PED

(i).Perfectly inelastic demand- PED =0

(ii) inelastic demand - PED is less than 1

(iii) unitary elasticity -PED =1

(iv) elastic demand - PED is greater than 1

(v) perfectly elastic demand -PED is infinity

GRAPHICAL ILLUSTRATION

(i). Perfectly inelastic demand

DETERMNANTS OF PED

The exact value of PED for a good is determined by a wide variety of factors

-The following questions has to be answered

(i). Why certain goods are characterized by inelastic demand while others have elastic demand

(ii). What type of goods and services tend to have elastic demand and which tend to have inelastic
demand.

1.Availability of substitutes

-The larger the number of substitutes and the closer the substitutes are, the greater the PED

-For instance salt has a few substitutes.

-When the price of salt increases, the demand for salt will change by a small percentage their PED is
inelastic.

-However, spaghetti has many substitutes like rice and macaroni as a result a rise in the price of
spaghetti will lead to a huge fall in demand. This makes the demand for spaghetti more elastic

2.Addictive/ habit forming goods

-Addictive goods have inelastic demand. This is because if the price of cigarettes increases the demand
will fall by a small percentage because customers are addicted.

-For totally addicted consumers, demand may be perfectly inelastic because consumers cannot survive
without the product.

3.Proportion of income spend on the product

-Goods that consume a greater part of a household’s income tends to be more elastic than those that
take a smaller proportion.

-e.g products like matches and salt take a very small share of a consumer’s budget thus price change
may have a negligible effect on demand.

4.Nature of the good(luxuries or necessities)

-The price elasticity of demand for necessities like basic foodstuffs, electricity, medical care and petrol
tends to be lower than the PED of luxury goods and services such as recreation, entertainment and
luxury motor cars.

-The demand for luxury goods is elastic because consumers can do without them.
5.Time period under consideration

-demand tend to be more elastic in the long run (LR) than in the short run(SR)

-when the price changes, consumers need time to adjust to the change in relative prices

-e.g when the price of fuel goes up, consumers will not be able to do anything immediately.

_in the LR, they can switch to smaller, fuel saving cars.

6.Durability

The more durable the good is, the more elastic demand will tend to be. Eg refrigerators, radios, washing
machines etc.

-If the price of a good rises, consumers may decide to keep their existing goods because old goods are
substituted by new goods.

7.Definition of the product

-The broader the definition of the product, the lower the PED.

-Broader definitions reduce the number of possible substitutes.

-The PED for food for example will be less than the PED for any particular type of food.

-The PED for beef is greater than the PED for meat.

PED AND TOTAL REVENUE (EXPENDITURE)

Total revenue= price x quantity demanded

Eg A firm sells fish at $2 each. 10 fish are sold each day. Calculate the total revenue per day

Solution

TR =P x Q

$2 x 10 =$20

-Total revenue is the same as total expenditure

-Expenditure is the total spending by households and firms.

-The degree of PED determines what happens to total revenue(total expenditure) when price changes.
1. When demand is elastic, price and TR move in opposite direction

-This implies that when prices increase, TR will decrease and when prices decrease TR will increase.

 When the price is $3 quantity demanded is 60 (60*$3=180)

 When the price is $4, quantity demanded will decrease to 30 units ($4*30 =120)

2. When demand is inelastic price and total revenue move in the same direction

 In the case of inelastic demand a rise in the price will cause an increase in total revenue and a
fall in price will cause a decrease in total revenue
  When the price is $3, quantity demanded will be 20 units
 TR =P*Q ($3*20=60)
 When price is increased to $4 quantity demanded will be decreased to 18 units
 TR=P*Q($4*18=72)

3. Total revenue does not change when PED =1 (unity)

 This is because given percentage change in price will cause an equal percentage change in
demand leaving total revenue unchanged

 TR remain the same because area A and area C are equal

PRACTICAL APPLICATION OF PED

 PRICING POLICY
 Firms need to know the degree of elasticity of demand of the product they will be producing
 The following questions has to be answered
 Is the demand of my product elastic or inelastic
 This is because the degree of elasticity has an impact on the total revenue of the firm
 In case where demand is price inelastic firms can raise prices to increase total revenue however
if demand is elastic firms need to reduce prices to increase total revenue

PRODUCTION PLANNING

 Firms can use it for production planning eg by estimating the effect of a price change ,firms can
plan the number of goods to produce ,number of people to employ and the impact on cash flow
 When demand is inelastic, its easier for firms to plan the quantities of output that there are
supposed to produce than where demand is elastic.
  If demand is elastic, the firm must ensure that production is increased to cater for an increase in
demand if prices are reduced.

PRICE DISCRIMATION

 This occurs when products are charged different prices yet there are produced under similar
cost conditions
 Price discrimination can be based on incomes, time, age
 In markets when demand is relatively inelastic firms tend to charge higher prices than in
markets where demand is elastic because customers are less reactive to price changes

GOVERNMENT POLICY

 The government can estimate impact of an indirect tax increase in terms of sales and tax
revenue
 Taxes are the major source for the government where demand is price inelastic the government
tend to charge a higher tax rate than in cases where demand is elastic
 It can also be used for devaluation and tariffs
 It is also used to estimate the impact on consumer spending, producer’s revenue and income of
any shift in supply

CROSS ELASTICITY OF DEMAND

 CED measures the responsiveness of quantity demanded of a particular good due to changes in
the price of a related good
 CED=%change in quantity demanded of good X
%change in price of good Y
 When CED is positive it means the goods are substitutes while if CED is negative it means the
goods are complements
 The mathematical sign of CED shows the nature of the relationship that exist between the two
goods
 CED can be elastic or inelastic
 Its elastic when it is greater than 1 or when its less than -1
 Its inelastic when it is less than 1 or greater than -1
 In the case of complements CED is negative
 Quantity demanded of good X is inversely related to the price y
 Examples are white board an white board markers

 CED=0 in this case the 2 goods are totally unrelated like margarine and motor car tyres
APPLICATION OF CED

1. Firms can estimate the effect on their demand of a competitor’s price cut .This implies that the
firm needs to know the nature of the good they are producing when compared to other goods
in the industry ie does it have substitutes or complements

2. It helps to show competitiveness of the product against rivals .if CED is positive and elastic it
means a cut in price will lead to an increase in sales. If competitors cut price there is need to
effect an equivalent price cut on your goods.

INCOME ELASTICITY OF DEMAND(YED)

 YED=%CHANGE IN QUANTITY DEMANDED

%CHANGE IN INCOME

 It measures the responsiveness of quantity demanded due to changes in income

THE SIGN

 Positive YED means that an increase in income is accompanied by an increase in quantity

demanded of that good ,these are known as normal goods
 Normal goods are further classified as luxury and necessities
 When YED is greater than one demand is income elastic and this will be a luxury good .eg plasma
television and expensive jewelery.
  For luxury goods a change in income leads to more than proportionate change in quantity
demanded
 When YED is positive but less than less 1 ie when demand is income inelastic the good will be a
necessity
 A change in income will result in a less than proportionate change in quantity (YED IS NEGATIVE)
 As income increases quantity demanded will decrease eg black and white television

The figure

 The higher the figure (ignoring the sign ),the greater the relationship between demand and
income
 ENGELS CURVE

It shows the relationship between income and quantity demanded

PRACTICTICAL APPLICATION OF YED

1. YED enables business to estimate growth in demand for different goods and services
from estimation of income growth
-If suppliers forecast a rise in consumer incomes, there is need to plan extra capacity to
supply goods with higher YED in order to maximize profits eg electronic equipment,
foreign travel
-Suppliers of food stuffs are greatly affected by this concept because a rise in consumer
incomes will not increase demand to a greater extend. This may account for poor
agriculture exports in recent years
2. Can determine what goods to produce or stock eg as the economy grows, firms might
want to avoid inferior goods
3. Can help firms plan production and employee requirements as the economy grows
 4. Can help firms estimate any potential changes in demand eg as overseas grow it may
create new markets

Disadvantages of using elasticities for decision making

1. Classification of goods may change with time so its difficult to use elasticity values for decision
making. Eg a good may be elastic today but inelastic in future
2. Planning and expansion depends on other factors such as the availability of capital,
environmental factors, expectations etc.
3. The pricing of goods is usually determined by the costs of production rather than elasticity
values.
4. PED figures are based on estimates, therefore their degree of accuracy is low which makes it
difficult for firms to use them for decision making.

PRICE ELASTICITY OF SUPPLY(PES)

 PES=%CHANGE IN QUANTITY SUPPLIED

%CHANGE IN PRICE

 Responsiveness of quantity supplied due to changes in price

 PES is always positive ,this is because of the positive relationship that exist between price and
quantity supplied

DIFFERENT CATEGORIES OF PES

PES CAN BE

1. PERFECTLY ELASTIC (INFINITE)

2. ELASTIC(>1)
3. UNITARY(=1)
4. INELASTIC (BTWN ZERO AND ONE)
5. PERFECTLY INELASTIC(0)

PERFECTLY ELASTIC SUPPLY

 A firm can supply any quantity it wishes at the ruling market price P0
 If there is a slight decrease in prices below p0 quantity supplied will become zero
 Suppliers are too sensitive to a price decrease
ELASTIC SUPPLY

 Any change in price cause a more proportionate change in quantity supplied

 Any supply curve that intersect the price axis is elastic over the entire length of curve


UNITARY SUPPLY

 In case a change in price causes a proportionate change in quantity supplied (PES=1)

 Any straight line from the origin shows unitary elasticity of supply
INELASTIC SUPPLY

 PES=BETWEEN 0 AND 1
 In this case a change in price causes a less than proportionate change in quantity supplied
 Any supply curve that intersect the horizontal axis is inelastic over an entire length of the curve
 PERFECTLY INELASTIC SUPPLY
 Supply is totally unresponsive to changes in prices
 A fixed quantity (Q0) will be supplied at any price even if the price is low
 The PES coeffient will be zero

DETERMINANTS OF PES

i. TIME
In the short run most supply is inelastic because suppliers dont have sufficient time to respond
to price changes. However in the long run ,they can adjust their levels of production in response
to changes in prices eg they can expand their factories and increase the level of production

DIFFERENT PRODUCTION TIME PERIODS

THE MOMENTARY OR MARKET PERIOD

 Supply is limited to the quantities already available in the market and it cannot be
increased even if a substantial rise in prices occur
 All factors of production are fixed
 Supply is perfectly inelastic
Short run
 Supply is constrained by fixed factors ,a firm cannot alter current size of plant or factory
  Output can only be increased by employing factors of production that are variable eg
labour
 Supply is generally inelastic
 One factor of production if fixed(capital) and the other one is variable (labour)

Long run

 The time period in which all factors of production can be varied

 Production can now be increased by varying all factors of production ie there are no fixed
factors
 The period is long enough to change the quantity of all inputs into relevant production process
 In the industry, the number of firms and their sizes can now be increased since new firms cab be
established and old firms may leave the industry
 Supply is more elastic than in the short run

The very long run

 The period is long enough for basic technology in the industry to change ie the whole production
function changes
 The time it takes to move from the short run to the long run depends on how long it takes to
change all the factors of production
 This may take years eg in the nuclear power station but weeks or months for a local market

Ii] NUMBER OF PRODUCERS

One producer –inelastic supply

Many producers – elastic supply
 The more the producers ,the easier it should be for the industry to increase output in
response to a price increase

Iii] Existence of spare capacity

 spare capacity refers to unutilized resources

 also known as spare capacity ‘
 these are resources that will be unemployed
 firm A has spare capacity-supply elastic
 firm B has no excess capacity –supply inelastic
 the more capacity there is in industry , the easier it should be to increase output if prices
go up ,in the short run it may be possible to increase suppliers if there is a pool of
unemployed labour and unused machinery in the industry hence supply will be elastic
 however if firms are at full employment ie there are fully utilizing their resources supply
will usually be inelastic
 iv)EASE OF STORING UNSOLD STOCKS

 FIRM A PRODUCES PERISHABLE –INELASTIC SUPPLY

 FIRM B PRODUCES NON PERISHABLE –ELASTIC SUPPLY
 If it is easy to stock goods , then if the price raises their firm can sell these stocks and so
supply is more elastic
 However in the case of goods such as fresh flowers it may not be easy to store them
hence supply will not be flexible ie will be inelastic

(v) AVAILABITY OF INPUTS

 FIRM A HAS INPUTS-ELASTIC SUPPLY
 FIRM B HAS NO INPUTS-INELASTIC SUPPLY
 If essential inputs are not available firms cannot increase their output in reaction to an
increase in the price of the product eg non-renewable resources

(vi) FACTOR (RESOURCE) MOBILITY

 FACTORS ARE MOBILE –ELASTIC SUPPLY

 FACTORS ARE IMMOBILE –INELASTIC
 The easier it is for resources to move into the industry , the more elastic will be eg in agriculture
if land and labour can readily be shifted from crop A to crop B then the supply of crops will be
more elastic
(vi) LENGTH OF THE PRODUCTION PERIOD
 The quicker a good is to produce the easier it will be to respond to a change in price eg supply in
manufacturing is usually more price elastic than in agriculture

(vii) DEGREE OF SUBSTUTABILITY

 LABOUR AND CAPITAL ARE SUBSTITUTES –ELASTIC SUPPLY
 LABOUR AND CAPITAL ARE NOT SUBSTITUTES –INELASTIC SUPPY

FUNCTIONS OF PRICES IN AN ECONOMY

 In the market system resources are allocated by the price mechanism

 The price will adjust to equate demand and supply
 The following functions of the price mechanism

1.RATIONING FUNCTION

 Given that resources are scarce and wants are infinite , the price mechanism rations
demand to meet supply
 Eg if demand is greater than supply prices will increase to reduce quantity demanded
until equilibrium is restored
2.INCENTIVE FUNCTION

 High prices act as an incentive for producers in other markets to leave them and come
into this one because of the high profits that can be earned
 As prices increase producers will tend to supply more to the market since they are
driven by the profit motive
 An increase in price will force producers to divert their resources to those products that
are more profitable

 A decrease in demand for good A has led to a reduction in the price of good A from P0
to P1 .There is no incentive for producers to supply more to the market resulting in a
decrease in quantity supplied from qo to q1
 However for good B whose prices has increased due to an increase in demand ,
producers have reacted by increasing quantity supplied since there is an incentive to do
so
3.SIGNALLING FUNCTION

 The price acts as a signal to producers eg if prices increase this is a signal for producers
eg if prices increase , this is a signal for producers to supply more to the market
 The signaling function is related to the incentive function eg according to the above
diagrams the shift in the demand curve producers to increase quantity supplied
 This is because there is an incentive to supply more
 Producers find it possible to expand their output at the higher price the price price
 The price level is also a signal to producers about consumer preferences

INTER-RELATIONSHIPS BETWEEN MARKETS

1.COMPLEMENTS (JOINT DEMAND)

-These are goods that are jointly used to satisfy a want

-e.g cars and petrol, tea and sugar, dvd disks and dvd recorders

-A fall in the price of dvd recorders will increase the quantity demanded for dvd recorders.

-This will increase the demand for a complementary good i.e dvd disks.

-As a result, there will be an increase in price and quantity demanded of dvd disks.

-On the other hand , a in the price of dvd recorders will reduce the quantity demanded of dvd recorders.

-This will reduce the demand for dvd disks which is a complementary good.

-As a result, there will be a fall in price and quantity demanded of dvds

-The relationship between complement can be shown using a price-consumption curve.

As the price of dvd recorders increases, less quantity of dvd disks will be demanded.

2.SUBSTITUTES( COPETITIVE DEMAND)

- A substitute is a good that can be used in place of another good to satisfy a certain want. Eg butter and
margarine, beef and pork, colgate and close-up, geisha and lux etc

-Substitutes are said to be in competitive demand or alternative demand.

-An increase in the price of butter will cause a fall in quantity demanded of butter

-This will increase the demand for the other substitute ie margarine.

-Consumers will substitute margarine for butter.

-As a result, a rise in demand for margarine will cause a rise in its price and quantity demanded.

-Substitutes can also be shown using a price consumption curve.

-If the price of butter rises from Po to P1, the demand for margarine rises as shown by a rise in
consumption from Q0 to Q1.

3.DERIVED DEMAND

-Is when the demand for one good comes from the demand for another good.

-eg * the demand for steel comes from the demand for cars.

* the demand for flour comes from the demand for bread

* the demand for sugar comes from the demand for bavereges.

-The demand for steel comes the demand for cars

- A rise in demand for cars will cause a rise in demand for steel.

- A rise in demand will cause a rise in price and quantity demanded of goods with a derived demand.

4.COMPOSITE DEMAND

- Occurs when a good is demanded for two or more distinct uses.

- eg milk may be demanded for yoghurt making or cheese making.

- Land may be demanded for residential, industrial or commercial

-A rise in demand for one composite good will lead to a fall in supply for another.

- A rise in demand for milk in yoghurt making shifts its demand to the right.

-This increases the price of milk and quantity demanded will also increase.

-However, the supply of milk for cheese making will fall

- This causes the price of milk to rise but the quantity demanded of milk for cheese making falls.

JOINT SUPPLY (COMLEMENTS IN PRODUCTION)

-These are goods that are produced togather.

-It implies that an increase in supply for one good will automatically cause an increase in supply of other
goods with which it is in joint supply.

- beef and leather, sugar and molasses, oil and gas.

-A rise in demand for one good in joint supply will lead to an increase in its price i.e beef

-This leads to an increase in quantity supplied.

-However, the supply of the other complement will increase.

-As a result, the price will fall and quantity demanded increases.

UPWARD SLOPING DEMAND CURVES

-Demand curves are usually downward sloping, however there are possible reasons why the demand
curve for some goods maybe upward sloping.
(a).Inflation

-As prices increase customers will tend to buy more of the product as they fear further or future prices.
E.g 2008 in Zimbabwe.

(b) Goods with a snob appeal/ Veblen goods

-They are bought to confer status on the buyer

-Examples might be the demand for luxury cars such as Ferrari, expensive jeweliery.

-The argument is that these goods are demanded because few people can afford them because their
price is high.

-If a large number of people could afford to buy them, then quantity demanded will be low.

(c).Quality of goods

-Some consumers judge quality by price so they automatically assume that higher priced goods must be
of better quality than similar lower priced goods hence the higher the price the greater the quantity
demanded.

(d).Speculative goods

-The higher the price of shares, the higher the demand because buyers associate high share price with
large speculative gains in the future.

(e).Giffen goods

-These are a special type of inferior goods.

-It is a strongly inferior good, so if the price goes up, real income would fall forcing consumers to
abandon other goods to concentrate on necessities.

-In most cases they are relatively very cheap and are usually looked down upon by customers eg bread,
sadza etc

- A rise in the price of a giffen good such as bread will increase the quantity demanded of the good.

-This is because poor people would now have so little money to spend on other luxury goods.

CONSUMER SURPLUS

-It is the difference between the price a consumer is prepared to pay and the price he actually pays.

-It is a measure of surplus utility/ welfare the consumer receives over and above what they pays for.
-The demand curve indicates the highest price consumers are willing and able to pay for different
quantities of the good.

-Suppose price is p* and quantity demanded is q. This means that P xQ is the value that the last
consumer places on the laptop.

-If the price were slightly above P*, the last consumer would not buy the laptop.

-This last consumer is known as the marginal consumer.

-To the marginal consumer, P* represents the marginal benefit derived from consuming this good