01 CAL Demand Elasticity

Elasticity Overview

Concept

Elasticity is a key economic concept that measures how the quantity demanded of a good or service responds to changes in various factors, most notably price, consumer income, and the price of related goods. Understanding elasticity helps businesses and policymakers make informed decisions that can impact revenues and economic welfare.

Types of Elasticity

1. Price Elasticity of Demand (PED): This measures the responsiveness of the quantity demanded to a change in the price of the good itself.

2. Cross Elasticity of Demand (CED): This gauges the responsiveness of the quantity demanded for one good in relation to the price change of another good.

3. Income Elasticity of Demand (YED): This assesses how the quantity demanded changes in response to a change in consumer income.

Learning Outcomes

• Define and differentiate between various types of elasticity: Ep (Price Elasticity), Ecross (Cross Elasticity), and Ey (Income Elasticity).

• Calculate different types of elasticity using specific formulas and methodologies.

• Understand the significance of elasticity in relation to business pricing strategies and government policies affecting the economy.

Price Elasticity of Demand (PED)

Definition

PED is a measure indicating how much the quantity demanded of a good or service changes when there is a change in its price. A high elasticity indicates that consumers are sensitive to price changes, while low elasticity signifies a relative insensitivity.

Types of Demand

• Elastic Demand: When PED > 1, indicating a proportionately larger change in quantity demanded than the change in price. For example, luxury goods typically exhibit elastic demand.

• Inelastic Demand: When PED < 1, indicating that the change in quantity demanded is proportionately smaller than the change in price. Essential goods like medicine may show inelastic demand.

• Unit Elastic Demand: When PED = 1, meaning that the percentage change in quantity demanded is exactly the same as the percentage change in price.

Total Revenue and Elasticity

• Elastic Demand: If the price of an elastic good increases, total revenues decrease because the loss in quantity demanded outweighs the gain in price.

• Inelastic Demand: A price increase for inelastic goods will lead to an increase in total revenue, as the quantity demanded decreases only slightly.

Calculating Elasticity

1. Percentage Change Method: The formula for calculating PED is:

   • PED = (% Change in Quantity Demanded) / (% Change in Price)

2. Midpoint Method: This approach employs the average of the initial and final quantities and prices to provide a more accurate elasticity measure over larger price changes.

Characteristics of Demand

• Elastic Goods: Characteristics include the presence of many substitutes, the classification as luxury items, and a high proportion of consumer income being spent on these goods.

• Inelastic Goods: Typically possess fewer substitutes, are necessary for consumers, and constitute a low proportion of income.

Cross Elasticity of Demand (CED)

Definition

CED measures how the quantity demanded of one good responds to changes in the price of another good.

Relationship

• Positive CED: Indicates that the two goods are substitutes; when the price of one good increases, the quantity demanded for its substitute goes up (e.g., margarine and butter).

• Negative CED: Suggests that the goods are complements; when the price of one good rises, the quantity demanded of its complement falls (e.g., gaming consoles and video games).

Income Elasticity of Demand (YED)

Definition

YED assesses how the quantity demanded of a good changes in response to changes in consumer income.

Types of Goods

• Luxury Goods: These have a YED greater than 1, meaning demand increases significantly as incomes rise.

• Normal Goods: Characterized by a YED between 0 and 1; demand increases with income but at a lesser proportion.

• Inferior Goods: Defined by a YED less than 0, indicating that demand decreases as consumer income increases (e.g., discount groceries).

Implications for Pricing Decisions

Firms utilize elasticity to devise optimal pricing strategies.

• Price Discrimination: This strategy allows firms to adjust prices based on varying demand conditions, consumer segments, and time periods (e.g., hotels charge different rates for weekends versus weeknights).

• Revenue Maximization: A comprehensive understanding of elasticity enables firms to enhance revenues by strategically adjusting prices in accordance with demand elasticity profiles.