Business Economics Topic 4: Elasticity - Elasticity Study Notes

Learning Objectives of Topic 4: Elasticity

• At the end of the lecture, students should be able to:
  • Explain the concept of price elasticity of demand and identify its various determinants.
  • Apply the underlying principles of price elasticity of demand to actual pricing practices in business.
  • Explain the specific relationship between price elasticity of demand and total revenue ($TR$).
  • Explain price elasticity of supply and identify its various determinants.
• Reference: Parkin, M. (2023). Economics, 14th ed. Pearson Global Edition, Chapter 4.

1. Price Elasticity of Demand (PED)

• In previous study, it was established that an inverse relationship typically exists between the price of a good and the quantity demanded, provided all other factors remain constant (ceteris paribus).
  • An increase in the price of a good results in a decrease in original quantity demanded.
  • A fall in the price of a good results in an increase in quantity demanded.
• Price elasticity of demand is calculated to quantify exactly how responsive consumers are to these price changes.
• The Sign of Price Elasticity of Demand:
  • Because of the inverse relationship described by the Law of Demand, the calculated sign of price elasticity of demand will always be negative.
  • In calculations, the negative sign can be kept in the final answer.
  • However, to determine the classification of the elasticity (whether it is elastic, inelastic, etc.), practitioners focus on the magnitude or the absolute value ($|Ep|$) and ignore the minus sign.
  • The magnitude tells us how responsive or elastic the demand is to a price change.

2. Various Possible Elasticities of Demand (Buyer’s Behaviour)

• Elastic Demand ($Ep > 1$):

  • Occurs if the percentage change in quantity demanded is greater than the percentage change in price ($\% \Delta QD > \% \Delta P$).
  • Demand is described as "price elastic."
  • Buyer Responsiveness: Buyers are very responsive to changes in price.
  • Numerical Example: A rise or fall in price by, for instance, $10\%$ will lead to a greater than $10\%$ change in quantity demanded.
  • Curve Characteristics: The gentler (flatter) the demand curve, the more elastic the demand is considered to be.
  • Examples:
    • Expensive items such as holiday travel packages and branded luxury watches.
    • Products with many available substitutes, such as a specific brand (Brand X) of bubble milk tea.

• Inelastic Demand ($0 < Ep < 1$):

  • Occurs if the percentage change in quantity demanded is less than the percentage change in price ($\% \Delta QD < \% \Delta P$).
  • Demand is described as "price inelastic."
  • Buyer Responsiveness: Buyers are not very responsive to changes in price.
  • Numerical Example: A rise or fall in price by, for example, $10\%$ will lead to a less than $10\%$ change in quantity demanded.
  • Curve Characteristics: The steeper the demand curve, the more inelastic the demand is considered to be.
  • Examples:
    • Inexpensive items/cheap stuff, such as a packet of salt.
    • Basic necessities or items with very few close substitutes, such as rice, water, or electricity.

• Summary of Classifications (Magnitude $\text{Ep}$):

  • Perfectly Inelastic: $Ep = 0$. The quantity demanded does not change at all regardless of price changes.
  • Inelastic: $0 < Ep < 1$.
  • Elastic: $1 < Ep < \infty$.
  • Perfectly Elastic: $Ep = \infty$. The quantity demanded changes infinitely with any change in price.
  • Note: Always ignore the negative sign when performing these classifications.

3. Factors Affecting the Elasticity of Demand

• a. Closeness of Substitutes:

  • The closer and more numerous the substitutes for a good or service, the more elastic the demand for that item becomes.
  • Comparison Example: Comparisons between various brands of fresh milk versus goat's milk illustrate this.
    • There are many brands of fresh milk available (e.g., in stores like FairPrice), providing many close substitutes. Thus, demand for a particular brand's fresh milk is more elastic.
    • In contrast, goat's milk has fewer close substitutes. Thus, the $Ep$ for goat's milk is lower (less elastic/more inelastic) compared to the $Ep$ for a specific brand of fresh milk.
  • Decision Rule: many close substitutes = more elastic; few close substitutes = less elastic or inelastic.

• b. Proportion of Income Spent on the Good:

  • Other things remaining equal, the greater the proportion of a consumer's income spent on a good, the more elastic the demand for that good will be.
  • Comparison Example: Air tickets versus bus fares.
    • Buying an air ticket represents a large proportion of a person's income, making consumers very price-sensitive (more elastic).
    • Paying a bus fare represents a small proportion of income, making consumers less price-sensitive (less elastic or inelastic).

• c. Time to Adjust to Price Changes:

  • Demand becomes more elastic as consumers are given more time to adjust to price changes.
  • When a price first changes, consumers may continue buying similar quantities out of habit or lack of immediate alternatives.
  • Given sufficient time, consumers can find acceptable and less costly substitutes.
  • Decision Rule: long time to adjust = more elastic; short time to adjust = less elastic/inelastic.

4. Relationship Between Price Elasticity of Demand and Total Revenue

• Total Revenue (TR) Definition:
  • Total revenue is the amount spent on goods by buyers and received by the sellers.
  • Formula: $\text{Total Revenue} = \text{Price} \times \text{Quantity Sold}$ ($TR = P \times Q$).
• Revenue vs. Profit:
  • $TR$ is not the same as Profit. Profit is calculated as the difference between Total Revenue and Total Cost: $\text{Profit} = TR - TC$.
  • Most firms aim to increase $TR$ because it usually leads to higher profit.
• Case 1: Elastic Demand ($Ep > 1$):
  • A $1\%$ fall in price will lead to an increase in quantity sold by more than $1\%$.
  • Effect on Revenue: Revenue will increase because the percentage increase in quantity demanded outweighs the percentage fall in price.
  • Reverse Case: If price rises when demand is elastic, $TR$ will fall.
• Case 2: Inelastic Demand ($Ep < 1$):
  • A $1\%$ fall in price will lead to an increase in quantity sold by less than $1\%$.
  • Effect on Revenue: Revenue will fall because the percentage fall in price is greater than the percentage increase in quantity demanded.
  • Reverse Case: If price rises when demand is inelastic, $TR$ will rise.

4.1 Applying Price Elasticity of Demand to Businesses

• Case Study: Apple iPhone:
  • iPhone users generally exhibit inelastic demand.
  • Reasoning: There are no close substitutes that utilize the iOS operating system or allow seamless syncing to the Apple ecosystem (e.g., MacBook, iPad, Apple TV).
  • Comparison: Conversely, a model of an Android phone has many close substitutes available, making its demand more elastic.
  • Strategic Application: Because Apple knows demand is inelastic, it can increase the price of iPhones to increase its total revenue.
• Discussion Questions:
  • F1 Grand Prix Scenario: During the F1 Grand Prix, is demand for hotel accommodation elastic or inelastic?
  • Strategic Decision: Should hotels increase or decrease their room rates during the F1 GP to increase total revenue?

5. Price Elasticity of Supply (PES)

• There is a direct relationship between the price of a good and the quantity supplied, ceteris paribus (as price increases, quantity supplied increases).
• Note on Calculation: Explicit calculation of price elasticity of supply is not covered in this curriculum. Instead, the focus is on comparing the percentage changes ($\% \Delta$) between price and quantity supplied.
• Classifications of Supply (Seller's Behaviour):
  • Inelastic Supply: A rise or fall in price by (e.g., $10\%$) will lead to a less than $10\%$ change in quantity supplied ($\% \Delta QS < \% \Delta P$). Sellers are not very responsive to price changes.
  • Perfectly Inelastic Supply: A rise or fall in price will not change the quantity the seller is willing and able to sell.
  • Elastic Supply: A rise or fall in price by (e.g., $10\%$) will lead to a greater than $10\%$ change in quantity supplied ($\% \Delta QS > \% \Delta P$). Sellers are very responsive to price changes.

6. Factors Affecting the Elasticity of Supply

• a. Resource Substitution Possibilities:

  • Goods/services produced using unique or rare productive resources have inelastic supply because production cannot be easily increased even if prices rise.
  • Goods/services produced using commonly available resources have elastic supply as resources can be easily reallocated from other tasks.
  • Example 1: Flight Services: Supply of flights is inelastic because it takes a long time to hire and train air crew. Airlines are constrained by a lack of skilled labor.
  • Example 2: Swab Services: Swabbers can be easily trained. Medical facilities can increase supply quickly in response to price/demand changes, making it elastic.
  • Note on Airlines: Supply of flight services is actually elastic when airlines are reducing quantity supplied, as they can cease all flight services almost immediately if required.
  • Example 3: Agricultural vs. Manufactured Goods: Supply of agricultural products is typically more inelastic than manufactured goods because agricultural products require specific climates and specific time frames for harvesting.

• b. Time Frame for the Supply Decision:

  • Producers and sellers are more responsive to price changes in the long run than in the short run.
  • Case Study: Malaysia Export Ban (June 2022): Malaysia imposed an export ban of fresh chickens into Singapore.
    • Initial Phase (Short Run): Supply of chicken rice in Singapore was inelastic because most sellers relied exclusively on fresh chickens.
    • Adjusted Phase (After 2 months): Supply became more elastic after two months as sellers adapted by importing fresh chickens from Indonesia or substituting them with frozen chicken.