MICROECONOMICS [DETERMINANTS OF ELASTICITY] October 2, 2012 PED YED CED Def PED measures the degree YED measures the degree CED measures the degree of of responsiveness of of responsiveness of responsiveness of quantity quantity demanded of a quantity demanded to a demanded of a good to a change in good to a change in its change in the income of the price of another good, ceteris own price, ceteris paribus consumers, ceteris paribus paribus Formula Sign Always negative Can be positive or negative Can be positive or negative Price 1 << Normal goods YED > 1 Normal goods/ CED > 0 Substitutes Elastic Luxury goods CED <0 Complements YED < 0 Inferior goods Price 0 << 1 Necessities 0 < YED < 1 Necessities CED = 0 Unrelated goods, sales Inelastic independent of each other

Determinants of PRICE Elasticity of Demand:

o Availability of Substitutes

Most important determinant is the number and closeness of substitutes. The greater the number of substitutes available for a good and the closer the substitutes, the more price elastic is the demand for that good. This is because more consumers are likely to switch to alternatives when the price of the good increases. Conversely, the demand for electricity is price-inelastic as there are no close substitutes for electricity currently.

*number and closeness of substitute goods also depend on the broadness of the definition of the good. The broader the definition, the more price-inelastic is the demand.

o Necessity

Basic Goods: if goods are necessities, the consumption of such goods is essential and usually cannot be delayed or postponed. These are goods that are required for daily consumption in order to sustain a basic quality of life. It is easier to forgo luxuries but not necessities. As such, the demand tends to be relatively price inelastic.

Habit/Addiction: demand for these goods tends to be price inelastic if the good is bought on a habitual basis. If consumers are addicted to the product, they cannot easily change their consumption habits in response to price changes.

o Proportion of Income

The higher the proportion of income spent on the good, the more price-elastic is the demand. For example, table salt is relatively price-inelastic as consumers spend a tiny fraction of their income on it. Consumers would have little difficulty paying even if there is a relatively large percentage increase in prices of salt. In contrast, there will be a much bigger effect when major items, such as cars and houses rise in price.

By Tong Xueyin 1 MICROECONOMICS [DETERMINANTS OF ELASTICITY] October 2, 2012 o Time Period

In general, the demand for most goods and services would be relatively price-inelastic in the short run and relatively price-elastic in the long run. This is because when prices rise, consumers may take time to adjust their consumption patterns and find suitable alternatives. The longer the time period after a price change, the more price-elastic will be the demand for the good as consumers have more time to make necessary adjustments in response to the price change.

*Useful for firms and producers: pricing strategies and Government: raise tax revenues and reduce negative externalities

Determinants of INCOME Elasticity of Demand:

o Nature of good

In general, demand of necessities is income inelastic whereas demand for non-necessities such as luxury goods is income elastic.

Necessities: YED is mainly determined by the degree of necessity for the good. Basic goods usually have relatively low positive income elasticities. YED is relatively low because the desire for increased consumption usually does not grow in direct proportion to increased incomes for such basic goods which are meant to provide for a minimum decent living standard.

Luxury Goods: YED is positive and high as people generally prefer to spend a higher percentage of their extra income on them to enhance their quality of life when they become affluent. On the other hand, these are goods that people will consider first in cutting back expenditures when times are bad and incomes fall.

o Level of Affluence of Consumers

According to Engel’s law, the same good might be considered an inferior, normal or luxury good depending on the income level of the consumer. In general, what may be considered as luxuries to the poor or low-income households might be considered as necessities or even inferior to the wealthy or high income households. As our income rises, we tend to want to consume better quality goods.

*application of YED for firms: output decisions (what and when to produce?) and targeting different income groups in different locations

*application of CED for firms’ reaction to rival firms selling SUBSTITUTES: pricing strategy – match price-cut; non-pricing strategy – product differentiation, discounts. COMPLEMENTS: joint promotion

Determinants of PRICE Elasticity of Supply

PES Definition PES measures the degree By Tong Xueyin 2 MICROECONOMICS [DETERMINANTS OF ELASTICITY] October 2, 2012 of responsiveness of quantity supplied of a good to a change in its own price, ceteris paribus Formula Sign Always positive Price Elastic 1 < PES < Price Inelastic 0 < PES < 1 o The existence of Spare Capacity

If spare or unused capacity exists and if variable inputs such as labour and raw materials are available, it should be possible to increase production quickly in the short run while the reverse is true.

*Spare capacity ≠ new/expansion of capacity

o Nature of Production

Ease of factor substitution (factor mobility): many firms produce a range of products and are able to switch factors from one type of production to another. If factors of production can be switched easily in terms of its use, then the supply of the product will tend to be price elastic. Thus, the degree of mobility of resources determines the extent to which factor substitution can be carried out.

*the ease at which the factors of production can move around is termed geographical and occupationally mobility of factors

Length of production period: the shorter the time period for firms to convert factor inputs into outputs, the more price-elastic is the supply of the good. Supply of primary products usually tends to be highly price inelastic, while supply of manufactured goods tends to be relatively much more elastic because it is easier to adjust the production period.

o The Ease of Accumulating Inventory or Stocks

Inventory refer to the firm’s stocks of unsold goods, which are produced but have yet to be sold or put on sale in the market. If it is easy to store unsold stocks at low cost, firms will be able to meet a sudden increase in demand by running down stocks. Likewise, they can respond to a sudden fall in demand and price by taking supply off the market and by diverting production into stock accumulation.

o Time Period

In general, the supply for most goods and services is price-inelastic in the short run and relatively more elastic in the long run. In the short run, there may be greater difficulty for sellers to increase supply in respond to higher demand due to the lack of spare capacity; immobility of resources or

By Tong Xueyin 3 MICROECONOMICS [DETERMINANTS OF ELASTICITY] October 2, 2012 inadequate stocks. However, in the long run, firms can take measure to rectify these “supply bottlenecks” and thus be in a better position to increase production.

*PED & PES affect: extent of price volatility, output and extent of changes in consumer expenditure

By Tong Xueyin 4