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ECONOMICS FOR BUSINESS Chapter 3 Elasticity of Demand and Supply Delivered by: Sithari Herath MFE(Reading) (UOC), Bsc.Fin(Sp.) (USJP), ACCA, ACMA Elasticity - Economics for Business - IFD 1 1 Scope 1. Price Elasticity of Demand 2.

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SLIDE 1

ECONOMICS FOR BUSINESS

1 Elasticity - Economics for Business - IFD

Chapter 3 – Elasticity of Demand and Supply

Delivered by: Sithari Herath

MFE(Reading) (UOC), Bsc.Fin(Sp.) (USJP), ACCA, ACMA

1

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Scope

  • 1. Price Elasticity of Demand
  • 2. Factors affecting Price Elasticity ofDemand
  • 3. Price Elasticity of Supply
  • 4. Factors affecting Price Elasticity ofSupply
  • 5. Practical use of Price Elasticity ofDemand
  • 6. Income Elasticity ofDemand
  • 7. Cross Elasticity ofDemand

Elasticity - Economics for Business - IFD 2

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1.Price Elasticity of Demand

Price elasticity of Demand (PED) is the degree of sensitivity of demand for a good to changes in price of that good.

Change inQuantity Demand (%) Change inPrice (%) Degreeof Response Degreeof Influence

Elasticity - Economics for Business - IFD 3

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1.Price Elasticity of Demand cont.

𝑄𝐹𝐸 = Calculating PED π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π·β„Žπ‘π‘œπ‘•π‘“ 𝑗 π‘œπ‘Ÿπ‘£π‘π‘œπ‘’π‘—π‘’π‘§π‘’π‘“π‘›π‘π‘œπ‘’π‘“π‘’ π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π‘‘β„Žπ‘π‘œπ‘•π‘“π‘— π‘œπ‘žπ‘ π‘—π‘‘π‘“ 𝑄𝐹𝐸 = 𝑅

1

𝑅2 βˆ’ 𝑅1 Γ—100 𝑄1 𝑄2 βˆ’ 𝑄1 Γ—100

P Q

D

𝑸 𝑸 𝑹 𝑹 (𝟐) (πŸ‘)

Elasticity over a range or arcof the demand curve. E.g. point (1) to(2) using Point Elasticity ofDemand using Arc Elasticity ofDemand Elasticity of a specific pointon demand curve. E.g. point(1) 𝑅1 +𝑅2 2 𝑄1 + 𝑄2 2

Elasticity - Economics for Business - IFD

𝑅2 βˆ’π‘…1 𝑄2 βˆ’π‘„1 𝑄𝐹𝐸 = Γ—100Γ· Γ—100

4

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1.Price Elasticity of Demand cont.

Perfectly Inelastic Inelastic Unitary Elasticity Elastic Perfectly Elastic No Response Low Response Equal Response Perfect Response High Response

Elasticity - Economics for Business - IFD

T ypes of Demand Elasticity 𝑄𝐹𝐸 =∞ PED for mostgoods is negative, so the minus sign is often ignored when taking about PED. For example, we could say that the price elasticity of demand at point(1) is 4, when strictly speaking it is βˆ’4. 𝑄𝐹𝐸 =0 𝑄𝐹𝐸 =1 𝑄𝐹𝐸 <1 𝑄𝐹𝐸 >1

5

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1.Price Elasticity of Demand cont.

Elasticity and DemandCurves

P Q

D 𝐹 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ β†’ 𝑄𝐹𝐸 > 1 βˆ†π‘„% βˆ†π‘…% When PED>1, demand is relatively elastic and the quantity demanded is very responsive to pricechanges

P Q

D 𝐽 π‘œ 𝑓 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ β†’ 𝑄𝐹𝐸 < 1 βˆ†π‘„% βˆ†π‘…% When PED<1, demand isrelatively inelastic and the quantity demanded is not very responsive to pricechanges

Elasticity - Economics for Business - IFD 6

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1.Price Elasticity of Demand cont.

Elasticity and DemandCurves

P Q

D π‘„π‘“π‘ π‘”π‘“π‘‘π‘’π‘šπ‘§π½ π‘œ 𝑓 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ 𝑄𝐹𝐸 =0 The same quantity will be demanded, regardless ofthe price.

P Q

D π‘„π‘“π‘ π‘”π‘“π‘‘π‘’π‘šπ‘§πΉ π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ 𝑄𝐹𝐸 =∞ A very small change inprice results in and infinitelylarge change in demand.

P Q

D π‘‰π‘œπ‘—π‘’π‘π‘ π‘§πΉ π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ 𝑄𝐹𝐸 =1 Percentage change in demand will equal to percentage change in quantity demanded. Rectangular hyperbola

Elasticity - Economics for Business - IFD 7

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1.Price Elasticity of Demand cont.

PED on a straight – line demand curve PED (point elasticity) is different at different points of a demand curve, even if that β€œcurve” is a straight line.

P Q

D 𝑄𝐹𝐸 =∞

Elasticity - Economics for Business - IFD

𝑄𝐹𝐸 =0 𝑄𝐹𝐸 >1 𝑄𝐹𝐸 =1 𝑄𝐹𝐸 <1 Mid point

8

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1.Price Elasticity of Demand cont.

Positive PED Example: Goods bought for the purpose of ostentation, Giffengoods

P Q

D Potato Price Potatoes Demanded Meat Demanded

Elasticity - Economics for Business - IFD 9

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  • 2. Factors affecting Price Elasticity of Demand

The price of the product in relation to totalspending The relative importance of price in relation to other influences ondemand Time

1 2

The availability of substitutes

3 4

Habitual consumption

5

Elasticity - Economics for Business - IFD 10

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  • 3. Price Elasticity ofSupply

Price elasticity of Supply (PES) is the degree of sensitivity ofsupply

  • f a good to changes in price of

that good.

Change inQuantity Supply (%) Change inPrice (%) Degreeof Response Degreeof Influence

Elasticity - Economics for Business - IFD 11

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  • 3. Price Elasticity of Supply cont.

𝑄𝐹𝑇 = Calculating PES π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π·β„Žπ‘π‘œπ‘•π‘“ 𝑗 π‘œπ‘Ÿπ‘£π‘π‘œπ‘’π‘—π‘’π‘§π‘‡π‘£π‘žπ‘žπ‘šπ‘§ π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π‘‘β„Žπ‘π‘œπ‘•π‘“π‘— π‘œπ‘žπ‘ π‘—π‘‘π‘“ 𝑄𝐹𝑇 = 𝑅

1

𝑅2 βˆ’ 𝑅1 Γ—100 𝑄1 𝑄2 βˆ’ 𝑄1 Γ—100

P Q

S

𝑸 𝑸 𝑹 𝑹 (𝟐) (πŸ‘)

Elasticity over a range or arcof the Supply curve. E.g. point (1) to(2) using Point Elasticity ofSupply using Arc Elasticity ofSupply Elasticity of a specific pointon Supply curve. E.g. point (1) 𝑅1 +𝑅2 2 𝑄1 + 𝑄2 2

Elasticity - Economics for Business - IFD

𝑅2 βˆ’π‘…1 𝑄2 βˆ’π‘„1 𝑄𝐹𝑇 = Γ—100Γ· Γ—100

12

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SLIDE 13

Perfectly Inelastic Inelastic Unitary Elasticity Elastic Perfectly Elastic No Response Low Response Equal Response Perfect Response High Response

Elasticity - Economics for Business - IFD

T ypes of SupplyElasticity 𝑄𝐹𝑇 =∞ PES for mostgoods is positive, so the positive sign is

  • ften ignored when

taking about PES. For example, we could say that the price elasticity of supply at point (1) is 4, when strictly speaking it is +4. 𝑄𝐹𝑇 =0 𝑄𝐹𝑇 =1 𝑄𝐹𝑇 <1 𝑄𝐹𝑇 >1

  • 3. Price Elasticity of Supply cont.

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Elasticity and SupplyCurves

P Q

S 𝐹 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘π‘‡π‘£π‘žπ‘žπ‘šπ‘§β†’ 𝑄𝐹𝑇 >1 βˆ†π‘„% βˆ†π‘…% When PES>1, supply is relatively elastic and the quantity supplied is very responsive to price changes

P Q

𝐽 π‘œ 𝑓 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘π‘‡π‘£π‘žπ‘žπ‘šπ‘§β†’ 𝑄𝐹𝑇 <1 S βˆ†π‘„% βˆ†π‘…% When PES<1, supply isrelatively inelastic and the quantity supplied is not very responsive to price changes

  • 3. Price Elasticity of Supply cont.

Elasticity - Economics for Business - IFD 14

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Elasticity and SupplyCurves

P Q

S π‘„π‘“π‘ π‘”π‘“π‘‘π‘’π‘šπ‘§π½ π‘œ 𝑓 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘π‘‡π‘£π‘žπ‘žπ‘šπ‘§ 𝑄𝐹𝑇 =0 The same quantity will be supplied, regardless ofthe price.

P Q

S π‘„π‘“π‘ π‘”π‘“π‘‘π‘’π‘šπ‘§πΉ π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘π‘‡π‘£π‘žπ‘žπ‘šπ‘§ 𝑄𝐹𝑇 =∞ A very small change inprice results in and infinitelylarge change in supply .

P Q

S π‘‰π‘œπ‘—π‘’π‘π‘ π‘§πΉ π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘π‘‡π‘£π‘žπ‘žπ‘šπ‘§ 𝑄𝐹𝑇 =1 Percentage change in price will equal to percentage change in quantity supplied.

  • 3. Price Elasticity of Supply cont.

Elasticity - Economics for Business - IFD 15

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  • 4. Factors affecting Price Elasticity of Supply

The existence of surplus capacity Length of the production process Ease of entry into themarket Alternative uses and availability offactors Time

1 2 3 4 5

Elasticity - Economics for Business - IFD 16

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  • 5. Practical use of Price Elasticity ofDemand

Q

D

πŸ” 𝟐𝟏 𝟐𝟏 πŸ‘πŸ

PED andRevenue 𝑢𝒑𝒖𝒇: π‘ˆπ‘π‘’π‘π‘šπ‘†π‘“π‘€π‘“π‘œπ‘£π‘“(π‘ˆπ‘†) = 𝑄 Γ— 𝑅 π‘‰π‘œπ‘—π‘’π‘π‘ π‘§πΉ π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ β†’ 𝑄𝐹𝐸 =1

P

Change in Price T

  • talRevenue

π‘ˆ = 10 Γ—10 = 100 π‘ˆ = 5 Γ—20 = 100

𝑻𝒃𝒏𝒇

Elasticity - Economics for Business - IFD

𝑻𝒃𝒏𝒇

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5. Practical use of Price Elasticity of Demand cont.

P Q

D

πŸ• 𝟐𝟏 πŸ”πŸ πŸπŸ”πŸ

𝐹 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ β†’ 𝑄𝐹𝐸 > 1 Change in Price T

  • talRevenue

PED andRevenue 𝑢𝒑𝒖𝒇: π‘ˆπ‘π‘’π‘π‘šπ‘†π‘“π‘€π‘“π‘œπ‘£π‘“(π‘ˆπ‘†) = 𝑄 ×𝑅 π‘ˆ = 10 Γ—50 = 500 π‘ˆ = 6 Γ—150 = 900

Elasticity - Economics for Business - IFD 18

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5. Practical use of Price Elasticity of Demand cont.

P Q

D

πŸ” πŸπŸ‘ 𝟐𝟏 πŸπŸ”

𝐽 π‘œ 𝑓 π‘š 𝑏 𝑑 𝑒 𝑗 π‘‘πΈπ‘“π‘›π‘π‘œπ‘’ β†’ 𝑄𝐹𝐸 < 1 Change in Price T

  • talRevenue

PED andRevenue 𝑢𝒑𝒖𝒇: π‘ˆπ‘π‘’π‘π‘šπ‘†π‘“π‘€π‘“π‘œπ‘£π‘“(π‘ˆπ‘†) = 𝑄 ×𝑅 π‘ˆ = 12 Γ—10 = 120 π‘ˆ = 5 Γ—15 = 75

Elasticity - Economics for Business - IFD 19

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  • 6. Income Elasticity ofDemand

Income elasticity of demand (YED) measures thesensitivity

  • f demand for a goodto

changes in consumer income

Change inQuantity Demand (%) Change in consumer Income (%) Degreeof Response Degreeof Influence

Dependent Variable

𝑍𝐹𝐸 = π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π·β„Žπ‘π‘œπ‘•π‘“ 𝑗 π‘œπ‘Ÿπ‘£π‘π‘œπ‘’π‘—π‘’π‘§π‘’π‘“π‘›π‘π‘œπ‘’π‘“π‘’ π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π‘‘β„Žπ‘π‘œπ‘•π‘“π‘— π‘œπ‘—π‘œπ‘‘π‘π‘›π‘“ 𝑍𝐹𝐸 = 𝑅

1

𝑅2 βˆ’ 𝑅1 Γ—100 𝑍

1

𝑍

2 βˆ’ 𝑍 1 Γ—100

The sign of Income elasticity of demand (YED) Normal good

Elasticity - Economics for Business - IFD

Inferior good

Independent Variable

20

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  • 7. Cross Elasticity of Demand

Cross elasticity of demand (XED) measures thesensitivity

  • f demand for one good

to changes in the price

  • f another good.

Change inQuantity Demand (%) Change in price

  • f othergood(%)

Degreeof Response Degree of Influence π‘ŒπΉπΈ = π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π·β„Žπ‘π‘œπ‘•π‘“ 𝑗 π‘œπ‘Ÿπ‘£π‘π‘œπ‘’π‘—π‘’π‘§π‘’π‘“π‘›π‘π‘œπ‘’π‘“π‘’ 𝑝𝑔 𝐻𝑝𝑝𝑒𝐡 π‘„π‘“π‘ π‘‘π‘“π‘œπ‘’π‘π‘•π‘“π‘‘β„Žπ‘π‘œπ‘•π‘“π‘— π‘œπ‘žπ‘ π‘—π‘‘π‘“π‘π‘” 𝐻𝑝𝑝𝑒 𝐢 π‘ŒπΉπΈ = 𝑅𝐡

1

𝑅𝐡2 βˆ’ 𝑅𝐡1 Γ—100 𝑄𝐢1 𝑄𝐢2 βˆ’ 𝑄𝐢1 Γ—100 The sign of Cross elasticityof demand (XED) Substitute good

Elasticity - Economics for Business - IFD

Complement goods

Dependent Variable Independent Variable

21

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Substitutes vs Complements

Elasticity - Economics for Business - IFD

When the cross-price elasticity of demand is positive, the two goods are substitutes e.g. Pepsi and coke, bmw and Audi When the cross-price elasticity of demand isnegative, the two goods are complements e.g. Playstation/ playstation games

22

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Elasticity - Economics for Business - IFD

Government Intervention

TAXATION

  • A tax is a levy charged by the government on

producers & consumers.

  • Types of taxes –direct tax & indirect tax
  • Direct tax-individuals and firms pay to the govt.

Out of their own pocket.

  • Indirect tax –firms collect tax from customers

and pays the govt.

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Elasticity - Economics for Business - IFD 24

Specific vs ad Valorem tax

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Elasticity - Economics for Business - IFD 25

SUBSIDY

  • A grant given by the government to encourage production.
  • More resources are used to produce that good
  • Reallocation of resources to subsidised firms
  • Does not always have to be financial.
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Questions

create Knowledge

Elasticity - Economics for Business - IFD 26

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Thank You!

Elasticity - Economics for Business - IFD 27