What is elasticity and what are its main determinants

Explain what is meant by the term elasticity and briefly discuss its main determinants. Using diagrams, equations and real life examples try to examine this concept in the airline industry.

Elasticity is the measure of responsiveness to a percentage change of a variable to a percentage change to one of its determinants. This is usually the price or the income. There are many different elasticities, this includes price elasticity of demand (PED), price elasticity of supply (PES), income elasticity of demand (YED) and cross elasticity of demand (XED).

There are many uses for the application of elasticities, this includes government policies such as tax, where the government can analyse the effects a decrease or an increase in the various tax’ could have. The effect on firms due to changing prices is another situation where elasticities can be applied. Likewise, the effect on firms due to a change in income can also be a use for elasticities. For example, during the recession thousands of people had to cut down on the hours at work, therefore there was a decrease in their income, how could this have affected demand? Elasticities can also be used to analyse future consumption, for example, strawberries are seasonal therefore demand in the summer is greater than demand in the winter, by using elasticities firms could analyse how many strawberries would be required to match consumption and also be used as a guide for future investments. These are just a few of the many uses of elasticities.

Price elasticity of demand (PED) is the degree of responsiveness of quantity demanded of a change in price. This is calculated by using the following formula:

PED= Percentage change in quantity demanded

Percentage change in price

An example of this would be if quantity demanded for TV’s falls by 10% due to a 2.5% increase in the price then PED= -10/2.5=-4. As there will always be a fall in price and an increase in quantity demanded or an increase in price and a fall in quantity demanded PED will always be negative.

There are two types of PED’s; these are elastic demand and inelastic demand. Elastic demand is when a percentage change in price brings about a more than equal percentage change in quantity demanded. This means that a price increase will result in a greater loss in revenue and a decrease in price will result in a more than equal gain in revenue. For the PED to be elastic, the value of elasticity would be greater than 1. For example if the price of a phone decreased by 10%, causing demand to increase by 20% then PED= 20/-10=-2. When the PED value is 1, this is called unitary elasticity; this is when quantity demanded changes by the same percentage as price.

Inelastic demand is when a percentage change in price brings about a less than equal percentage change in quantity demanded. This means that a price increase will result in a less than equal percentage decrease in quantity demanded, therefore a gain in revenue, likewise a decrease in price will result in a less than equal percentage change in quantity demanded therefore a loss in revenue. For the PED to be inelastic, the value of elasticity has to be between 0 and 1. For example if quantity demanded for oil falls by 4% due to a 10% increase in price then PED=-4/10=-0.4. This is usually the case for oil as the substitutes to oil and its complimentary item; a car isn’t as strong as other items. For example if there was a huge increase in the price of a phone, then there are many alternatives therefore its elastic. There are many reasons for oil to be inelastic, such as a car is a long term product and it can’t work without oil, therefore despite an increase in prise consumers are obliged to continue using oil. They can use substitutes to cars, such as the bus, train, bike, walking, etc. However they may be more expensive to operate than a car and will always lack the comfort and sense of privacy a car has. When the PED value is 0, this is known as perfectly inelastic, this is when quantity demanded remains exactly the same regardless of the change in price. The following are elastic and an inelastic diagram.

Elastic Inelastic

Pi

Price Pe1 Price

P P1

Pe P

Pi1

Q Qe1 Q1 Qe Qi Q Qi1

Quantity demanded and supplied Quantity demanded and supplied

In the elastic diagram you can see elastic line (blue) and a perfectly elastic line (red). For the perfectly elastic line you can see that price will always remain the same, regardless of the change in demand as shown by Q and Q1. However for the elastic line you can see that when the price increases from Pe to Pe1, there is a huge (more than equal) contraction in quantity demanded from Qe to Qe1. In the inelastic demand diagram you can see the inelastic line (blue) and the perfectly inelastic line (red). For the perfectly inelastic line demand will always remain the same, even if prices are changed. However for the inelastic line you can see that despite the huge fall in price from Pi to Pi1, quantity demanded has only slightly shifted (less than equal) from Qi to Qi1.

There are many determinants for PED. The PED can vary to all sorts for different products and industries. Substitutes are one of the main determinants for PED. A substitute is a good that can be replaced by another good in order to satisfy a want. The better the substitute, the higher the PED tends be. For example tea has many substitutes, such as coffee, hot chocolate, energy drinks, etc. therefore if the cost of tea increases, many consumers would happily move onto alternatives. On the other hand, sugar has very few substitutes, not many products can replace sugar, and hence an increase in price will have minimal effect on demand.

Time is another major determinant of PED.

“Between December 1973 and June 1974 the price of crude oil quadrupled, which led to large increases in the price of petrol and central-heating oil. Over the next few months, there was only a very small reduction in the consumption of oil products. Demand was highly inelastic. The reason was that people still wanted to drive their cars and heat their house.” (Sloman & Wride, 2009)

From this we could see that oil is incredibly inelastic, therefore despite high prices over long periods of time demand only decreased slightly. The passage then went on saying;

“Over time, however, as the higher oil prices persisted, new fuel-efficient cars were developed and many people switched to smaller cars or moved closer to their work. Similarly, people switched to gas or solid fuel central heating, and spent more money insulating their houses to save on fuel bills. Demand was thus much more elastic in the long run.” (Sloman & Wride, 2009)

As there were no substitutes to oil in the car industry, cars were made more efficient and new ways were developed for central heating, therefore making demand much more elastic in the long run.

Income elasticity of demand (YED) is the degree of responsiveness of quantity demanded of a percentage change in income. This calculated by using the following formula:

YED= Percentage change in quantity demanded

Percentage change in income

An example of this would be tickets for football matches, if incomes fall by 10%, consequently causing quantity demanded fall by 20% then YED=-20/-10=2. As we can see by this example, unlike PED, the YED value isn’t always negative it can also be positive. A change in income can be caused by changes in wage rates, tax rates, government policies, etc.

There are three types of YED’s these are superior goods, inferior goods and normal goods. Superior goods are when a small percentage increase in income leads to a large percentage rise in demand and a small percentage decrease in income would lead to a large fall in demand. For the YED to be superior, the value of elasticity would be greater than 1. For example incomes increase by 2.5% due to a reduction in in income tax causes quantity demanded to increase by 10%, therefore YED=10/2.5=4.

Inferior goods are when an income rise produces a fall in demand for an inferior good as we can afford the more expensive and superior alternatives. This also means that there would be an increase in demand for inferior goods if incomes were to fall. For YED to be inferior the value of elasticity has to be below 0 (negative). An example of this would be during the recession, people used cheaper alternatives as a result of job uncertainties and because of the lower incomes due to having to cut back on hours at work. Demand for the big superstores; Tesco, Asda, Sainsbury’s, etc. fell and demand for low cost chains such as Lidl, Aldi, 99p Stores increased.

Normal goods are when there is a small but positive response to high incomes. YED between 0-1 are normal. Food and clothing are usually normal.