Economics | Elasticity

👋 Welcome to the Chapter on Elasticity!

Hello future economists! This chapter is one of the most practical and important concepts in the entire "Market System" section. Don't worry if the formulas look scary; at its heart, elasticity is just a fancy way of measuring sensitivity.

Think of it like a rubber band: how much does it stretch when you pull on it? In Economics, we ask: How much does the quantity demanded or supplied change when the price (or income) changes?

Understanding elasticity helps businesses decide on pricing, helps governments predict the impact of taxes, and helps you understand consumer behavior. Let’s dive in!

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1. The Core Concept: What is Elasticity?

Definition

Elasticity measures the responsiveness of one variable (like quantity demanded) to a change in another variable (like price or income).

• If a small change in price causes a huge change in quantity demanded, demand is Elastic (very sensitive, like stretchy elastic).
• If a huge change in price causes only a small change in quantity demanded, demand is Inelastic (not sensitive, like stiff cardboard).

The General Formula Trick

All elasticity formulas follow the same pattern. You are always dividing the percentage change in the "effect" by the percentage change in the "cause."

\[ \text{Elasticity} = \frac{\text{Percentage Change in Quantity}}{\text{Percentage Change in Price/Income/Other Price}} \]

Quick Review: We use percentage changes because it allows us to compare products with different price ranges (e.g., comparing the price change of a $1 candy bar vs. a $50,000 car).

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2. Price Elasticity of Demand (PED)

Definition and Formula

Price Elasticity of Demand (PED) measures how responsive the quantity demanded of a good is to a change in its own price.

Key Formula:

\[ \text{PED} = \frac{\text{\% Change in Quantity Demanded}}{\text{\% Change in Price}} \]

Important Note on the Sign: Because the Demand Curve slopes downwards (Law of Demand), Price and Quantity always move in opposite directions. This means the PED calculation will always result in a negative number. For simplicity and comparison, economists usually ignore the negative sign and look only at the absolute value (the magnitude).

Interpreting the PED Value

When we look at the absolute value of PED, we classify demand into three main categories:

Case 1: Elastic Demand (\( \text{PED} > 1 \))

• The percentage change in quantity demanded is greater than the percentage change in price.
• Example: If the price rises by 10%, the quantity demanded falls by 20%. (PED = 20/10 = 2).
• Consumers are very sensitive to price changes.
• Analogy: A very stretchy rubber band.

Case 2: Inelastic Demand (\( \text{PED} < 1 \))

• The percentage change in quantity demanded is less than the percentage change in price.
• Example: If the price rises by 10%, the quantity demanded falls by only 5%. (PED = 5/10 = 0.5).
• Consumers are not very sensitive to price changes.
• Analogy: A piece of wood (rigid).

Case 3: Unitary Elasticity (\( \text{PED} = 1 \))

• The percentage change in quantity demanded is exactly equal to the percentage change in price.
• Example: If the price rises by 10%, the quantity demanded falls by 10%.

Extreme Cases:
Perfectly Elastic (PED = \(\infty\)): The slightest price change causes demand to drop to zero.
Perfectly Inelastic (PED = 0): Quantity demanded does not change, regardless of price (e.g., a life-saving drug).

Factors Determining Price Elasticity of Demand (Determinants of PED)

Why is the demand for milk inelastic, but the demand for a specific brand of chocolate elastic? It depends on these key factors:

1. Availability of Substitutes (The Most Important Factor)

• If there are many close substitutes (e.g., different coffee brands), consumers can easily switch if the price increases. Demand is Elastic.
• If there are few or no close substitutes (e.g., electricity, insulin), consumers have to keep buying regardless of price. Demand is Inelastic.

2. Necessity vs. Luxury

• Necessities (like staple foods, basic housing) are needed regardless of price changes. Demand is Inelastic.
• Luxuries (like vacations, designer clothes) can be postponed or done without if the price rises. Demand is Elastic.

3. Proportion of Income Spent on the Good

• If the good takes up a tiny fraction of your income (e.g., a packet of chewing gum), a price change won't affect your decision much. Demand is Inelastic.
• If the good is a major purchase (e.g., a new car or television), a price change is very noticeable. Demand is Elastic.

4. Time Period

• In the short run, consumers may not have time to find alternatives or adjust their habits. Demand tends to be more Inelastic.
• In the long run, consumers have time to search for substitutes or change consumption patterns. Demand becomes more Elastic. (Example: You cannot switch from gasoline immediately, but over 5 years, you might buy an electric car.)

PED and Total Revenue (A crucial link for firms!)

A firm’s Total Revenue (TR) is calculated by Price (\(P\)) multiplied by Quantity Sold (\(Q\)). Understanding PED tells a firm whether raising or lowering the price will increase their revenue.

If Demand is...	To Increase Total Revenue...	Why?
Elastic (\( \text{PED} > 1 \))	LOWER the Price	A small drop in price leads to a proportionately much larger increase in quantity sold. The gain in quantity outweighs the loss per unit price.
Inelastic (\( \text{PED} < 1 \))	RAISE the Price	Consumers barely reduce their quantity demanded, so the higher price per unit brings in more revenue overall.
Unitary (\( \text{PED} = 1 \))	Changing price will not change total revenue.	The changes cancel each other out.

💡 Memory Aid: If demand is Elastic, you should Ease the price down (Lower it) to get more revenue.

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3. Income Elasticity of Demand (YED)

We often change what we buy when our income changes. YED measures this relationship.

Definition and Formula

Income Elasticity of Demand (YED) measures how responsive the quantity demanded of a good is to a change in consumers' incomes.

Key Formula:

\[ \text{YED} = \frac{\text{\% Change in Quantity Demanded}}{\text{\% Change in Income}} \]

Did you know? This time, the sign (positive or negative) matters hugely!

Interpreting the YED Value and Sign

YED is used to classify goods into two main types:

Case 1: Normal Goods (\( \text{YED} > 0 \))

• If income increases, demand for the good also increases (and vice versa).
• YED is positive.
• Example: Most goods you buy—like branded clothing, fresh produce, restaurant meals.

Case 2: Inferior Goods (\( \text{YED} < 0 \))

• If income increases, demand for the good decreases, as consumers switch to better-quality, more expensive alternatives.
• YED is negative.
• Example: Cheap instant noodles, basic bus travel (when you can now afford a car), or store-brand value products.

Encouragement: Don't worry about the magnitude for YED (whether it’s 0.5 or 3.0), just focus on whether the number is positive or negative!

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4. Cross Elasticity of Demand (XED)

XED measures how a change in the price of one product affects the demand for another product.

Definition and Formula

Cross Elasticity of Demand (XED) measures the responsiveness of the quantity demanded of Good A to a change in the price of Good B.

Key Formula:

\[ \text{XED} = \frac{\text{\% Change in Quantity Demanded of Good A}}{\text{\% Change in Price of Good B}} \]

Like YED, the sign is critical for classifying the relationship between the two goods.

Interpreting the XED Value and Sign

Case 1: Substitutes (\( \text{XED} > 0 \))

• If the price of Good B increases, the demand for Good A increases (because consumers switch away from B).
• XED is positive.
• Example: If the price of Coca-Cola goes up, demand for Pepsi (a substitute) goes up.
• The higher the positive number, the closer the substitutes are.

Case 2: Complements (\( \text{XED} < 0 \))

• If the price of Good B increases, the demand for Good A decreases (because people buy less of the item they use together).
• XED is negative.
• Example: If the price of petrol goes up, people drive less, and demand for tires (a complement) goes down.

Case 3: Unrelated Goods (\( \text{XED} = 0 \))

• The price change of one good has no measurable effect on the demand for the other good.
• Example: The price of bread and the demand for calculators.

🔑 Quick Check: If the two goods are substitutes, they move in the same direction (Price B up, Demand A up = Positive XED).

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5. Price Elasticity of Supply (PES)

We’ve looked at consumers (Demand). Now we look at producers and how they respond to price changes.

Definition and Formula

Price Elasticity of Supply (PES) measures how responsive the quantity supplied of a good is to a change in its own price.

Key Formula:

\[ \text{PES} = \frac{\text{\% Change in Quantity Supplied}}{\text{\% Change in Price}} \]

Note: Because price and quantity supplied move in the same direction (Law of Supply), the PES value will almost always be positive.

Interpreting the PES Value

The interpretation is similar to PED, but focusing on the producer's ability to adjust output:

Case 1: Elastic Supply (\( \text{PES} > 1 \))

• Producers can rapidly increase output without a huge rise in costs.
• Supply is very responsive to price changes.

Case 2: Inelastic Supply (\( \text{PES} < 1 \))

• Producers struggle to increase output quickly (e.g., they need a new factory or machinery).
• Supply is not very responsive to price changes.

Factors Determining Price Elasticity of Supply (Determinants of PES)

What makes a supplier quick or slow to respond to a price change?

1. Time Period of Production

• Short Run: Firms usually have fixed capacity (cannot build new factories instantly), making supply Inelastic.
• Long Run: Firms have time to expand production, hire more staff, or build new facilities, making supply much more Elastic.
• Example: It takes years to grow new wine grapes (Inelastic), but hours to produce more pizza (Elastic).

2. Availability of Spare Capacity

• If a factory is already running 24/7 (no spare capacity), supply is Inelastic because they cannot immediately produce more.
• If a factory is only running at 50% capacity, they can easily ramp up production when the price increases. Supply is Elastic.

3. Ease of Switching Production (Factor Mobility)

• If the factors of production (labour, raw materials) can be easily moved or adapted to produce a different good, supply is Elastic. (Example: A baker can easily switch from making sourdough to focaccia.)
• If factors are specialized and fixed (e.g., specific machinery for oil drilling), supply is Inelastic.

4. Storage and Stock Levels

• If a firm holds large inventories (stock), they can quickly meet unexpected increases in demand simply by selling existing stock. Supply is Elastic.
• If the product cannot be stored (e.g., fresh services or perishable items), supply tends to be Inelastic.

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📝 Final Study Tips for Elasticity

Elasticity is foundational! Remember that the key to success is knowing which elasticity you are dealing with, and then focusing on the correct rule:

• PED: Focus on the magnitude ( > 1 or < 1). Does the change in price cause a large or small reaction in quantity?
• YED: Focus on the sign (+ or -). Does higher income mean higher demand (Normal) or lower demand (Inferior)?
• XED: Focus on the sign (+ or -). Do the goods move together (Substitutes = +) or against each other (Complements = -)?
• PES: Focus on the determinants, especially time and spare capacity.

You’ve covered a lot of ground! Practice using the formulas and linking the elasticity values back to real-world examples, and you will master this chapter!