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Elasticities Explained

Elasticities Explained. Cross Elasticity of Demand. Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products. We normally focus on the links between changes in the prices of substitutes and complements. Formular.

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Elasticities Explained

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  1. ElasticitiesExplained

  2. Cross Elasticity of Demand • Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products. We normally focus on the links between changes in the prices of substitutes and complements.

  3. Formular • Cross Price Elasticity of Demand (CPed) = % change in the demand for Good X /% change in the price of Good Y

  4. The main use of cross price elasticity concerns changes in the prices of substitutes and complements.

  5. With substitute goods such as brands of cereal or washing powder, an increase in the price of one good will lead to an increase in demand for the rival product. Cross price elasticity will be positive. In recent years, the prices of new cars have been falling. This should increase the demand for new cars and reduce the demand for second hand cars and mass transport services such as bus travel (ceteris paribus

  6. With goods that are in complementary demand such as the demand for DVD players and DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought, leading to an expansion in market demand for DVD videos

  7. When there is no relationship between two products, the cross price elasticity of demand is zero.

  8. If CPEoD > 0 then the two goods are substitutes • If CPEoD =0 then the two goods are independent (no relationship between the two goods • If CPEoD < 0 then the two goods are complements

  9. XED • Cross inelastic if between +1 and – 1 • Cross elastic if > 1 and <-1

  10. Why does a firm want to know XED? • Knowing the XED of its own and other related products enables the firm to map out its market. Mapping allows a firm to calculate how many rivals it has, and how close they are. It also allows the firm to measure how important its complementary products are to its own products. • This knowledge allows the firm to develop strategies to reduce its exposure to the risks associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute. • Risks can be reduced in a number of ways, including adopting the following strategies:

  11. Horizontal integration • Horizontal integration usually means merging with a rival, such as the merger of pharmaceutical giants Glaxo Wellcome and SmithKline Beecham to create GlaxoSmithKline (GSK) in 2000. Horizontal integration occurs when two or more firms producing similar products merge with each other, or where one takes over the other.

  12. Vertical integration • Vertical integration means merging with a complement producer, such as a record producer merging with or taking over a record store, or radio station.

  13. Alliances and collusion • Joint alliances with competitors can also take place, such as Sony-Ericsson combining resources to create mobile phones. • Collusionis also a possibility. For example, firms may enter into price fixing agreements so that they avoid having to fight a price war. This is more likely to occur in oligopolosticmarkets, where there are only a few competitors.

  14. PED • PED is ELASTIC > 1 • PED is INELASTIC < 1 • PED is UNITARY Elastic = 1

  15. Determinants of PED • The availability of substitutes: • If a product has few substitutes like salt , petrol it will be inelastic compared to a good which has a lot of substitutes like pasta.

  16. Time : the longer the time period the more price elastic a good becomes. • E.g. Oil price rise in the short term remained inelastic but over time consumers could switch to gas or fuel efficient cars

  17. PES • Price elasticity of supply measures the relationship between change in quantity supplied and a change in price. The formula for price elasticity of supply is: • Percentage change in quantity supplied / Percentage change in price

  18. Inelastic between 0 and 1 • Elastic between 1 and infinity • Unitary is 1 • Perfectly inelastic is 0 • Perfectly elastic is infinity

  19. FACTORS THAT DETERMINE ELASTICITY OF SUPPLY • The elasticity of supply depends on the following factors • The value of price elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa. The elasticity of supply depends on the following factors:

  20. SPARE CAPACITYHow much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic

  21. STOCKSThe level of stocks or inventories - if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic

  22. EASE OF FACTOR SUBSTITUTIONConsider the sudden and dramatic increase in demand for petrol canisters during the recent fuel shortage. Could manufacturers of cool-boxes or producers of other types of canister have switched their production processes quickly and easily to meet the high demand for fuel containers?

  23. TIME PERIODSupply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and determined by planting decisions made months before, and climatic conditions, which affect the production, yield.

  24. When supply is perfectly inelastic, a shift in the demand curve has no effect on the equilibrium quantity supplied onto the market. Examples include the supply of tickets for sports or musical venues, and the short run supply of agricultural products (where the yield is fixed at harvest time) the elasticity of supply = zero when the supply curve is vertical.

  25. When supply is perfectly elastic a firm can supply any amount at the same price. This occurs when the firm can supply at a constant cost per unit and has no capacity limits to its production. A change in demand alters the equilibrium quantity but not the market clearing price.

  26. When supply is relatively inelastic a change in demand affects the price more than the quantity supplied. The reverse is the case when supply is relatively elastic. A change in demand can be met without a change in market price.

  27. YED • Demand is inelastic between +1 and -1 • Demand is elastic greater 1 and less than -1

  28. Normal goods have a positive income elasticity of demand so as income rise more is demand at each price level. We make a distinction between normal necessities and normal luxuries (both have a positive coefficient of income elasticity).

  29. Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because we have a limited need to consume additional quantities of necessary goods as our real living standards rise. The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle.

  30. Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with “big-ticket” items of spending, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to rein in their spending and rebuild savings and household financial balance sheets.

  31. Inferior GoodsInferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example if we find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).

  32. PED and Total Expenditure • If a good is inelastic then total expenditure will rise when price rises • If a good is elastic then spending will fall if price rises

  33. PED and Total Revenue • TR = PxQ • Price Elastic : when a good is price elastic then a fall in price will lead to an increase in total revenue

  34. Elastic demand, price increase: total revenue decreasesElastic demand, price decrease: total revenue increasesInelastic demand, price increase: total revenue increasesInelastic demand, price decrease: total revenue decreasesUnit elastic demand: total revenue does not change

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