Price Elasticities of Demand and Supply

This is really important when taking supply and demand to the next level, and relates to the market as a whole. But what is this price elasticity?

Price Elasticities

Measure how sensitive something is to changes in price, the main ones are market demand and supply

Elasticities Define Price: It is largely why prices for some goods are higher than others, especially where there is a fixed amount available(‘perfectly inelastic supply’) I mean, just look at major event tickets selling for thousands.

So let’s look at the two types…..

Price Elasticity of Demand

Measures how much demand for a good changes when it’s price changes. When a goods price increases, less people will want it, but to what extent?

PED is given by a number, calculated by…..

% change in quantity demanded/% change in price

The dependence on oil means it has a low PED

What Defines PED

PED is mainly affected, but not limited to, the following factors

  • Value for money of Complements
  • Value for money of Subsititutes
  • Fraction of price to total income
  • Brand Loyalty
  • Rushed for time?
  • Luxury or Necessity for everyday life?

Price Elasticity of Supply

The change in supply of a good where its price changes. Measured by…

% Change Supplied/% Change Price

It may be seen as the extent the price mechanism works, simply by how many more people are willing to sell the good when its price increases.

Some things, like talent, remain scarce at any price…

What it depends upon..

PES depends on mainly, but n0t limited to, the following factors…

  • Scarcity of people, equipment needed. E.g. Music, Computers in 1980’s
  • Performance of other markets which use the same factors. E.g. Cornfields when wheat prices are high
  • Expectations of entrepreneurs. E.g. How long will prices stay this way?
  • Level of competition of producers. E.g. Patented drugs, IP

The Jargon

There are various categories with what to describe a good, related to elasticities mainly PED but can also be PES..

A good is…

  • Elastic: Where demand is price sensitive and the equation greater than 1.
  • Inelastic: The good is price insensitive, with the equation less than 1.
  • Unit Elastic:  Where the equation equals 1
  • Perfectly Elastic: Where demand (or supply) any value at one price. Equation is infinity.
  • Perfectly Inelastic: Where the equation equals 0, no price sensitivity at all.

Other Elasticities…..

Income Elasticity of Demand

Here, we measure how demand for a good changes with varying income.

Say you get a huge pay rise (yes, we can dream on here): Which goods are you likely to buy that you didnt before, and which goods will you stop buying or buy less of?

Measured by…

% change in quantity demanded/% change in income

Like before, we can categorise goods, but with this time their income elasticity of demand….

Normal Goods: Goods you will buy more of with higher pay and vice versa.

It usually substitutes a lesser quality equivalent E.g. Ben & Jerry’s, Maldives Hotel, Ipad 2

Inferior Goods: Goods you buy less of with more income and vice versa. Negative YED.

Cheaper alternatives usually replaced by normal goods, but can also be habits ditched altogether E.g. Tesco Neopolitan, holiday with the lads in Magaluf, Ipad 1 🙂

Cross Elasticity of Demand

The extent of the change in demand for a good due to a change in another’s price is the Cross Elasticity of Demand between them.

% Change in Demand for Good ‘Y’/% Change in Price for Good ‘X’.

Where X,Y different goods.

Example: Shortened to XED. Say we have, beer and cider. If the price of beer increases by 20%, more are likely to switch to cider, say about a 5% increase in demand.

Complements and Substitutes: Complementary goods have a negative cross elasticity of demand, when the price of one rises, demand for the other falls with it. Substitutes have a positive value, demand rises with the price of the alternative.

Uncommon Elasticities

Giffen Goods

A giffen good is one which demand increases when its price increases, and is largely theoritical with few examples in practice. It is an inferior good and price inelastic and the sample often has to already be spending a high portion of their income on it.

How It Works: The fact that the demand falls due to rising price is offset by the disposable income of the consumer falling, causing greater demand as the consumer downgrades. As a higher amount of income is needed to buy the good when it’s price rises, less income is available for other things.

The income effect on the inferior good is greater than the price elasticity of demand effect

Necessity: Giffen Goods are often a necessity. Bread was the original example of such a good.

Veblen Good.

As a goods price increases to very high levels, it may be seen as flash and expensive, and people may want to buy it to show off where they are wealthy already. Examples are diamonds, other expensive jewellery, hotels such as the Ritz(where food is still just food).

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