Elasticity

What elasticity means

Elasticity measures how much one thing responds to a change in another. In this topic it measures how much quantity responds to a change in price.

Price elasticity of demand

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PED = percentage change in quantity demanded ÷ percentage change in price

PED is normally negative, because price and quantity move in opposite directions. Most answers ignore the minus sign and compare the number to 1.

A worked calculation. Price rises by 10% and quantity demanded falls by 5%:

PED = −5% ÷ 10% = −0.5. Ignoring the sign, 0.5 is less than 1, so demand is inelastic, quantity has changed proportionately less than price.

What makes demand elastic or inelastic. Remember SPLAT:

Time is the one students forget. Demand is always more elastic in the long run, because people eventually find substitutes and change their habits.

Price elasticity of supply

PES = percentage change in quantity supplied ÷ percentage change in price

PES is positive, because price and quantity supplied move in the same direction.

What makes supply elastic:

• Time period: the most important factor. In the short run firms cannot expand quickly, so supply is inelastic. Given time to build factories and hire workers, supply becomes elastic.
• Spare capacity: idle machines and workers mean output can rise quickly.
• Stocks: goods that can be stored have elastic supply; fresh food does not.
• How easily resources can be switched into producing this good.
• How long production takes: farming and mining have very inelastic short-run supply, because crops and mines take years.

Why elasticity matters

For firms, the link to revenue. This is the highest-value application in the topic.

Total revenue = price × quantity sold.

The reasoning: if demand is inelastic, quantity falls only a little when price rises, so the higher price more than makes up for the lost sales. If demand is elastic, quantity falls a lot, and the lost sales outweigh the higher price.

So a firm selling a good with inelastic demand can raise price and earn more; a firm with elastic demand should think very carefully before doing so. This is why firms advertise and build brands, successful branding makes demand less elastic.

For governments. Governments put indirect taxes on goods with inelastic demand, fuel, alcohol, tobacco, because:

• Consumption barely falls, so tax revenue is large and reliable.
• But that also means the tax does not change behaviour much, which is a problem if the aim was to reduce consumption.

There is a real tension here: a tax that genuinely stopped people buying the good would raise very little revenue.

Worked example

A government puts a large tax on cigarettes, hoping to cut smoking and raise revenue.

1. The tax raises firms' costs
2. supply shifts left
3. price rises and quantity falls.

Because demand for cigarettes is very inelastic; they are addictive, have few close substitutes and take a small share of most smokers' income:

1. Quantity falls proportionately less than price rises
2. smoking falls only slightly
3. but the government collects tax on nearly the same number of packets
4. revenue rises a lot.

Evaluation.

• The policy works well as a way of raising revenue and poorly as a way of reducing smoking, at least in the short run.
• The tax is regressive, it takes a bigger share of income from poorer smokers than from richer ones.
• It may create a black market in smuggled cigarettes, so recorded sales fall more than actual smoking does.
• In the long run PED rises: substitutes such as vaping appear and habits change, so smoking falls more than the short-run figures suggest.
• Combining the tax with health education and help to quit would raise PED and make the health aim achievable.

Judgement: taxing an inelastic good is an effective way to raise money but a weak way to change behaviour on its own. It works best alongside measures that give people alternatives.

Common exam mistakes

• Comparing elasticity to zero instead of to 1.
• Saying "demand is elastic" without giving a value or a reason.
• Forgetting the minus sign on PED, or worrying about it too much. Say you are using the value ignoring the sign.
• Using absolute changes instead of percentage changes in the formula.
• Forgetting time, which is the strongest determinant of both PED and PES.
• Getting the revenue rule backwards. Inelastic → raise price to raise revenue.

Exam technique

Show the formula, put the numbers in, then say what the answer means. The interpretation earns more than the arithmetic. Always finish with "so demand is inelastic because 0.5 is less than 1".

When explaining a determinant, give the mechanism: "there are many substitutes for this brand of cereal, so if its price rises shoppers switch easily to another brand, making demand elastic."

For evaluation, use the time period (elasticity rises in the long run) and the point that elasticity estimates come from past data, so they may not hold in future.

Quick revision

• PED = %ΔQd ÷ %ΔP: normally negative; compare the value to 1.
• Inelastic = less than 1. Elastic = more than 1.
• Determinants: SPLAT, Substitutes, Proportion of income, Luxury/necessity, Addictive, Time.
• PES = %ΔQs ÷ %ΔP: positive. Determinants: time, spare capacity, stocks, resource mobility, length of production.
• Both are more elastic in the long run.
• Inelastic demand: raise price → revenue rises. Elastic demand: lower price → revenue rises.
• Governments tax inelastic goods for reliable revenue, but the tax then does little to change behaviour.
• Advertising and branding aim to make demand less elastic.

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