Price Elasticity

Price Elasticity In general, the elasticity of a particular variable is the percentage change in quantity demanded or supplied, divided by the percentage change in the variable of concern. This ratio is often called the elasticity coefficient. Price elasticity is defined as the percentage change in quantity demanded divided by the percentage change in price. The price elasticity of demand can be expressed as: Formula 3.1

Example: Price Elasticity Where Ep is the price elasticity coefficient, %Q represents the percentage in quantity, and %P represents the percentage in price. If the price of gasoline goes up by 50%, and the quantity demanded decreases by 20%, the price elasticity of gasoline would be: Ep = % Quantity % Price = -20% = -0.4 +50%

Typically, the negative sign is ignored and we would say that the price elasticity of gasoline is 0.4. To calculate elasticity we must first have data for quantities purchased at different prices. Suppose that the price of a good goes from P0 to P1, and that we have data for the change in quantity demanded, which goes from Q0 to Q1. The calculation is typically made by dividing the actual change by the average(or midpoint) of the beginning and ending values. Suppose that the quantity demanded of a good goes from 10 to 14. The percentage change in quantity demanded could be expressed as: (Q0 - Q1) = 0.5(Q0 + Q1) 4 = 0.333 0.5(24)

That number would be multiplied by 100 to get the percentage change, which in this case would be 33.3%. Similarly, the percentage change in price can be expressed as:

(P0 - P1) x 100 0.5(P0 + P1) Look Out! Sometimes the denominator used for these percentage change calculations is simply the original value (P0 and Q0). Because the CFA text uses the midpoint method, unless the exam has instructions to the contrary, it would be safer to use the midpoint method.

The following definitions apply to calculations of price elasticity: 1) If Ep > 1, Demand is elastic. The percentage change in price will produce a greater percentage in quantity demanded. If the price goes up, then total revenues will go down. If the price goes down, then total revenues willincrease. 2) If Ep < 1, Demand is inelastic. The percentage change in price will produce a lower percentage in quantity demanded. If the price goes up, then total revenues will go up. If the price goes down, then total revenues will decrease. Put simply, these changes will be less drastic than if demand is elastic. 3) If Ep = 1, Demand has unitary elasticity. A percentage in price will produce the exact same percentage change in quantity. Therefore, changes in price will no have effect on total revenues. If demand is elastic for a product, then a small change in price will cause a large change in quantity demanded. If the demand for a product is inelastic, even a large change in price might cause little change in quantity demanded.

Elasticity of Demand Determinants of price elasticity include:

Availability of substitutes - if substitutes are plentiful, then demand should be elastic. Relative percentage of expenditure - if an item takes up a considerable proportion of a consumer's income, then demand should be elastic; if it takes up a very small amount, then demand should be expected to be inelastic. Amount of time - consumers can make more adjustments to prices changes over time and, therefore, demand tends to be more elastic as time passes. Necessities or luxuries - demand for necessities will tend to be inelastic, while demand for luxuries will tend to be elastic.

Cross Elasticity of Demand

Cross elasticity of demand relates the percentage change in quantity demanded of a good to the percentage change in price of a substitute or complementary good. Examples of complementary goods would include peanut butter and jelly, and large SUVs and gasoline. The cross elasticity of demand will be positive for a substitute, and negative for a complement; i.e. demand for a substitute (complement) will go up (down), if the price of the substitute (complement) goes up. The following formula can be used to calculate cross-elasticity of demand: Formula 3.2

Where: CEp is the cross-price elasticity coefficient, %Q represents the percentage change in quantity demanded, and %P represents the percentage change in price of the substitute or complement.

Income Elasticity
Income Elasticity is defined as the percentage change in quantity demanded divided by the percentage change in income. The calculations are similar to those for price elasticity, except that the denominator would include a change in income instead of a change in price. Usually the amount of goods purchased will be positively correlated with income; if consumers' incomes go up (down), more (less) goods will be purchased. Any good with a positive income of elasticity of demand is said to be a normal good. Luxury goods have high income elasticity (greater than one). The proportionate amount of spending for those goods will go up as incomes increase. The amount spent on some goods decrease as incomes goes up. Such goods are referred to as inferior goods. Examples of inferior goods include margarine (inferior to butter) and bus travel (inferior to owning a vehicle).

Elasticity of Supply
Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in price. It is calculated as per the following formula: Formula 3.3

The calculation of elasticity of supply is comparable to the calculation of elasticity of demand, except that the quantities used refer to quantities supplied instead of quantities demanded. Factors that influence the elasticity of supply include the ability to switch to production of other goods, the ability to go out of business, the ability to use other resource inputs and the amount of time available to respond to a price change. Over a short time period, firms may be able to increase output only slightly in response to an increase in prices. Over a longer period of time, the level of production can be adjusted greatly as production processes can be altered, additional workers can be hired, more plants can be built, etc. Therefore, elasticity of supply is expected to be greater over longer periods of time. We would expect the supply elasticity of wheat to be very high as farmers can easily switch land that is used for wheat over to other crops such as corn and soybeans. On the other hand, an oil refinery cannot easily switch its production capacity over to another product, so low oil-refining margins do not reduce the quantity supplied by very much. Due to high capital costs, higher refining margins do not necessarily induce much greater supply. So the supply elasticity for oil refining is fairly low.