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Worksheet on Elasticity (Tutor Version)

This worksheet looks at the measure of price elasticity of demand; how to measure it, what determines its value and what value it is to companies as a measure. To cover the worksheet fully, students should have a sound knowledge of the principles underlying supply, demand and the determination of price in a market.

Step 1 - E L A S T I C or INELASTIC?

Throughout the worksheet we use the formula:

We do not assume any knowledge of point or arc elasticity in this worksheet. We simply use the formula above with the percentage change being assumed to be the change from the original price. The answers will need adapting if students have been taught other methods of calculation.

Use the formula above to calculate values of Price Elasticity for all the situations below:

In each case identify whether you would describe it as elastic / unit elastic / inelastic

1. Elastic
2. Inelastic
3. Elastic
4. Inelastic

Step 2 - E L A S T I C MONEY?

This section aims to introduce the concept that an increase in price for an inelastic good will still increase revenue, whereas an increase in price for an elastic good will reduce revenue.

To see the effect that elasticity has on total revenue fill in the table below:

Has revenue increased or decreased in each case?

1. Decrease
2. Increase
3. Decrease
4. Increase

In the table below put a tick in the box that associates the appropriate elasticity value with the appropriate effect on total revenue when price rises (as in the above examples):

Step 3 - What determines E L A S T I C I T Y?

As we have seen above it is important to a company to have an idea of the value of the elasticity of demand of its good or service as it will affect what happens to their total revenue as price changes. What should the company aim to do with their price in each of the circumstances below?

Students should also consider why firms are not always free to increase their price when they want to - the effect of competition.

If the company want to estimate the value of the price elasticity of their product, then they need to judge it against the following criteria:

• Proportion of income spent on the good - the lower the proportion of income spent, the more inelastic the good will tend to be
• The number of substitutes - the more substitutes a good has the easier it is for consumers to switch to another product if the price goes up
• The strength of the brand - the stronger the brand, the more inelastic the product will be
• The level of necessity or addiction - the more necessary or addictive something is, the more inelastic it will be

Other determinants of price elasticity like durability, number of uses and time could also be introduced to see the impact they have on elasticity values.

Judge the products in the table below to decide whether you think they will be elastic or inelastic:

The answers given are suggestions of possible elasticity values. Many will be open to discussion, and students should be encouraged to justify their views using the criteria above.

Step 4 - E L A S T I C brands? (not bands!)

As we saw above, the strength of the brand will affect the elasticity. The stronger the brand, the more likely people are to buy it whatever the price. Draw a new demand curve on the diagram below to show the effect of a major advertising campaign that strengthens the brand:

The impact of the campaign is to give the brand a stronger identity and therefore reduce the importance of price to consumers, making demand more inelastic.

We can see this effect if we consider the price of a well-established consumer product - JEANS. To see the effect, try going to the Lycos shopping channel and follow the links to clothing and then to trousers. Find the price of a branded pair of jeans - say Levis, and then find the price of an equivalent pair of unbranded jeans (or perhaps a less well-known brand). Fill these prices in in the table below:

Write a short explanation (referring to price elasticity where possible) of why these different brands of jeans differ in price.

Though there will be quality differences, students should also discuss the importance of the branding of the product. Because consumers want named brands more, they will be willing to pay higher prices for them. They could also refer to the effect shown by the diagram above. They should also discuss the relative level of demand for each of the brands - how does demand differ in total?

Step 5 - Needing E L A S T I C I T Y

The value of the price elasticity will affect the firm's pricing strategy. We have also seen above that the value of the elasticity depends on the degree of necessity.

To check this, go to the British Airways site (http://www.britishairways.com/) and look at their on-line booking section. Then go through the following steps:

• Choose an international flight (to New York?)
• Choose dates to fly out and back a week apart
• Find out the price for economy class
• Find out the price for business class
• Find out the price for first class

Students should find significant price differences between the different classes of travel.

Why do these prices differ?

Prices will differ because of the different level of service. The amount of space, the quality of the food, the services available (phones, laptop computer facilities and other business services) and the level of service offered by cabin staff.

To what extent do these prices show that the greater the level of need, the more inelastic the demand for the flight? (N.B. Try comparing the business price and the economy price - does the price difference fully justify the difference in the level of service?)

Because business travellers travel through necessity and the fare is paid by the firm, they are much less price-sensitive as a group than economy class travellers. The proportion of income is much lower (because it is a business that is paying), there are no substitutes (unlike holidaymakers who can go elsewhere) and the level of need is much greater. All this adds up to demand for business travel being much more inelastic. A further example of this could be to consider the price of train fares at commuting times compared to other times during the day.