1.2 How Markets Work LS12-16 Flashcards
Price elasticity of demand definition?
Measures the responsiveness of demand given a change in price
When is demand said to be price elastic?
When a change in price causes a proportionately larger change in demand
When is demand said to be price inelastic?
When a change in price causes a proportionately smaller change in demand
Determinants of price elasticity of demand
- Number of substitutes: more substitutes = more price elastic
- Time available: more time = consumers can find alternatives = more price elastic
- Addictivness of product: more addictive = consumers less likely to be deterred by changes in price = more price inelastic
- Luxury/Necessity: if necessity, likely to be price inelastic as people need it no matter the price
- Proportion of income on the product: greater proportion of income on product = more price elastic as consumers less able to afford any price increases
Price elasticity of demand formula
PED
%△D / %△P
When is supply said to be price elastic?
When a change in price causes a proportionately larger change in supply
When is supply said to be price inelastic?
When a change in price causes a proportionately smaller change in supply
Price elasticity of supply definition?
The responsiveness of supply given a change in price
Determinants of price elasticity of supply?
- Time required to produce the product: greater time = more price inelastic supply
- Level of spare capacity: greater spare capacity = more price elastic supply, factors of production will be available to use
- Number of stocks/finished goods available: more finished goods available = more price elastic supply
- Time: time available to suppliers to reduce or expand their production, greater time period = more price elastic supply
- Perishability of product: more perishable = less stock = more price inelastic supply
PES/PED greater than 1 means..
Price elastic
PES/PED equal to 1 means..
Unitary elasticity
PES/PED between 0 and 1 means..
Price inelastic
PES/PED equal to 0 means..
Perfectly inelastic
Consumer surplus?
The extra amount of money consumers are prepared to pay for a good or service above what they actually pay
Producer surplus?
The extra amount of money paid to producers above what they are willing to accept to supply a good or service
What is the incidence of a tax?
- The distribution of the tax between consumers and producers
- Depends on the elasticity of both demand and supply
When demand is price elastic, who will the burden of the tax mostly fall on?
Producers
When demand is price inelastic, who will the burden of the tax mostly fall on?
Consumers
What is the incidence of a subsidy?
- How the gains of the subsidy are distributed between consumers and producers
- Depends on the elasticity of both supply and demand
When demand is price elastic, who will most of the gains of a subsidy go to?
Producers
When demand is price inelastic, who will most of the gains of a subsidy go to?
Consumers
Income effect?
With fixed level of income, income effect means that as price falls, the amount that consumers can afford increases and so demand increases
Marginal utility?
The utility or satisfaction obtained from consuming one extra unit of a good or service
Diminishing marginal utility?
As successive units of a good are consumed, marginal utility gained from each extra unit will fall
What does cross price elasticity of demand (XED) measure?
The responsiveness of demand for one good to changes in the price of another good
XED formula
%Δ in quantity demanded of product A /
%Δ in price of product B)
What type of goods have a positive XED?
Substitute goods
As price of B goes up, QD for A goes up as consumers switch
Strong 0.6 Weak 0.2
What type of good has a negative XED?
Complementary goods
As price of B goes up, QD for A falls as they are purchased together
Strong 0.6 Weak 0.2
What does income elastictity of demand (YED) measure?
The responsiveness of demand to changes in income
YED formula?
%Δ in quantity demanded /
%Δ in income
What type of goods have a negative YED?
Inferior
What type of goods have a positive YED?
Normal goods
Normal goods with a YED between 0 and 1 are..
…income inelastic
* tend to be necessities
Normal goods that have a YED larger than 1 are…
…income elastic
* tend to be luxurious goods
What are the functions of the price mechanism?
- Signalling: if prices increase, it is a signal to firms to produce more of that product
- Incentive: if prices increase, firms are incentivised to switch production to that product
- Rationing: if demand > supply, prices increase so the product is rationed to those who can afford to pay
What are the effects on total revenue given an increase in price when demand is elastic vs inelastic?
- Elastic: an decrease in total revenue
- Inelastic: an increase in total revenue
What are the effects on total revenue given a decrease in price when demand is elastic vs inelastic?
- Elastic: an increase in total revenue
- Inelastic: a decrease in total revenue
