Application of Demand and Supply Analysis Flashcards
Price Elasticity of Demand, PED
The degree of responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.
Determinants of PED: Number and Closeness of Substitutes
Goods with many close substitutes are likely to have price elastic demand. Because when prices rises, consumers can easily find substitutes and so the quantity demanded of the good falls to a larger extent, vice versa.
Determinants of PED: Nature of the good
Demand for habitually consumed products such as staple foods tend to be price inelastic. Where an increase in price is likely to result in a less than proportionate fall in quantity demanded.
Demand for non-essential good such as luxury goods tend to be price elastic. If prices rise, consumers will reduce their quantity demanded of it more than proportionately.
Determinants of PED: Proportion of Consumers’ income spent on the good
The larger the proportion of income spent on a good, the more price elastic the demand for the good will be. For any given percentage increase in the price of good, many consumers will find themselves unable to afford it, leading to a more than proportionate decrease in the quantity demanded.
The lower the proportion of income spent on a good, the more price inelastic the demand for the good will be. For any given percentage increase in the price of good, consumers will find little difficulty in paying for the good, leading to a less than proportionate fall in the quantity demanded.
Determinants of PED: Time Period
In the short term, consumers may find it hard to change their consumption pattern. The longer the time period considered, the more price elastic the demand for a good.
Consumers are better able to adapt and adjust their expenditure patterns to price changes in the longer time period. Substitutes are also likely to be found or developed.
Price Elasticity of Supply, PES
Price Elasticity of Supply measures the degree of responsiveness of the quantity supplied of a good to a change in its price, ceteris paribus.
Determinants of PES: Short Run Time Period
The short run is a time period when at least one factor of production is fixed. The producer can vary output by utilising more or less of the variable factors.
Supply curve is likely to be relatively price inelastic. For example, a manufacture can order more raw materials and workers to work overtime (Variable Factors), however is unable to obtain more machines at the point in time (Fixed Factors).
Determinants of PES: Long Run Time Period
The long run is a time period when all factors of production are variable. There is sufficient time for producers to change all inputs, production capacity, and for firms to enter or leave the industry.
Supply curve is likely to be relatively price elastic
Determinants of PES: Availability of FOP
The greater the spare capacity there is in the industry (available stock of raw materials, workers and machines), the easier it is to increase the output of the good if prices increases. This means that the supply of the good is more price elastic when factors of production are available.
Determinants of PES: Mobility of FOP
The easier it is for resources to move into the industry, the more price elastic the supply will be.
If inputs can easily be transported, an increase in price of a good will enable a producer to attract more inputs to rapidly increase production.
If inputs for one production process can be easily used for another production process, producers are also able to gather resources to increase production quickly in response to a price increase.
Determinant of PES: Level of stocks and Ease of storing them
The supply of the good will be relatively more price elastic if the firm has a high level of stocks which can be sold to consumers when there is an unanticipated surge in demand for the good.
If goods are stored easily, the firms will have greater availability of the stocks to sell when prices of goods rises. Thus the supply of the good is more price elastic.
If goods are perishable, it will not be possible to store them and so the supply will likely be price inelastic.
Determinants of PES: Length and Complexity of Production Process
The quicker and easier a good can be produced, the easier it will be for producers to respond to a change in price.
For example, Agricultural goods takes a longer time compared to other goods, since crops takes time to grow and harvest. Even if there is an increase in the price of agriculture goods, producers will find it difficult to increase the quantity supplied.
For example, Manufacturing aircraft is a relatively long and complex process compared to the manufacture of furniture. Hence, it would be more difficult for producers to respond to a change in price of aircraft compared to furniture. Supply of furniture is therefore relatively more price elastic to the supply of aircraft.
Limitation of Elasticity Concepts: Assumption of ‘Ceteris Paribus’ does not hold in reality
Unrealistic assumption may create problems in the accuracy of elasticity values. The cause of the change in quantity demanded of a good cannot be easily attributed to any one factor in reality. Consequently, calculations of PED, may be less accurate.
Limitation of Elasticity Concepts: Elasticity Values are Estimates
Elasticity values might be estimated using data from surveys. Problems may arise when the data collected lacks validity or reliability. This may be the case if the sample size is small, or if survey respondents are not truthful.
Just one elasticity value to represent elasticity values that may vary across different groups of consumers or producers may fail to accurately reflect the extent of their responsiveness.
Limitation of Elasticity Concepts: Time Lag
Elasticity Values may be estimated using data based on past behaviour of consumers and producers or events. In dynamic markets where firms experience rapid changes, such data becomes obsolete quickly and cease to be good indicators of the future. The calculation of elasticity values on the basis of such data is therefore susceptible to time lag and may not be reliable when used.
