CH5:Price Elasticity of Demand and Supply Flashcards
Definition: Price elasticity of demand (PED)
How the demand for a product changes when its price changes
What are elastic goods?
demand for the goods changes dramatically when then price changes
What are inelastic goods?
demand for the goods changes only a little when the price changes
Formula: price elasticity of demand
PED =
% change in quantity demanded / % change in price
What are two methods used to calculate the PED?
1) Non-average arc method
2) Average arc method
What type of good is it if the range of price elasticity of demand is : between 0 and -1
between 0 and -1
INELASTIC - %change in quantity demanded is less than % change in price
What does it imply if the PED is -1
Unit elasticity - % change in price is the same as % change in demand
What type of good is it if the range of price elasticity of demand is : between -1 and minus infinity
Elastic - % change in quantity demanded is greater than % change in price
Formula: demand curves’ straight line
Qd= a - bP
Qd= quantity demanded a = point where the curve starts on the y-axis b= gradient of the line P = price
Definition: Perfectly elastic demand
A change in price leads to a total loss in demand (e.g if there is a cheaper substitute available)
Definition: Elastic demand
Demand is very responsive to changes in price, hence a change in price leads to a greater change in demand
Definition: Perfectly inelastic demand and what is the revenue implication?
Demand is completely unresponsive to changes in price.
Revenue impact: any increase in price will result in the same level of demand and hence increased revenues
Definition: Inelastic demand
Demand is not very responsive to changes in price, so any increase in price leads to a small change in demand.
Impact on revenue: increase in price would result in higher revenues
Definition: Unitary elastic demand and revenue impact?
Changes in demand are exactly proportional to changes in price
Revenue impact: if prices are raised or lowered, revenue remains the same
How does the price elasticity of demand (PED) for Veblen and Giffen goods differ from normal goods?
Normal goods tend to have a negative price elasticity (downward sloping demand curve)
vs.
Veblen and Giffen goods have an upward sloping demand curve (i.e. increase in price is met by an increase in demand) and hence have a a positive price elasticity
What are the 3 mains ways that PED can be used?
- By companies to forecast revenue changes - this helps them identify at which point they maximise profits (e.g. if its an elastic good then they can increase the price to increase revenues)
- By companies to choose a level of production or purchases - as companies can forecast the effect on demand of a change in price hence can use this info to decide how much to produce
- By government to forecast effect on sales tax revenue (e.g. VAT) as such a tax affects the price of the good/service
What is the expected impact on total revenue if the price of an inelastic good rises?
Increase in revenue as there is little impact on demand
What is the expected impact on total revenue if the price of an elastic good rises?
Decrease in revenue - there is a significant impact/decrease in of an elastic good if the price is increased
What would you expect to happen to the revenue if the price of unitary elastic good increases?
Total revenue remains the same
What factors influence price elasticity of demand?
Factors influencing PED:
- % / proportion of income spent on the goods/service - if its a small % of consumer’s income, the demand is likely to be inelastic (demand does not change much as price changes)
- The availability of substitutes - the more substitutes available, the more likely demand will be more elastic
- product status: necessity (demands tends to be inelastic) or luxury? (elastic)
- Time since price changed- demand will become more elastic as time passes - more likely consumers will realise that the price has increased and have more time to look for alternatives
- Brand loyalty - if customer is very loyal, demand is likely to be inelastic
- Competitor pricing - if a company does not decrease its pricing in light of a competitor decreasing its prices then its likely to encounter elastic demand for its goods at the higher price
- Habit- demand for habit-forming goods (e.g. cigarettes) is likely to be inelastic
- Definition of the market - the broader the definition, the less elastic the demand will often be
Definition: Price elasticity of Supply
the sensitivity of the level of supply to any change in price
Formula: Price elasticity of supply
PES = %change in quantity supplied / % change in price
What does price elasticity of supply greater than 1 indicate?
that supply is ELASTIC - change in price level results is a greater change in supply
What does price elasticity of supply of 1 indicate?
Supply is UNIT ELASTIC - the change in supply is directly proportional to the change in price
What does price elasticity of less than < 1 indicate?
Supply is INELASTIC - the change in supply is smaller than change in price
What i the straight line formula of a supply curve?
Qs = C + dP
Qs = Quantity supplied C = the point where the curve starts on the x axis d= gradient P= Price
Definition: perfectly inelastic supply
No matter how the price changes, supply remains the same (price elasticity of supply is zero)
Definition: perfectly elastic supply
Supply occurs at a given price only
What are the factors influencing price elasticity of supply?
- Availability of inputs - eg. raw materials - if they are readily available means an easy change in production levels, resulting in relatively elastic supply and visa versa
- Availability of factor of production - e.g. labour, ready availability will result in relatively elastic supply levels
- Stock - if a supplier keeps a reasonable level of finished goods/ or semi-finished goods then supply will be relatively elastic
Number of competitors - large number of suppliers, supply is likely to be elastic (industries where setup costs are low/ its easy for new entrants to the market)
Developments in technology - advancement in tech could change supply from being inelastic to elastic
Long run vs. short run = availability of inputs, factors of production or competitors may be restricted in the short run, but not in the long run. hence supply goes from inelastic in the short run to elastic in the long run
Production capacity - spare capacity will result in supply being elastic to price
Definition of the market - the broader the definition then the more elastic the supply
