CH5:Price Elasticity of Demand and Supply

Question 1

Definition: Price elasticity of demand (PED)

Answer 1

How the demand for a product changes when its price changes

Question 2

What are elastic goods?

Answer 2

demand for the goods changes dramatically when then price changes

Question 3

What are inelastic goods?

Answer 3

demand for the goods changes only a little when the price changes

Question 4

Formula: price elasticity of demand

Answer 4

PED =

% change in quantity demanded / % change in price

Question 5

What are two methods used to calculate the PED?

Answer 5

1) Non-average arc method

2) Average arc method

Question 6

What type of good is it if the range of price elasticity of demand is : between 0 and -1

Answer 6

between 0 and -1

INELASTIC - %change in quantity demanded is less than % change in price

Question 7

What does it imply if the PED is -1

Answer 7

Unit elasticity - % change in price is the same as % change in demand

Question 8

What type of good is it if the range of price elasticity of demand is : between -1 and minus infinity

Answer 8

Elastic - % change in quantity demanded is greater than % change in price

Question 9

Formula: demand curves’ straight line

Answer 9

Qd= a - bP

Qd= quantity demanded 
a = point where the curve starts on the y-axis
b= gradient of the line
P = price

Question 10

Definition: Perfectly elastic demand

Answer 10

A change in price leads to a total loss in demand (e.g if there is a cheaper substitute available)

Question 11

Definition: Elastic demand

Answer 11

Demand is very responsive to changes in price, hence a change in price leads to a greater change in demand

Question 12

Definition: Perfectly inelastic demand and what is the revenue implication?

Answer 12

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

Question 13

Definition: Inelastic demand

Answer 13

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

Question 14

Definition: Unitary elastic demand and revenue impact?

Answer 14

Changes in demand are exactly proportional to changes in price

Revenue impact: if prices are raised or lowered, revenue remains the same

Question 15

How does the price elasticity of demand (PED) for Veblen and Giffen goods differ from normal goods?

Answer 15

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

Question 16

What are the 3 mains ways that PED can be used?

Answer 16

• 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

Question 17

What is the expected impact on total revenue if the price of an inelastic good rises?

Answer 17

Increase in revenue as there is little impact on demand

Question 18

What is the expected impact on total revenue if the price of an elastic good rises?

Answer 18

Decrease in revenue - there is a significant impact/decrease in of an elastic good if the price is increased

Question 19

What would you expect to happen to the revenue if the price of unitary elastic good increases?

Answer 19

Total revenue remains the same

Question 20

What factors influence price elasticity of demand?

Answer 20

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

Question 21

Definition: Price elasticity of Supply

Answer 21

the sensitivity of the level of supply to any change in price

Question 22

Formula: Price elasticity of supply

Answer 22

PES = %change in quantity supplied / % change in price

Question 23

What does price elasticity of supply greater than 1 indicate?

Answer 23

that supply is ELASTIC - change in price level results is a greater change in supply

Question 24

What does price elasticity of supply of 1 indicate?

Answer 24

Supply is UNIT ELASTIC - the change in supply is directly proportional to the change in price

Question 25

What does price elasticity of less than < 1 indicate?

Answer 25

Supply is INELASTIC - the change in supply is smaller than change in price

Question 26

What i the straight line formula of a supply curve?

Answer 26

Qs = C + dP

Qs = Quantity supplied
C = the point where the curve starts on the x axis
d= gradient 
P= Price

Question 27

Definition: perfectly inelastic supply

Answer 27

No matter how the price changes, supply remains the same (price elasticity of supply is zero)

Question 28

Definition: perfectly elastic supply

Answer 28

Supply occurs at a given price only

Question 29

What are the factors influencing price elasticity of supply?

Answer 29

• 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