Chapter 1.3 - Elasticities

Question 0

Why will PED always have a negative value?

Answer 0

PED will always have a negative value because price and quantity move in opposite directions (since the demand curve is downward sloping).

Question 1

Define ‘Price Elasticity of Demand (PED)’.

Answer 1

PED = % change in quantity demanded/% change in price

Question 2

Define ‘price elastic’.

Answer 2

Price elastic is where a change has led to a larger % change in the quantity demanded/supplied.

Question 3

What is the value of PED when demand is price elastic?

Answer 3

The value of PED will be greater than 1.

Question 4

Define ‘price inelastic’.

Answer 4

Price inelastic is where a change in price has led to a smaller % change in the quantity demanded/supplied.

Question 5

What is the value of PED when demand is price inelastic?

Answer 5

The value of PED will be between 0 and 1.

Question 6

Define ‘unit elastic’.

Answer 6

Unit elastic is where a change in price has led to the same % change in the quantity demanded/supplied.

Question 7

What is the value of PED when demand is unit elastic?

Answer 7

The value of PED will be 1 and the demand curve will be a rectangular hyperbola.

Question 8

Define ‘perfectly elastic’.

Answer 8

Perfectly elastic is where a small increase in the price of a product causes the quantity demanded to fall to 0.

Question 9

What is the value of PED when demand is perfectly elastic?

Answer 9

The value of PED will be infinity and the demand curve will be horizontal.

Question 10

Define ‘perfectly inelastic’.

Answer 10

Perfectly inelastic is where a change in price has had no effect on the quantity demanded/supplied.

Question 11

What is the value of PED when demand is perfectly inelastic?

Answer 11

The value of PED will be 0 and the demand curve will be vertical.

Question 12

Define ‘total revenue’.

Answer 12

Total revenue is the value of goods sold by a firm and is calculated by multiplying price by the quantity sold.

Question 13

What are the key relationships between PED and total revenue (TR)?

Answer 13

When demand is elastic, a price change causes TR to change in the opposite direction.
When demand is inelastic, a price change causes TR to change in the same direction.
When demand is unit elastic, a price change causes TR to remain unchanged.
When demand is perfectly elastic, a price change causes TR to fall to 0.
When demand is perfectly inelastic, a price change causes TR to change in the same direction by the same proportion.

Question 14

State and explain 6 influencing factors of PED.

Answer 14

1. Availability of substitutes - if substitutes are available there will be a strong incentive to shift consumption to these when the price of the product rises, making its demand elastic.
2. Proportion of income spent on a product - if only a all % of income is spent on a product e.g. salt, demand will tend to be elastic.
3. Nature of the product - if the product is addictive, demand will tend to be inelastic e.g. alcohol, tobacco.
4. Durability of the product - if the product is long lasting and hard wearing, then demand will be fairly elastic since it is possible to postpone purchases. However, demand for non-durable goods will tend to be inelastic because these must be replaced regularly.
5. Length of time under consideration - it usually takes time for consumers to adjust their expenditure patterns following a price change so demand is usually more price elastic in the long run than in the short run.
6. Breadth of definition of a product - if a product is broadly defined (e.g. fruit), demand is likely to be price inelastic. However, demand for a particular type of fruit is likely to be more price elastic.

Question 15

What is the significance of PED for firms?

Answer 15

If firms know that demand for their product is price inelastic then they know that they can increase TR by increasing price.
However, if firms know that demand is price elastic they can increase TR by reducing price.

Question 16

What is the significance of PED for the government?

Answer 16

If the government wishes to maximise its tax revenue then it will place indirect taxes on those products whose demand is price inelastic.
However, in this case the consumer will bear most of the tax burden.
The government may therefore also tax products and services whose demand is price elastic, in which case the producers will bear a higher proportion of the tax burden.

Question 17

Define ‘Cross Elasticity of Demand (XED)’.

Answer 17

XED = % change in quantity demanded of good A/% change in price of good B

Question 18

What does a positive XED indicate?

Answer 18

A positive XED indicates that the products are substitutes (e.g. a rise in the price of one product will cause an increase in the demand for the other good).

Question 19

What does a negative XED indicate?

Answer 19

A negative XED indicates that the products are complements (e.g. a rise in the price of one product will cause a decrease in the demand for another product).

Question 20

What is the significance of XED to businesses?

Answer 20

A knowledge of XED is helpful to businesses in setting prices for their goods.
Firms know that complementary goods can command high prices e.g. printers are often relatively cheap unlike the ink cartridges required for them, as a certain type is needed for each particular printer.
At the same time, if a firm is selling a product with a close substitute then it would expect the demand for its product to fall if it increased the price.

Question 21

Define ‘Income Elasticity of Demand (YED)’.

Answer 21

YED = % change in quantity demanded/% change in income

Question 22

What does a positive YED indicate?

Answer 22

A positive YED indicates that the product is normal good e.g. a rise (fall) in real income will cause an increase (decrease) in demand.

Question 23

What does a negative YED indicate?

Answer 23

A negative YED indicates that the product is an inferior good e.g. a rise in real income would cause a fall in demand.

Question 24

Define ‘income elastic’.

Answer 24

Demand is said to be income elastic because a change in real income has led to a more than proportionate change in demand.

Question 25

What is the value of YED when demand is income elastic?

Answer 25

The value of YED will be greater than +1.

Question 26

Define ‘income inelastic’.

Answer 26

Demand is income inelastic because a change in real income has led to a less than proportionate change in demand.

Question 27

What is the value of YED when demand is income inelastic?

Answer 27

The value of YED will be between 0 and +1.

Question 28

Define ‘inferior goods’.

Answer 28

Inferior goods are those for which consumption will decline as real incomes increase because consumers can now afford higher quality alternatives.

Question 29

What is the relationship between demand and income for:

(a) normal goods
(b) inferior goods?

Answer 29

There is a positive relationship between demand and income for a normal good (supply curve diagrammatically) and a negative relationship for an inferior good (demand curve diagrammatically).

Question 30

Define ‘Price Elasticity of Supply (PES)’.

Answer 30

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

Question 31

Why will PES always have a positive value?

Answer 31

PES will always have a positive value because price and quantity move in the same direction (since the supply curve is upward sloping).

Question 32

What is the value of PES when supply is price elastic?

Answer 32

The value of PES will be greater than 1.

Question 33

What is the value of PES when supply is price inelastic?

Answer 33

The value of PES will be between 0 and 1.

Question 34

What is the value of PES when supply is unit elastic?

Answer 34

The value of PES will be 1 and the supply curve will be a straight line drawn through the origin.

Question 35

When is supply said to be perfectly elastic?

Answer 35

Supply is said to be perfectly elastic if an infinite amount could be supplied at a certain price.

Question 36

What is the value of PES when supply is perfectly elastic?

Answer 36

The value of PES will be infinity and the supply curve will be horizontal.

Question 37

When is supply said to be perfectly inelastic?

Answer 37

Supply is said to be perfectly inelastic because a change in price has had no effect on the quantity supplied.

Question 38

What is the value of PES when supply is perfectly inelastic?

Answer 38

The value of PES will be 0 and the supply curve will be vertical.

Question 39

State and explain 4 influencing factors of PES.

Answer 39

1. Time - it is often difficult to change supply quickly in response to a price change, making it very inelastic in the short run. Therefore, the longer the time period under consideration, the more elastic supply is likely to be.
2. Stocks - if stocks of finished goods are available, the supply will be relatively elastic because manufacturers will be able to respond quickly to a price change.
3. Spare capacity - if a firm has under-utilised machinery and under-employed workers or if it is possible to introduce a new shirt or workers, then supply is likely to be elastic.
4. Availability and cost of switching resources from one use to another - if resources (e.g. labour) have very specific skills, or machinery is highly specific, or it is expensive to reallocate resources from one use to another, then supply will be relatively inelastic.

Question 40

Define ‘consumers’ surplus’.

Answer 40

Consumers’ surplus is the difference between how much consumers are willing to pay and what they actually pay for a product.
Diagrammatically, the consumers’ surplus is the area under the demand curve and above the market price.

Question 41

State 2 factors affecting the size of the consumers’ surplus.

Answer 41

1. The gradient of the demand curve. The steeper it is, the greater the consumers’ surplus.
2. Changes in the conditions of demand e.g. an increase in demand will increase the amount of consumers’ surplus.

Question 42

Define ‘producers’ surplus’.

Answer 42

Producers’ surplus is the difference between how much firms are willing to supply at each price and the market price.
Diagrammatically, the producers’ surplus is the area between the supply curve and the market price.

Question 43

State 2 factors affecting the size of the producers’ surplus.

Answer 43

1. The gradient of the supply curve. The steeper it is, the greater the producers, surplus.
2. Changes in the conditions of supply e.g. an increase in supply will increase the amount of producers’ surplus.