Chapter 3 Flashcards
What is the price elasticity of demand?
The responsiveness of quantity demanded to a change in price. If we know the price elasticity of demand for a product, we can predict the effect on price and quantity of a shift in the supply curve for that product.
How do we measure the price elasticity of demand?
We want to compare the size of the change in quantity demanded with the size of the change in price. As these are different units the only way to do this is with a percentage. Thus: percentage change in quantity demanded/percentage change in price.
How do you interpret the figure for elasticity?
Positive or negative sign. Demand curves are generally downward sloping. Price and quantity change in opposite directions. A rise in price (positive) will cause a fall in the quantity demanded (negative). Similarly, a fall in price will cause a rise in the quantity demanded. Either way we get a negative figure.
The value (greater or less than one). If we ignore the negative sign, elasticity is indicated by the symbol: ∈
Elastic demand > 1. Where a change in price causes a proportionately larger change in the quantity demanded.
Inelastic demand < 1. Where a change in price causes a proportionately smaller change in the quantity demanded.
Unit elastic demand = 1. This is where price and quantity demanded change by the same proportion.
List 3 determinants of price elasticity of demand.
- The number and closeness of substitute goods. Most important determinant. E.g., no close substitute for oil. Also applies to brands.
- The proportion of income spent on the good. The higher the proportion the more we will be forced to cut consumption when its price rises: the bigger will be the income effect and the more elastic the demand.
- The time period. People may take time to adjust their consumption patterns and find alternatives. The longer the time period after a price changes, the more elastic the demand is likely to be.
How do we calculate how much we spend on a good at a given price?
Total consumer expenditure (TE) is price multiplied by quantity purchased. Total consumer expenditure will be the same as total revenue received by firms from the sale of the product (before tax and other deductions).
Explain elastic demand.
When demand is elastic, quantity demanded changes proportionately more than price. Thus, a change in quantity has a bigger effect on total consumer expenditure than a change in price. I.e., when demand is elastic a rise in price will cause a fall in total consumer expenditure and a fall in the total revenue that firms receive. A reduction in price, however, will result in consumers spending more and hence firms earning more.
Explain inelastic demand.
When demand is inelastic price changes proportionately more than quantity. Thus, a change in price has a bigger effect on total consumer expenditure than a change in quantity. Firms revenue will increase if there is a rise in price and fall if there is a fall in price.
Can you measure elasticity along an entire curve?
No – elasticity will change at different points on the curve. However you can talk about the elasticity between any two points on it (arc elasticity).
Describe the 3 special cases of elasticity.
- Totally inelastic demand. A vertical straight line. No matter what happens to price, quantity demanded remains the same.
- Infinitely elastic demand. A horizontal straight line. This is in fact relatively common for an individual producer. When firms are small relative to the whole market they have to accept the price, but at that price they can sell as much as they produce. Demand is not literally infinite, but as far as the firm is concerned it is.
- Unit elastic demand. This is where price and quantity change in exactly the same proportion. Any rise in price will be exactly offset by a fall in quantity, leaving total revenue unchanged.
How does demand respond to changes in income?
The income elasticity of demand measures the responsiveness of demand to a change in consumer incomes. It enables us to predict how much the demand curve will shift for a given change in income. % change in quantity demanded/% change in income. The major determinant of income elasticity of demand is the degree of “necessity” of the good. Demand for some goods (inferior goods) will actually decrease as income rises.
How does demand respond to changes in the price of other goods?
The cross-price elasticity of demand is a measure of the responsiveness of demand for one product to a change in the price of another (either a substitute or a complement). It enables us to predict how much the demand curve for the first product will shift when the price of the second product changes. % change in quantity demanded for good a/% change in price of good b.
If good b is a substitute for good a, a’s demand will rise as b’s prices rise. In this case, cross-elasticity will be a positive figure.
If good b is complementary to good a, a’s demand will fall as b’s price rises and the quantity of b demanded falls. In this case, cross elasticity of demand is a negative figure.
The major determinant is the closeness of the substitute or complement. The closer it is the greater will be the effect.
How do we measure price elasticity of supply?
% change in quantity supplied/% change in price. This allows us to determine how responsive quantity supplied is to a change in price.
Unlike the price elasticity of demand the figure is likely to be positive (assuming supply curve is upward sloping). This is because price and quantity supplied change in the same direction.
What 2 things does advertising do to the demand curve?
- Shift the demand curve to the right. Need to bring more people’s attention to the product and increase people’s desire for it.
- Make the demand curve less elastic. This will occur if advertising creates brand loyalty. This will allow the firm to raise its price above its rivals without a significant fall in sales. There will only be a small substitution effect because consumers have been led to believe that there are no close substitutes.
List 2 determinants of price elasticity of demand.
- The amount that costs rise as output rises. The less the additional costs of producing additional output, the more firms will be encouraged to produce for a given price and the more elastic supply will be. Supply is thus likely to be elastic if firms have plenty of spare capacity, if they can readily get supplies/raw materials, if they can easily switch away from producing alternative products and if they can avoid having to introduce overtime working.
- Time period. The elasticity of supply will increase the long the period that occurs between the change in price and the adjustment of supply. There are three adjustment periods.
* Immediate time period. Firms are unlikely to be able to increase supply by much immediately. Supply is high inelastic.
* Short run. Some inputs can be increased (e.g., raw materials) while others are fixed (e.g., heavy machinery). Supply can increase somewhat.
* Long run. There will be sufficient supply for all inputs to be increased and for new firms to enter the industry. Supply is likely to be highly elastic.
How do price expectations and speculation contribute to changes in supply and demand?
A belief that prices will go up will cause people to buy now, and a belief that prices will go down will cause people to wait. The reverse applies to sellers. Speculation tends to be self-fulfilling (i.e., the actions of spectators tend to bring about the very effect on prices that were anticipated).
