Chapter 6 - Elasticity Flashcards
What does elasticity mean?
A measure of the sensitivity of one variable to changes in another variable
What is the price elasticity of demand (PED)?
A measure of sensitivity of quantity demanded to a change in the price of a good or service.
The formula is % change in quantity demanded / % change in price
PED is always LESS than 0
What does elastic mean?
A term used when the price elasticity of demand is less than -1 but greater than negative infinity
This shows that demand is highly price sensitive.
What does inelastic mean?
A term used when the price elasticity of demand is greater than -1 but less than zero.
This shows that demand is not very sensitive to price.
What does unit elastic mean?
A term used when price elasticity of demand is equal to -1
What is PED like at lower and higher prices?
Demand is price elastic at higher prices and inelastic at lower prices
Why may firms have an interest in PED?
Because they might be considering to change their prices, and they want to see the effect that it has on their revenue
How would you find the total revenue on a demand curve?
Multiply price and Qd. Find the area from where the point on the demand curve joins with the price and Qd axis.
What is the relationship between PED and total revenue?
When elastic, total revenue falls when price increases and rises when price decreases.
When unit elastic, total revenue does not change when price changes
When inelastic, total revenue rises when price increases and falls when price decreases
Total revenue is maximised when demand is unit elastic
What does it mean when demand in perfectly inelastic?
It is where demand may sometimes be totally insensitive to price, so that the same quantity will be demanded whatever price is set for it.
The demand curve in this case is vertical.
In this situation, the numerical value of the price elasticity is zero, as quantity demanded does not change in response to a change in the price of the good.
What does it mean when demand is perfectly elastic?
It has a horizontal demand curve. The numerical value of the elasticity here is minus infinity.
Consumers demand an unlimited quantity of the good at given price. No firm has any incentive to lower price below this level, but if price were to rise above the given price, demand would fall to zero.
What are the factors that influence PED?
- The availability of close substitutes for the good - if there are substitutes, demand will be elastic. If not, it will be inelastic.
- Whether the good is perceived as a necessity - if necessity, demand will be inelastic. If not, it will be elastic.
- The proportion of income or expenditure devoted to the good - Small changes in the price of an inexpensive item means demand will be inelastic. A change that involves a significant proportion of their income will have elastic demand.
- The time period over which elasticity is considered - Consumers may respond more strongly to a price change in the long run than in the short run. An increase in the price of petrol may have limited effects in the short run. However, in the long run, consumers may buy smaller cars or switch to diesel. Therefore, demand tends to be more elastic in the long run than in the short run.
What is income elasticity of demand (YED)?
A measure of the sensitivity of quantity demanded to a change in consumer incomes.
The formula is % change in quantity demanded / % change in income
What are superior goods?
One for which the income elasticity of demand is positive, and greater than 1, such
that as income rises, consumers spend proportionally more on the good.
What does each YED value represent?
Below -1 = Elastic inferior good
Between -1 and 0 = Inelastic inferior good
0 = No relationship between income and quantity demanded
Between 0 and 1 = Inelastic normal good
Above 1 = Elastic normal good - also known as a superior good
What is cross elasticity of demand (XED)?
A measure of the sensitivity of quantity demanded of a good or service to a change in the price of some other good or service.
The formula is % change in quantity demanded of Good X / % change in PRICE of good Y
What does each XED value represent?
Below -1 - Strong complement
Between -1 and 0 - Weak complement
0 - No relationship between the 2 goods
Between 0 and 1 - Weak substitute
Above 1 - Strong substitute
How can XED be applied in the real world?
XED can be used in competition policy. The Competition and Markets Authority has the responsibility of safeguarding consumer interests by ensuring that firms do not exploit excessive market power.
An important part of its investigations entails an evaluation of whether firms face competition in their markets. The cross elasticity of demand can reveal whether or not two products are regarded as substitutes for each other.
If they are shown to be, then this implies that the firms do face competition. This is an important application of this concept, as it can affect the judgement of whether a firm is in a position to exploit its market position.
What is price elasticity of supply (PES)?
A measure of the sensitivity of quantity supplied of a good or service to a change in the price of that good or service.
The formula is % change in quantity supplied / % change in price
What does each PES value represent?
If the elasticity is greater than 1, supply is referred to as being elastic.
If the value is between 0 and 1, supply is considered inelastic.
Unit elasticity occurs when the price elasticity of supply is
exactly 1.
What would the value of PES depend on?
The value of the elasticity will depend on how willing and able firms are to increase their supply.
For example, if firms are operating close to the capacity of their existing plant and machinery, they may be unable to respond to an increase in price, at least in the short run. So here again, supply can be expected to be more elastic in the long run than in the short run.
In the short run, firms may be able to respond to an increase in price only in a limited way, so supply may be relatively inelastic. However, firms can become more flexible in the long run by installing new machinery or building new factories, so supply can then become more elastic.
What is perfectly inelastic supply?
A situation in which firms can supply only a fixed quantity, so cannot increase or decrease the amount available: elasticity of supply is zero.
What is perfectly elastic supply?
A situation in which firms will supply any quantity of a good at the going price: elasticity of supply is infinite.
How are elasticities useful in decision making?
The PED will be informative about how buyers of the good are likely to respond to a price change. If you know they will be sensitive to a price increase, you might hesitate about raising price because this would affect revenues.
The significance of the PED turns partly on the difficulty of obtaining an estimate of it. This is beyond the means of even a medium-sized firm. For the firm wanting to change its price, the market elasticity may not be meaningful anyway, as much will depend upon the actions of other firms in the market.
The YED will help to forecast changing demand if real incomes are increasing, or if the economy is heading into a recession. Knowing whether a good is normal or inferior is significant in this situation.
The XED helps in anticipating changes in demand if the prices of other products are changing. A firm needs to know who its competitors are when devising its own strategy, so it may be important to be aware of whether another firm’s products are close substitutes, or whether they are complements. Knowing the PES of rival firms would be useful, but estimating a precise value is not easy.
From the government perspective, imposing an indirect tax will raise the price and lead to a fall in demand, so knowing the PED helps to forecast the tax revenues expected. Introducing a subsidy would reduce the selling price of a good, and knowing the PED allows the government to assess the impact of such a move.
