Elasticity

Question 1

Define the term elasticity.

Answer 1

Elasticity refers to the responsiveness (in terms of quantity demanded) of a product to a change in price.

Question 2

Identify the 2 types of elasticity a product can have.

Answer 2

1. An elastic good is more responsive (in terms of supply or demand) to a change in price.
2. An inelastic good is less responsive (in terms of supply or demand) to a change in price.

Question 3

How is price elasticity calculated?

Answer 3

PE = % Δ in quantity / % Δ in price

Question 4

How does this elasticity coefficient indicate the type of price elasticity (of demand & supply)?

Answer 4

1. Elastic coefficient greater than 1 → quantity demand is more responsive to change in price - elastic.
2. Elastic coefficient less than 1 → quantity demand is less responsive to change in price - inelastic.

Question 5

What are the determinants of price elasticity of demand?

Answer 5

Availability of substitutes
1. Many substitutes → elastic
2. Few substitutes → inelastic

Necessity or luxury
1. Luxury → elastic
2. Necessity → inelastic

Broad or narrow market
1. Narrow market → elastic
2. Broad market → inelastic

Proportion of income spent
1. Higher proportion of income spent → elastic
2. Lower proportion of income spent → inelastic

Time
1. Long-run → elastic
2. Short-run → inelastic

Question 6

Explain price elasticity of demand in the context of total revenue (producers) / expenditure (consumers).

Answer 6

A product with elastic demand:
1. Increase in price → decrease in TR (reduced demand)

2. Decrease in price → increase in TR (increased demand).

A product with inelastic demand:
1. Increase in price → increase in TR (constant or slight increase in demand)

2. Decrease in price → decrease in TR (constant or slight decrease in demand)

Question 7

What are the determinants of price elasticity of supply?

Answer 7

Time
1. Long-run → elastic
2. Short-run → inelastic

Nature of Industry
1. Manufactured goods → elastic
2. Commodity or primary good → inelastic

Ability to store inventories
1. Increase capacity to store inventories (non-perishable goods) → elastic
2. Reduced capacity to store inventories (perishable goods) → inelastic

Question 8

Provide understanding of the implication of price elasticity of supply and demand, with reference to businesses and government taxation.

Answer 8

Understanding the concept of price elasticity plays an important role in explaining the consumer and producer response to a change in price.

It allows businesses (producers) to understand by how much can they stretch the price (hence the term elasticity), to accommodate for changing demand.

In the context of taxation, the government can maximise their total revenue (government revenue) through understanding which products to tax.

How would they know which products to tax? Price elasticity.

1. Imposing a tax will increase price of a product
2. So with an increase in price of a product, which product will maintain its revenue or even increase it?
3. Products with inelastic demand
4. Therefore, the government will impose larger taxes on products with inelastic demand because of its total revenue, and by justifying it with the social costs that inflict through purchasing the product.

Example:
1. Government imposes a tax on petrol - an inelastic good.

2. Due to inelasticity of petrol (petrol is a necessity, and people require the use of petrol on a frequent basis), revenue collected from petrol is maintained, or can even increase.
3. Government revenue increases through taxation of petrol.
4. Level of pollution caused through petrol (social cost) is reduced.

Question 9

Explain the idea of cross price elasticity.

Answer 9

Cross price elasticity refers to the responsiveness of supply or demand for one good (A) to a change in price of another related good (B).

Question 10

How is cross price elasticity calculated?

Answer 10

XED = % Δ in quantity of good A / % Δ in price of good B

Question 11

What is the purpose of cross price elasticity?

Answer 11

Cross price elasticity can determine whether a pair of goods are substitute goods or complementary goods.

Substitute goods
1. Increase in price for good B → increase in demand for A
2. Decrease in price for good B → decrease in demand for A

Complementary goods
1. Increase in price for good B → decrease in demand for A
2. Decrease in price for good B → increase in demand for A

Question 12

Describe an example of this application.

Answer 12

Substitute Goods:
1. Good B increase in price by 30% → Good A increase in quantity demanded by 50%
XED = 50% / 30% = 1.6 (positive ∴ substitute good)
2. Good B decrease in price by 30% → Good A decrease in quantity demanded by 50%.
XED = -50% / -30% = 1.6 (positive ∴ substitute good)

Complementary Goods:
1. Good B increase in price by 30% → Good A decrease in quantity demanded by 50%.
XED = -50% / 30% = -1.6 (negative ∴ ‘complementary good’)
2. Good B decrease in price by 30% → Good A increase in quantity demanded by 50%.
XED = 50% / -30% = -1.6 (negative ∴ ‘complementary good’)

Question 13

Explain the idea of income elasticity.

Answer 13

Income elasticity refers to the responsiveness of supply or demand of a product to a change in income.

Question 14

How is income elasticity calculated?

Answer 14

YED = % Δ in quantity demanded / % Δ in consumer’s real income

Question 15

Explain income elasticity in the context of a ‘normal good’.

Answer 15

The income elasticity of a ‘normal good’ is positive (YED > 0), because it is directly proportional.
Why? Because when income increases, people have the desire to spend it on the best (‘normal goods’). But when people don’t have money, they can’t afford to spend it on these ‘normal goods.’
1. Income increase → Demand increase
2. Income decrease → Demand decrease

Question 16

Describe an example of this application.

Answer 16

A2 milk retails at approximately 50% more than non-A2 milk. It is much harder to produce, which is why it may be regarded as better quality milk. So when:

1. Consumers real income increases → demand for A2 milk increases
2. Consumers real income decreases → demand for A2 milk decreases
3. YED = 30% / 70% = 0.43 (positive ∴ ‘normal good’)
4. YED = -30% / -70% = 0.43 (positive ∴ ‘normal good’)

Question 17

Explain income elasticity in the context of an ‘inferior good’.

Answer 17

The income elasticity of an ‘inferior good’ is negative (YED < 0), because it is inversely proportional.
Why? Because when people have money, they have the desire to spend it on the best (‘normal goods’), so they don’t spend it on cheap goods (‘inferior goods’). But when people don’t have money, they can’t afford to spend it on the best (‘normal goods’), so they choose the affordable version of it (‘inferior goods’).

1. Income increase → Demand decrease
2. Income decrease → Demand increase.

Question 18

Include an example of this application.

Answer 18

Woolworths Homebrand milk is relatively cheaper, and does not have the same reputation that A2 would have despite its affordability. So when:

1. Consumers real income increases → demand for Woolworths Homebrand milk decreases
2. Consumers real income decreases → demand for Woolworths Homebrand milk increases
3. YED = 30% / -70% = -0.43 (negative∴ ‘inferior good’)
4. YED = -30% / 70% = -0.43 (negative ∴ ‘inferior good’)

*People recognise that better quality products are more expensive. But expensive products don’t necessarily mean better quality products.