elasticity

Question 1

how can demand elasticity be calculated?

Answer 1

with respect to any factor affecting demand.

by how much does demand change when price of the good changes = price elasticity

by how much does demand change when consumer’s income changes = income elasticity

by how much does demand change when the price of another related good changes = cross-price elasticity

Question 2

what is price elasticity of demand?

Answer 2

a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as a percentage change in quantity demanded divided by the % change in price.

Question 3

how can PED value be interpreted?

Answer 3

a percentage change in the quantity demanded given a one percent change in the price of the good

Question 4

what is the equation for PED?

Answer 4

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

Question 5

what is the interpretation of PED?

Answer 5

the elasticity is usually reported as a positive number while it is formally negative

• we interpret elasticities on their absolute values i.e. |-0.2| = 0.2
• a larger price elasticity is interpreted as a greater responsiveness of quantity demanded to price

Question 6

what value of PED makes it price elastic?

Answer 6

demand is price elastic if PED>1
quantity demanded changes proportionally more than price, i.e., quantity demanded responds strongly to price changes

Question 7

what value of PED makes it price inelastic?

Answer 7

demand is price inelastic if 0<PED<1
quantity demanded changes proportionally less than price
quantity demanded does not respond strongly to price changes

Question 8

what value of PED makes it price unit elastic?

Answer 8

PED=1
quantity demanded changes by the same percentage as price

Question 9

what are the 2 special cases?

Answer 9

price is perfectly elastic if PED=∞ - quantity demanded changes infinitely with any change in price

price is perfectly inelastic if PED=0
quantity demanded does not respond to price changes

Question 10

how do we use the midpoint method to calculate PED?

Answer 10

% change = (final value - initial value)/midpoint of final and initial value (x100)

this gives an average estimate a change in price has on quantity demanded

Question 11

what happens to revenue depending on PED?

Answer 11

if demand is price inelastic, an increase in price, leads to an increase in revenue

if demand is price elastic, an increase in price, leads to a decrease in revenue

if demand is unit elastic, an increase in price does not affect total revenue

Question 12

what determines the elasticity of demand?

Answer 12

• availability of close substitutes: goods with close substitutes have more elastic demand (if there is a small increase in price, they will switch to the alternatives)
• necessities vs luxuries; necessities have more inelastic demand (if price rise for an essential good, buyers will continue to buy it)
• proportion of income spent on a good: goods for which a higher proportion of income is spent have more elastic demand

time horizon: demand over longer time periods is more elastic (easier to substitute away from a product in the long run than in the short run)

Question 13

what is income elasticity of demand?

Answer 13

measures how much the quantity demanded of a good responds to a change in consumer’s income, computed as the percentage change in quantity demanded divided by the percentage change in income

Question 14

what is the equation of income elasticity?

Answer 14

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

Question 15

what is IED for normal goods?

Answer 15

normal goods have positive income elasticity of demand (i.e. IED>0), quantity demanded increases with a rise of income.

for necessities: income elasticity of demand is between 0 and 1 (i.e. 0<IED<1) -> demand increases less rapidly than an increase in income e.g. food, clothing, medical services

for luxuries: income elasticity of demand is greater than 1 (i.e, IED > 1) -> demand increased more rapidly than an increase in income (e..g sports cars, expensive food)

Question 16

what is IED for inferior goods?

Answer 16

negative income elasticity of demand (i.e. IED<0) -> quantity demanded decreases with a rise in income (e.g. frozen pizza)

Question 17

what is cross-price elasticity of demand?

Answer 17

measures how much the quantity demanded of a good responds to a change in price of a related good, computed as the percentage change in quantity demanded divided by the percentage change in price of the related goods

Question 18

what is the equation for cross-price elasticity of demand?

Answer 18

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

Question 19

what is the CED of substitutes and complements?

Answer 19

for substitutes: cross-price elasticity of demand is positive. Consumers will buy more of good A when the price of good B rises

for complements: cross-price elasticity of demand is negative. Consumers buy less of good A when the price of good B rises.

if CED=0 the goods are unrelated, the higher CED, the more the goods are related

Question 20

what is the price elasticity of supply?

Answer 20

a measure of how much the quantity supplied of a good responds to a change in the price of the good, computed as the percentage change in quantity supplied divided by the percentage in price.

PES depends on the flexibility of sellers to change the amount of good they produce.

Question 21

what is the equation for PES?

Answer 21

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

Question 22

what value of PES makes supply price elastic?

Answer 22

PES >1
quantity moves proportionately more than price

Question 23

what value of PES makes supply price inelastic?

Answer 23

0<PES<1
quantity moves proportionately less than price

Question 24

what value of PES is price unit elastic?

Answer 24

PES =1
quantity moves in same proportion as price

Question 25

what value of PES is perfectly elastic?

Answer 25

PES = ∞
quantity changes infinitely with any change in price

Question 26

what value of PES is perfecly inelastic?

Answer 26

PES =0
quantity does not respond to price changes

Question 27

what determines whether supply of a good is elastic or inelastic?

Answer 27

time period:
- over short periods of time, firms cannot easily change the size of their factories to make more or less of a good
- over longer periods, firms can build new factories or close factories. New firms can enter the market and old firms can shut down. Quantity supplied can respond substantially to price.
- therefore supply is generally more elastic in the long run than in the short run

productive capacity: it is easier to expand output when a firm is not operating at full capacity (period of strong economic growth vs period of slow economic growth)

size of the firm/industry: the response of supply to changes in price in large firms/industries may be less elastic than in smaller firms/industries

• mobility of factors of production: when the mobility of the factors of production is high, supply will be more elastic
• ease of storing stock/inventory: in industries where inventory build-up is relatively easy and cheap, supply is more price-elastic than in industries where it is much harder to do this.