Elasticity Quiz Flashcards
Price elasticity of demand
The responsiveness of demand to a change in price. When price rises demand falls but by how much? Elasticity is measuring the extent to which demand will change.
Elastic demand
Demand is responsive or sensitive to a change in price. A change in price will lead to a more than proportional change in quantity demanded.
Inelastic demand
Demand is not very responsive to a change in price. A change in price leads to a less than proportionate change in quantity demanded
Unitary elasticity
The percentage change in quantity demanded is equal to the percentage change in price.
Perfectly elastic
Consumer demand is unlimited at that price. No firm has an incentive to drop price, however an increase in price by even a penny would mean demand drops to zero. Rare and usually occurs in markets where producers can instantly and costlessly adjust production. The coefficient is infinity. E.g. Agricultural goods with perishable crops may exhibit near-perfect elasticity in the short run, as farmers can quickly adjust supply in response to price changes. An extreme that in reality doesn’t exist.
Perfectly inelastic
In the case of perfect inelasticity, quantity supplied does not respond to price changes. Producers are unable or unwilling to adjust supply in response to price fluctuations. The coefficient is zero. E.g. Life-saving medications may have perfectly inelastic supply; their production cannot be immediately increased, regardless of price changes. An extreme that in reality doesn’t exist.
Calculating PED
the formula used to calculate PED is
% change in quantity demanded (QD) / % change in price (P)
to work out % change - difference / original x 100
using PED to find relationship
If answer <1 the relationship in inelastic ( consumers do not react much to a change in price) perfectly price inelastic at 0
If answer between >1 the relationship is elastic (consumers do react to a change in price) perfectly price elastic at infinity
If value is 1 then it is unitary
Impact of price on elasticity - Elastic
Response to a rise in price- % change in QD is larger than % change in price
PED coefficient - > 1
Impact on total revenue if price Increases/ decreases -
Increase in price = decrease in revenue
decrease in price = increase in revenue
Impact of price on elasticity - Unitary elasticity
Response to a rise in price- % change in QD is same as % change in price
PED coefficient - 1
Impact on total revenue if price Increases/ decreases -
Increase in price = no change in revenue
decrease in price = no change in revenue
Impact of price on elasticity - Inelastic
Response to a rise in price- % change in QD is less than % change in price
PED coefficient - <1
Impact on total revenue if price Increases/ decreases -
Increase in price = increase in revenue
decrease in price = decrease in revenue
Revenue vs Profit
Firms who have products that are price elastic would benefit from a price cut to increase their revenue. However it is important to note that this does not mean there will be an increase in profit. Where there are extra sales, there is likely to be an increase in costs, therefore total costs will rise as well as total revenue. If costs actually rise more than revenue , profits will fall
Products which are price elastic
( Demand will fall if prise rises )
-Goods with close substitutes ( e.g. spaghetti )
-Luxuries
-Longer time period
Products which are price inelastic
( Demand won’t fall despite price rise)
-Shorter time period
-Necessities
-Addictive goods - cigarettes, alcohol
-Goods with no clear alternative - e.g apple iPhone
Factors Influencing PED
S- substitutes
P- proportion of income
L- luxury or necessity
A- addiction
T- time
Factors Influencing PED - Substitutes
- Existence of close alternatives or substitutes, will increase PED (become more elastic). Where there are close substitutes including other brands it is important for firms to differentiate their products to make their products less price responsive because substitutes become less attractive in comparison.
Income Elasticity of Demand
Income elasticity of demand (YED) is the responsiveness of quantity demanded to changes in income. The basic formula for calculating the coefficient of income elasticity is:
% change in quantity demanded / % change in income
Normal good
Have a positive income elasticity of demand. As consumer income rises, more is demanded at each price level. I.e there is a right shift of the demand curve.
Normal goods can be separated into 2 groups:
-(Normal) Necessities. Coefficient = 0 -> 1. E.g. Fruit and veg
-(Normal) Luxuries. Coefficient = 1-> infinity. E.g. holidays, sports car, designer clothes.
Inferior goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. However in a recession the demand for inferior goods may actually increase. Coefficient = -infinity -> 0. Examples include tinned food and public transport
Significance of YED
Inferior goods can benefit from an increase in sales during a recession as consumers tend to consider their spending. In a boom producers of inferior goods will feel the need to diversify. They need to increase their range of products to include some with growing markets. They may need to find new ways of adding value to their products. Whereas producers of luxury products tend to see the sales of their products fall significantly during a period of recession. Finally when interpreting YED not all consumers will view goods in the same way. A good that is regarded as a luxury to one person might be viewed very differently by someone else who has a higher level of income/ wealth
Income elasticity and co- efficient
Below -1 = Income elastic inferior good
Below -1 and 0 + income inelastic inferior good
0 = No relationship between income and QD
0 and +1 = Income inelastic normal good/necessity
Greater than +1 = Income elastic normal good/ luxury
Cross Elasticity of Demand
(XED) : Measures the responsiveness of a change in demand of one good to a change in price of another good.
The Factors:
- Substitutes
-Complements
-No correlation
% change in quantity demanded X / % change in Price of Good Y
Co efficient of Substitutes
Co- efficient
Strong substitutes: +1 -> infinity
Weak substitutes: 0 -> +1
Explanation of change in price for one good on the demand for the other:
Increase in price causes an increase in demand for the other
Decrease in price causes an decrease in demand for the other
( significant change for strong)
Co efficient of Complements
Co- efficient
Strong Complements: -1 -> -infinity
Weak Complements: 0 -> -1
Explanation of change in price for one good on the demand for the other:
Increase in price causes an decrease in demand for the other
Decrease in price causes an increase in demand for the other
( significant change for strong)
Co efficient if no correlation between goods
Co- efficient- 0
Explanation of change in price for one good on the demand for the other:
If there is an increase or decrease in price there is no change
Using Elasticities
PED will help firms judge the impact of a change in price. YED will help to forecast changing demands if real incomes are increasing / decreasing. XED helps anticipate changes in demand based on changes in prices of other products. From the prospective of Government, knowing the PED will help inform them of the impact of imposing/ increasing direct taxes on the revenue received. Similarly the impact of introducing a subsidy can be estimated.
Price elasticity of supply
PES measures the responsiveness of QS of a good or services to a change in price of that good/ service
% change in quantity supplied / % change in price
Supply curve - PES
The supply curve is upward sloping - price elasticity of is positive
An increase in the market price is likely to encourage firms to supply more
If PES is between 0 and 1 then supply is inelastic
If PES is more than 1 then supply is elastic
When = 1 it is unitary
inelastic supply
A change in price causes a smaller proportionate change in quantity supply
Firms can’t increase supply easily, it can be expensive and/or take a long time
Grapes- Harvest is once a year, so in short term, supply would be very inelastic
elastic supply
A change in price causes a bigger proportionate change in supply
Firms can increase supply at little cost
Taxi Services- easy for people to work as taxi drivers, licence and car.
unitary elastic supply
A unitary elastic supply has a change in supply which is equal to the change in price
E.g. 10% change in price leads to a 10% change in supply.
Perfectly inelastic supply
-Supply fixed, so if there is a change in demand, it can’t be met, not straight away anyways
PES = 0, supply is perfectly price inelastic
What affects Price elasticity of supply
- How willing and able firms are to respond to a change in price
-Spare production capacity: if there is plenty of spare capacity, a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. - Stocks of finished products and components and perishability. If stocks of raw material and finished products are high, then a firm can respond to a change in demand - supply will be elastic - perishable goods are often harder / more expensive to store - this makes supply less elastic.
-Ease and costs of factor substitution / factor mobility : if capital and labour are occupationally mobile then the elasticity of supply is higher as resources can be mobilised to supply extra output e.g. reallocation of workers to new tasks
-Time period and production speed : supply is more price elastic the longer the time that a firm is given to adjust their production levels.
What affects Price elasticity of supply PSSST B
P- production lag
S- stock
S- spare capacity
S- substitutability of factors of production (CELL)
T- time
B- carries to entry
What affects price elasticity of supply
- How willing and able firms are to respond to a change in prices
- A firm that has high levels of stock / running at below capacity is likely to be able to respond very quickly to a change in price - Where as a firm who will need to pay overtime / rent new buildings or machinery may be less responsive to a change in price
Supply could be inelastic for the following reasons
-In the short term, capital is fixed in the short term .e.g. firms do not have time to build a bigger factory
-It is difficult to employ factors of production e.g. if highly skilled labour is needed
-With agricultural products, supply is inelastic in the short run, because it takes at least 6 months to grow new crops. In September the farmers cannot suddenly produce more potatoes if the price goes up.
- Firms operating close to full capacity
Supply could be elastic for the following reasons
- If there is spare capacity in the factory
- If there are stocks available
- In the long run, supply will be more elastic, because capital can be varied
-If it is easy to employ more factors of production
