Module 3 - Elasticity And Uncertainty

Question 1

Price elasticity of demand (PED)

Answer 1

A measure of the responsiveness (sensitivity) of quantity demanded to a change in price.
ε = % change in quantity demanded / % change in price

Question 2

Elastic / Inelastic

Answer 2

Elastic
Demand is said to be elastic if PED > 1 (in absolute terms), ie the quantity changes by a larger percentage than the price.
If demand is (price) elastic, then any change in price will cause the quantity demanded to change proportionately more.

Inelastic
Demand is said to be inelastic if PED < 1 (in absolute term), ie the quantity changes by a smaller percentage than the price.
If demand is (price) inelastic, then any change will cause the quantity demanded to change by a proportionately smaller amount.

Question 3

Unit elasticity

Answer 3

Demand is said to have unit elasticity if PED = -1, ie the percentage changes in price and quantity are equal and opposite.
When the price elasticity of demand is unity, this is where quantity demanded changes by the same proportion as the price. Price elasticity is equal to 1.

Question 4

Original / Average method of calculating elasticity

Answer 4

“Original” Method
ε = (ΔQ / Original Q) / (ΔP / Original P)

“Average/Midpoint” Method
ε = (ΔQ / Average Q) / (ΔP / Average P)

Question 5

3 determinants of PED

Answer 5

1. The availability of substitute goods, which in turn may depend on the broadness of the product definition. (More substitutes -> more elastic demand)
2. The proportion of income spent on the good. (Large proportion -> More elastic demand)
3. The time period, as it takes time to find alternative goods. (Longer time period -> More elastic demand)

Question 6

Total sales revenue (TR)

Answer 6

The amount that a firm earns from its sales if a product at a particular price. TR = P x Q. (price times quantity)
Note that we are referring to gross revenue: that is, revenue before the deduction of taxes or any other costs.

Question 7

Implication of PED values for total revenue

Answer 7

If | PED | > 1, then an increase in price leads to a larger percentage fall in quantity demanded and so total revenue is reduced.
If | PED | < 1, then an increase in price leads to a smaller percentage fall in quantity demanded and so total revenue is increased.

Special cases:

• Totally inelastic demand: vertical demand curve (PED =0)
• Infinitely elastic demand: horizontal demand curve (PED = -infinity)
• Unit elasticity of demand: rectangular hyperbola (PED = -1)

Question 8

Income elasticity of demand (IED)

Answer 8

The responsiveness (sensitivity) of demand to a change in consumer incomes.

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

Question 9

Cross-price elasticity of demand (CPED)

Answer 9

The responsiveness (sensitivity) of demand for one good to a change in the price of another.

εc = % change in quantity demanded of good X / % change in price of good Y

Question 10

Price elasticity of supply (PES)

Answer 10

The responsiveness(sensitivity) of quantity supplied to a change in price.

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

Question 11

Factors that influence PES

Answer 11

1. How costs increase with output (Lower marginal costs -> higher PES)
2. Time period (Longer period -> higher PES)

Question 12

How price elasticities of demand and supply affect tax incidence and tax revenue

Answer 12

• The more elastic the demand, the smaller the price increase (and the smaller the consumer burden) and the greater the fall in quantity sold (and hence the lower the tax revenue)
• The more elastic the supply, the greater the price increase (and the greater the consumer burden) and the greater the fall in quantity sold (and hence the lower the tax revenue.

The government will raise more tax revenue if it taxes goods that have relatively inelastic demand and supply curves.

Question 13

How do the short-run and long-run adjustment of markets may lead to price fluctuations

Answer 13

As both demand and supply are typically more elastic in the long run, a change in either demand or supply often leads to a small short run quantity change and a large short run price change, followed by a larger long run quantity change and a smaller long run price change.

Question 14

Speculation

Answer 14

This is where people make buying or selling decisions based on their anticipations of future prices.

Question 15

Self-fulfilling speculation

Answer 15

The actions of speculators tend to cause the very effect that they had anticipated.

Question 16

Differences of stabilising and destabilising speculation

Answer 16

Stabilising speculation is where the actions of speculators tend to reduce price fluctuations.
Destabilising speculation is where the actions of speculators tend to make price movements larger.

Question 17

Difference between risk and uncertainty

Answer 17

Risk is when an outcome may or may not occur, but where its probability of occurring is known.
Uncertainty is when an outcome may or may not occur and where its probability of occurring is not known.

Question 18

Four ways in which firms can deal with uncertainty

Answer 18

1. Holding stocks of goods and services (which can be supplied to the market when prices are favorable)
2. Purchasing information (eg market research and trade publications)
3. Using futures and forwards
4. Using insurance

Question 19

Futures and forwards

Answer 19

Agreements to trade a specified quantity of a good or asset at a specified price at an agreed date in the future.

Question 20

Futures price

Answer 20

A price agreed today at which an item will be exchanged at some set date in the future.

Question 21

Spot price

Answer 21

The current market price, the price agreed now to exchange the good or asset now.