Price Elasticity of Demand, Other Elasticity Measures and Elasticity Applications Flashcards
price elasticity of demand
the responsiveness of the quantity demanded to changes in price = ED
for firms, knowledge that the demand curve for their product ‘slopes downwards’ is not enough information = of more interest is how responsive their customers are to changes in the price of their good
- specifically, ED measures the percentage change in the quantity demanded for each 1 percentage change in the price
- we calculate ED based on percentage change because we are interested in the relationship between the proportionate changes in Q and P
elastic demand
demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price
- ED > 1
- means consumers are quite responsive to changes in price
inelastic demand
demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price
- ED < 1
- means consumers are not very responsive to change in price
unit elastic demand
demand is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price
- ED = 1
- means responses to a change in price is exactly proportionate to this change
perfect elasticity
perfectly elastic demand
- demand curve is horizontal
- if price increases above its current equilibrium, QD will fall to zero
perfectly inelastic demand
- demand curve is vertical
- the same quantity of the good will be demanded regardless of what the price
calculating price elasticity of demand (standard formula and midpoint formula)
if you are given the percentages, use the standard formula
if you have to calculate the percentages from actual figures, use the midpoint formula
determinants
availability of close substitutes = the more close substitutes there are, the more people will ‘switch’ if you raise your price
time = the more time that passes, the greater the opportunity to find suitable alternatives
necessities versus luxuries = luxuries we can do without, hence more responsive to changes in price
definition of the market = the broader the market defined, the less elastic
share of budget spent on good = the smaller the fraction a good takes up the less elastic demand will be
elasticity and total revenue
elasticity of demand gives us important information about impact of price changes on total revenue
an increase in P means that the seller will gain in revenue per unit sold, but also lose revenue from fewer units sold
a decrease in P means that the seller will lose revenue per unit sold, but also gain revenue from selling more units due to increased demand
so the net effect of a price change on TR will depend on which of these effects are larger, which is precisely what ED tells us
impact on total revenue
if ED is greater than 1
- the percentage change is Q was greater than the percentage change in P
- therefore the impact of Q on TR is greater than the impact of P
- e.g. the loss from a lower volume of sales is greater than the gain from higher revenue per unit sold, resulting in a fall in TR
if ED is less than 1
- the percentage change is P was greater than the percentage change in Q
- therefore the impact of P on TR is greater than the impact of Q
- e.g. the gain from higher revenue per unit sold is greater than the loss from a lower volume of sales, resulting in an increase in TR
if ED is equal to 1
- the percentage changes of P and Q are the same
- therefore their impacts are the same
- the gain from higher revenue per unit sold is exactly balanced out against the loss from the lower volume of sales, resulting in no change to T
income elasticity of demand (equation)
measures the proportionate relationship between income and quantity demanded
inferior goods and services
- EI < 0
- there is a negative relationship between income and QD
normal goods and services
- 0 < EI < 1
- there is a positive relationship between income and QD, but demand is ‘not very’ responsive to changes in income
luxury goods and services
- EI > 1
- there is a positive relationship between income and QD, and demand is highly responsive to changes in income
cross elasticity of demand (equation)
measures how the quantity demanded of one good responds to a change in the price of another related good
substitute goods
- the relationship between PB and QA is positive and EX is greater than 0
- if the price of tea falls, people buy more tea, and therefore probably less coffee
complement goods
- the relationship between PB and QA is negative and EX is less than 0
- if the price of pasta falls, people buy more pasta, and therefore probably more pasta sauces
price elasticity of supply (equation)
measures how the quantity supplied responds to change in price
perfectly inelastic ES occurs when the quantity supplied is the same regardless of price
- the supply curve is vertical
- this can occur in the very short run = the production level in a factory may be set on a weekly basis, and the same quantity is supplied regardless of what happens with the price during that week.
- also for goods that are finite in supply = picasso paintings
perfectly elastic ES occurs when suppliers can produce any quantity at a given price, but will not produce anything if the price changes
- this could occur for certain digital goods if reproduced at zero marginal cost
- the supply curve is horizontal
determinants of elasticity of supply
time
- the longer the time frame, the more chance firms have to adjust the production of their good
- the longer the time frame, the more price elastic supply will be
- e.g. the supply of crops is currently fixed but can increase or decrease next season
the cost of inputs
- sometimes extra production means inputs become more scarce, and so more costly = supply will be relatively more price inelastic e.g. during the mining boom labour costs increased significantly making the supply of labour production more price inelastic
- however, if production can be increased without significant cost increases, then supply will be relatively more price elastic e.g. large scale factories can increase output without increasing unit costs
