Price Mechanism and its Applications Pt II Flashcards
What is price elasticity of demand?
The measure of degree of responsiveness of the quantity demanded of a good to a change in its price.
What is the mathematical formula of price elasticity of demand?
PED = (% change in quantity demanded)/(% change in price)
What is the sign of PED?
Negative. According to the Law of Demand, an increase in price, which is a positive change in the denominator, will cause a decrease in quantity demanded, which is a negative change in the numerator, and vice versa.
What does magnitude of PED indicate?
The sensitivity of consumers to price changes. Higher magnitude means greater sensitivity, lower magnitude means lower sensitivity.
What does |PED| < 1 indicate?
Demand is price inelastic, meaning that consumers are less sensitive to price changes, and hence quantity demanded is less responsive to changes in prices. A change in price would lead to a less that proportionate change in quantity demanded. Usually represented by a steep demand curve.
What does |PED| > 1 indicate?
Demand is price elastic, meaning consumers are more sensitive to price changes, and hence quantity demanded is more responsive to changes in prices. A change in price would lead to a more than proportionate change in quantity demanded. Usually represented by a gentle demand curve.
What does |PED| = 1 indicate?
Demand is unitary price elastic, meaning a change in price will cause an equal proportionate change in quantity demanded. Usually represented by a demand curve that is a hyperbola.
What does |PED| = 0 indicate?
Demand is perfectly price inelastic, meaning consumers are willing and able to pay any price for a given quantity of a good, and hence price changes have no effect on quantity demanded. Usually represented by a vertical straight line.
What does |PED| = ∞ indicate?
Demand is perfectly price elastic, consumers would buy any quantity of a good at a given price. Any increase in price will cause quantity demanded to decrease to 0 and any decrease in price will cause quantity demanded to increase infinitely. Usually represented by a straight horizontal line.
What are the determinants of PED?
Number and closeness of substitutes, habituality of consumption, proportion of income spent on good, time horizon.
How does number and closeness of substitutes affect PED?
Consumers are more likely to consider alternatives when the price of a good changes if there a large number of close substitutes available. If the price of the good increases, consumers can readily switch to these alternatives and thus there will be a more than proportionate change in quantity demanded for the good, making demand more price elastic.
What does availability of substitutes depend on?
It is dependent on the way the market is defined. Narrowly defines markets have a higher PED compared to broadly defined markets, because it is easier to find substitutes for specific goods.
How does habituality of consumption affect PED?
If a good is bought habitually, demand for it is more price inelastic as consumers would continue to buy a similar quantity of a good regardless of price changes, resulting in quantity demanded to be less responsive to price changes.
What is a special case of habituality of consumption?
Consumers’ addiction. The greater the degree of addiction, the more consumers will buy a similar quantity of a good regardless of price changes, causing quantity demanded to be less responsive to price changes and thus demand to be more price inelastic.
How does proportion of income spent on the good affect PED?
Higher proportion of income spent on the good will force people to reduce their consumption when price increases because small increases in price will take up more available income. Thus, a change in price will cause a more than proportionate change in quantity demanded and demand would be more price elastic.
How does time horizon affect PED?
When price rises, consumers will take time to adjust their consumption pattern and find alternatives. The longer the time period, the more likely consumers can switch to other substitutes, causing a more than proportionate change in quantity demanded and hence demand to be more price elastic.
How do differences in PED affect the impact of changes in supply on price and quantity?
Increase in supply, |PED| < 1: Large decrease in price, less than proportionate increase in quantity.
Increase in supply, |PED| > 1: Small decrease in price, more than proportionate increase in quantity.
Decrease in supply, |PED| < 1: Large increase in price, less than proportionate decrease in quantity.
Decrease in supply, |PED| > 1: Small increase in price, more than proportionate decrease in quantity.
How do differences in PED affect the impact of changes in price on total revenue?
Rise in price, |PED| < 1: Price increases, less than proportionate decrease in quantity, total revenue increases.
Rise in price, |PED| > 1: Small price increase, more than proportionate decrease in quantity, total revenue decreases.
Fall in price, |PED| < 1: Price decreases, less than proportionate increase in quantity, total revenue decreases.
Fall in price, |PED| > 1: Small price decrease, more than proportionate increase in quantity, total revenue increases.
How can firms use PED to make beneficial decisions?
- They can raise prices for goods with price inelastic demand, and lower prices for goods with price elastic demand.
- They can focus on strategies to make demand for their goods more price inelastic in the long run.
Explain why firms will raise the price of a good with price inelastic demand.
For a good whose demand is price inelastic, profits can rise as increase in revenue due to price increase is larger than fall in revenue due to decrease in quantity demanded. Total revenue thus increases. Additionally, with decrease in quantity, cost of production can decrease. Thus, profits can rise.
Explain why firms will decrease the price of a good with price elastic demand.
It is more likely profits will increase with a fall in price as the increase in revenue from the rise in quantity is larger than decrease in revenue due to the fall in price. However, with rise in quantity demanded, more goods have to be produced, leading to a rise in costs as well. If rise in total revenue is less than rise in total cost, profits will fall, thus it is rather uncommon for firms to lower price to increase profit.
Why do firms want to make the demand for their goods price inelastic?
In the short run, there tends to be a lack of close substitute to a firm’s good. However, in the long run, competitors have the time to replicate and produce close substitutes to the good. As such, demand for the good becomes more price elastic, and the firm will have to reduce prices to increase revenue. However, if they use strategies to keep the substitutability of their products, demand will remain price inelastic and the prices can be kept high. This will allow them to raise prices, with a less than proportionate fall in quantity, leading to a rise in revenue.
What is price elasticity of supply?
It is the degree of responsiveness of quantity supplied of a good to a change in its price.
What is the mathematical formula for PES?
PES = (% change in quantity supplied)/(% change in price)