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)
What is the sign of PES?
It is positive. According to the Law of Supply, as price increases, which is a positive change in the denominator, quantity supplied will increase, which is a positive change in the numerator, and vice versa.
What does magnitude of PES indicate?
The sensitivity of producers to change in prices. Higher magnitude indicates greater sensitivity, lower magnitude indicates lower sensitivity.
What does |PES| < 1 indicate?
Supply is price inelastic. Producers are less sensitive to changes in price, thus quantity supplied is less responsive as well. A change in price will lead to a less than proportionate change in quantity supplied. Usually represented by a steep supply curve.
What does |PES| > 1 indicate?
Supply is price elastic. Producers are more sensitive to price changes, and thus quantity supplied is more sensitive to price changes. A change in price will lead to a more than proportionate change in quantity supplied. Usually represented by a gentle supply curve.
What does |PES| = 1 indicate?
Unitary price elastic supply. A change in price will lead to an equal proportionate change in quantity supplied. Represented by a straight supply curve starting from the origin.
What does |PES| = 0 indicate?
Perfectly price inelastic supply. Price changes have no effect on quantity supplied. Represented by a vertical straight supply curve.
What does |PES| = ∞ indicate?
Perfectly price elastic supply. Price changes have huge effects on quantity supplied, any rise in price will lead to an infinite increase in quantity supplied, any fall in price will lead to quantity supplied to fall to zero. Represented by a horizontal straight supply curve.
What are the determinants of PES?
Level of stock or inventory, availability of spare capacity, mobility of factors of production, time horizon, length of production period.
How does level of stock affect PES?
It affects how readily producers can respond to price changes. If firms have high levels of stock, if price of the good increases and incentivises producers to increase quantity supplied, they can respond quickly and draw on the stock and offer the goods for sale. Thus quantity supplied is responsive to price changes, making the supply of the good price elastic when there are high levels of stock.
What does availability of stock depend on?
Ease of storing the stock.
How does availability of spare capacity affect PES?
If firms hold sufficient stock of raw materials and have the physical spare capacity, production can be increased readily in response to price changes. If the firm’s capacity is saturated, it will be more difficult to increase production when there is an increase in price. The greater the availability of spare capacity, the more price elastic supply is.
How does mobility of factors of production affect PES?
The greater the mobility of FOPs, the faster more goods can be produced, the greater the degree of responsiveness of quantity supplied to changes in price, the more price elastic supply is.
What is factor mobility?
It is the ease and speed at which FOPs can move from one industry to another.
How does time horizon affect PES?
When the price of good changes, producers need time to respond and adjust their production pattern and thus time is needed for quantity supplied to increase or decrease.
How does length of production period affect PES?
Time taken to produce goods affects how fast producers can respond to price change. The shorter the production period, the more responsive quantity supplied is to price changes and vice versa.
What is the elasticity of supply in the momentary period?
Supply is perfectly price inelastic because it is impossible for firms to change output as soon as there is a change in price as all FOPs are fixed. Supply is restricted to quantities available in the market at that point.
What is the elasticity of supply in the short run?
The short run is the period where production is restricted by at least one FOP. Supply is relatively price inelastic as quantity supplied can be increased to some extent in response to changes in price because some inputs can be varied while others remain fixed.
What is the elasticity of supply in the long run?
The long run is the period of time where all FOPs can be varied. There is sufficient time for firms to acquire inputs to expand production and for new firms to enter the market, quantity supplied can be more responsive and supply becomes highly price elastic.
How does PES affect the extent to which price and quantity supplied changes when demand changes in a perfectly competitive market?
Increase in demand, |PES|<1: Large increase in P, less than proportionate increase in Q
Increase in demand, |PES|>1: Small increase in P, more than proportionate increase in Q
Decrease in demand, |PES|<1: Large decrease in P, less than proportionate decrease in Q
Decrease in demand, |PES|<>: Small decrease in P, more than proportionate decrease in Q
What is cross elasticity of demand?
The measure of degree of responsiveness of the quantity demanded of a good to change in the price of another good.
What is the mathematical formula for CED?
CED = (% change in quantity demanded of good B)/(% change in price of good A)
What is the sign of CED?
If CED is positive, the two goods are substitutes. An increase/decrease in the price of good A will increase/decrease demand for good B.
If CED is negative, the two goods are complements. An increase/decrease in the price of good A will decrease/increase demand for good B.
If CED is zero, the two goods are unrelated. A change in price in good A will not affect demand for good B.
What does the magnitude of CED indicate?
The strength of the relationship between the goods.
What does CED<0 and |CED| is large indicate?
The two goods are strong complements. Consumers of good B are sensitive to the price of good A. Increase/decrease in price of good A will lead to a more than proportionate decrease/increase in quantity demanded for good B. Illustrated by a large shift in the demand curve for good B.
What does CED<0 and |CED| is small indicate?
The two goods are weak complements. Consumers of good B are less sensitive to the price of good A. Increase/decrease in price of good A will lead to a less than proportionate decrease/increase in quantity demanded for good B. Illustrated by a small shift in the demand curve for good B.
What does CED>0 and |CED| is large indicate?
The two goods are strong substitutes. Consumers of good B are sensitive to the price of good A. Increase/decrease in price of good A will lead to a more than proportionate increase/decrease in quantity demanded for good B. Illustrated by a large shift in the demand curve for good B.
What does CED>0 and |CED| is small indicate?
The two goods are weak substitutes. Consumers of good B are less sensitive to the price of good A. Increase/decrease in price of good A will lead to a less than proportionate increase/decrease in quantity demanded for good B. Illustrated by a small shift in the demand curve for good B.
