Price Mechanism Part 2 Flashcards
Price Elasticity of Demand
Measures the degree of responsiveness of the quantity demanded of a good to a change in its price, CETERIS PARIBUS
% change in qty demanded/ % change in price of good
[not to be used in explanation: PED is the change in qty/ change in price (opp of gradient if graph is price-qty)
Sign of PED
Normally negative due to inverse relationship between price and quantity demanded, according to law of demand
Price Inelastic Demand
Fall in price will lead to a less than proportionate increase in quantity demanded, CETERIS PARIBUS (|PED|<1)
Price Elastic Demand
Fall in price will lead to a more than proportionate increase in quantity demanded, CETERIS PARIBUS (|PED|>1)
Unitary Price Elastic Demand
Fall in price will lead to an equal proportionate increase in quantity demanded, CETERIS PARIBUS (|PED|=1)
Perfectly Price Inelastic Demand
Price changes have no effect on quantity demanded, occurs when consumers willing and able to pay any price for a given quantity of the good
Perfectly Price Elastic Demand
Price changes have huge effects on quantity demanded:
- At that exact price, consumers will buy any quantity of the good
- Fall of price will lead to infinite increase in qty demanded
- Rise in price will lead to qty demanded to fall to zero
Determinants of PED
- No. and closeness of substitutes
- Proportion of income spent on the good
- Habituality of consumption
- Time horizon
Number and closeness of substitutes
Greater number of closer substitutes available for a good, higher PED (if more close substitutes, consumers more likely to consider alternatives to the good so they can readily switch to them)
Depends on the way the market is define (easier to find close substitutes for narrowly defined markets)
Proportion of income
High proportion of income spent, higher PED (small increases take up more consumers’ available income and mean a much larger expenditure, causing more people to be forced to reduce consumption when price increases)
Habituality of consumption
If good is bought habitually/ consumer is addicted, lower PED (quantity demanded is not responsive to changes in price as consumers continue to buy a similar amount of good regardless of price changes)
Time horizon
Longer time period, higher PED (consumers take time to respond to price change, adjust consumption pattern and find alternatives, more likely to switch to other substitutes)
Applying PED to explain changes in price and qty
(Assuming supply decreases)
1. Since demand is price inelastic/ elastic,
2. when supply falls, shortage is created and is more persistent/ more readily eliminated
3. as quantity demanded does not/ does respond readily to price changes
4. prices have to/ do not have to rise by much to eliminate the shortage
5. Since |PED|</> 1, a rise in price will cause a less than/ more than proportionate fall in quantity demanded.
Applying PED to explain changes in total revenue
(Assuming supply decreases)
1. Since demand is price inelastic/ elastic
2. Rise in price will lead to a less than/ more than proportionate decrease in quantity demanded
3. Gain in revenue due to rise in price is more/ less than the loss in revenue resulting from the decrease in quantity demanded
4. Final revenue is greater/ smaller than initial revenue
5. Hence, rise in price will lead to an increase/ decrease in total revenue.
Applying PED to explain behaviour of firms
- Raise prices for goods with price inelastic demand demand and lower prices for goods with price elastic demand to increase revenue (use apply PED explain changes in total revenue)
- Focus on business strategies to make demand of their products more price inelastic by reducing substitutability of products to keep demand price inelastic in long run
- R+D around product development to improve product quality and reduce substitutability, allowing them to raise prices to increase revenue
Price Elasticity of Supply
Measure of degree of responsiveness of quantity supplied of a good to change in its price, ceteris paribus
Sign of PES
Positive because law of supply states that if there is increased price there will be a rise in quantity supplied
Price inelastic supply
Rise in price will lead to a less than proportionate increase in quantity supplied, CETERIS PARIBUS
|PES|<1
Price elastic supply
Rise in price will lead to a more than proportionate increase in quantity supplied, CETERIS PARIBUS
|PES|>1
Unitary Price Elastic Supply
Rise in price will lead to a proportionate increase in quantity supplied, CETERIS PARIBUS
|PES| = 1
Perfectly price inelastic supply
Price changes have no effect on quantity supplied, which remains fixed.
|PES| = 0
Perfectly price elastic supply
Price changes have huge effects on quantity supplied. At this price, producers can produce any quantity of the good, any rise in price will lead to an infinite increase in quantity supplied, any fall in price will cause quantity supplied to fall to zero.
Determinants of PES
- Level of stock or inventory
- Availability of spare capacity
- Mobility of factors of production
- Time horizon
- Length of production period
Level of stock or inventory
When there is a high level of stock, PES is high (when price rises and incentivises producers to increase output, firms with more stock and inventory can respond quickly by drawing down on their stock to offer their products for sale)
Depends on ease of storing the stock (when product is perishable and not easily stocked up, supply will be price inelastic)
Availability of spare capacity
When availability of spare capacity increases, PES increases (output can be increased readily in response to price increases with physical spare capacity [assuming firms hold sufficient stock of raw materials])
Mobility of FOP
More mobile, higher PES (more easy and quickly resources can be shifted between industries, greater degree of responsiveness of qty supplied to changes in price)
Time horizon
Longer time period, higher PES (Momentarily supply would be price inelastic because it is impossible for firm to change output immediately in response to price changes due to fixed FOP and restricted supply due to qty available in market)
(Short run, relatively price inelastic because qty supplied can be increased to a certain extent as some inputs can be varied whilst others remain fixed)
(Long run, price elastic because all FOP is variable, sufficient time for firms to acquire inputs to expand production, qty supplied is more responsive)
Short Run
Period where production is restricted by at least one factor of production
Long run
Period where all factors of production are variable
Length of production period
Longer production period, lower PES (Longer production period means producers take more time to respond to price changes by altering output accordingly
Applying PES to explain changes in price and quantity
- When demand rises, a shortage is created.
- Due to (determinant(s)), the supply is price inelastic/ price elastic, which means that quantity supplied cannot/ can change easily
- A much higher price would be needed to eliminate the persistent shortage/ Prices do not have to rise by much to eliminate the readily eliminated shortage
- Thus, a rise in price will cause a more than/ less than proportionate rise in quantity supplied, CETERIS PARIBUS.
Cross Elasticity of Demand
Measure of degree of responsiveness of quantity demanded of a good to a change in the price of another good
Sign of CED
Positive means 2 goods are substitutes, negative means 2 goods are complements, 0 means 2 goods are unrelated
Magnitude of CED
Indicates strength of relationship between 2 goods, closer they are, greater magnitude
Strong Complement
Negative CED with large magnitude (Rise in price of good leads to more than proportionate decrease in demand of the other good CETERIS PARIBUS) [big change in demand]
Weak Complement
Negative CED with small magnitude (Rise in price of good leads to less than proportionate decrease in demand of the other good CETERIS PARIBUS)
Weak Substitues
Positive CED with small magnitude (Rise in price of good leads to less than proportionate increase in demand for other good CETERIS PARIBUS)
Strong Substitutes
Positive CED with large magnitude (Rise in price of good leads to more than proportionate increase in demand for other good CETERIS PARIBUS)
Applying CED to explain behaviour of firms if high positive CED (impact and strategies)
When rival product price fall, large decrease for firm’s product and reduces firm’s revenue and profits CETERIS PARIBUS
Price Strategy: If price of substitute falls, firm has to lower price of its good to prevent huge loss of existing and potential customers
Non-price strategy: Reduce CED by making good less substitutable, reducing the effect of rival’s pricing policies on demand through advertising or development of product
Applying CED to explain behaviour of firms if high negative CED (impact and strategies)
When other firm product fall, large increase for firm’s product and increases firm’s revenue and profits CETERIS PARIBUS
Non-price strategy: Plan for increase in production of good or release inventory/ stocks
Income Elasticity of Demand
Measure of degree of responsiveness of quantity demanded for a good to a change in consumers’ income CETERIS PARIBUS
Sign of YED
Positive means normal good, negative means inferior good
Magnitude
Indicates strength of relationship between income and demand for the good, low positive YED means product is a necessity, while high positive YED means product is a luxury
Inferior Good
Negative YED (rise in income will lead to decrease in demand of good CETERIS PARIBUS)
Necessity (Normal Good)
0 < YED < 1 (Rise in income leads to less than proportionate increase in demand of product CETERIS PARIBUS)
Luxury (Normal Good)
YED >1 (Rise in income leads to a more than proportionate increase in demand of product CETERIS PARIBUS)
Determinants of YED (Degree of Necessity)
Degree of necessity of good (more basic an item it is in consumption pattern of households, lower YED)
WHICH IS DETERMINED BY
Level of income of consumer base (when income levels are low, only basic necessities have a high necessity so products have higher YED in markets with poorer consumers)
WHICH IS DETERMINED
Which stage of economic development countries are at
Applying YED to explain behaviours of firms during economic growth
Firms stand to benefit from higher demand of normal goods (demand for luxury goods rises more than necessity goods) increasing total revenue for firms and profits (assuming costs remain the same)
Firms can channel more resources into developing better quality products that are more luxurious, or add more luxurious features
Applying YED to explain behaviours of firms during economic recession
Demand for normal goods fall while demand for inferior goods rise
Firms can channel resources from the production of luxury goods to production of necessities to minimise fall in demand for products and can promote inferior goods to capture larger share of rising demand for inferior goods in market
Applying YED to explain behaviours of firms across different consumer bases
As what is considered luxurious differs across different consumer bases, during economic growth, supermarket can stock up more of what is considered luxurious to the consumers (organic food/ caviar)
Limitations of Elasticity
- Computation issues
- Issues with prediction
- Cost concerns
- Ceteris paribus assumption
