Topic 2 - Elasticity Flashcards
What is the Price Elasticity of Demand?
Price elasticity of demand (PED) is the responsiveness of quantity demanded to a change in price (when all other influences remain the same).
Why is PED vital for firms?
It defines the nature of the relationship between price and quantity.
What does total revenue = ?
Total Revenue (TR) = Price (P) x Quantity (Q)
How do we work out PED?
The change in quantity demanded divided by the change in price.
If PED = -x, we can say that 10% price cut will generate a x X 10% increase in quantity demanded.
Delta Q/Q ave … / Delta P/P ave
What is the general rule with PED along a curve?
As we move down along a linear demand curve, demand becomes more price inelastic.
What happens when quantity demanded remains constant when the price changes?
The PED = 0, and it’s perfectly inelastic demand.
Graph = vertical
What happens when quantity demanded equals price change?
The PED = 1, and it’s unit elastic demand.
What happens when quantity demanded > price change?
It’s perfectly elastic demand, and graph is horizontal.
What is elastic and inelastic with PED?
Inelastic = 0 - 1 Elastic = 1 - infinity
What happens to PED along a linear demand curve?
At prices above the midpoint, demand = elastic
At prices below the midpoint, demand = inelastic.
How is total revenue affected by PED?
If demand = elastic, 1% price cut increases quantity sold by more than 1%, so revenue increases
If demand = unit elastic, 1% price cut increases quantity sold by 1%, so revenue stays constant
If demand = inelastic, 1% price cut increases the quantity sold by less than 1%, so revenue decreases.
What happens at unit elasticity?
Total revenue = at its max
What is the total revenue test?
A method of estimating the PED, by observing the change in total revenue, that results from a change in price, when all other influences remain the same.
Price cut increases TR = PED is elastic
Price cut decreases TR = PED is inelastic
Price cut doesn’t change TR = PED is unit elastic
What are the axis for a TR graph?
x = Q y = TR
How does expenditure change when your ED changes?
Our demand = elastic, 1% price cut increases the Q we buy by >1%, so expenditure increases.
Our demand = inelastic, 1% price cut increases the Q we buy by <1%, so expenditure decreases.
Our demand = unit elastic, 1% price cut increases the Q we buy by 1%, so expenditure is constant.
What factors affect our ED?
1 = Closeness of substitutes 2 = Proportion of income spent on the good 3 = Time elapsed since price change
How does the closeness of substitutes affect our ED?
The closer the subs for a good, the demand is more elastic.
How does the proportion of income spent on the good affect our ED?
The greater the proportion of income spent on a good, the more elastic is the demand for it.
How does the time elapsed since price change affect our ED?
The longer the time that has elapsed since a price change, the more elastic is demand.
What is the cross elasticity of demand?
A measure of the responsiveness of the demand for a good to a change in price of a sub or complement.
How do we work out CED?
% Change in quantity demanded/ % Change in price of sub/complement
How does the value of CED affect our results?
\+ve = substitute (demand curve shifts right) -ve = complement (demand curve shifts left)
What is the income of elasticity?
A measure of the responsiveness of the demand for a good to a change in income.
How do we work out IOD?
%Change in Q demanded/ % Change in income
What do the results of IOD show?
If IOD > 1 = normal elastic good
If IOD +ve < 1 = normal inelastic good
If IOD -ve < 1 = inferior good
What happens when the demand for a good is income elastic?
The % of income spent on that good increases as income increases.
What happens when the demand for a good is income inelastic?
The % of income spent on that good decreases as income increases.
What is the elasticity of supply?
EOS = The responsiveness of the quantity supplied to a change in price.
How do we work out EOS?
% Change in Q supplied / % Change in P
How do we know if supply curves are unit elastic?
They all pass through the origin.
What happens if EOS = 0 and EOS = infinity?
If EOS = 0, supply curve in vertical
If EOS = infinity, supply curve is horizontal
What factors affect EOS?
1 = Resource Substitution Possibilities 2 = Time Frame for the supply decision
How do resource substitution possibilities affect EOS?
If goods can only be produced using rare resources they have a low EOS, whereas if they can be produced using widely available resources they have a high EOS.
How does a momentary supply affect EOS?
When the price of a good changes, the immediate response of the quantity supplied = determined by the momentary supply of the good.
How does the time frame for supply decision affect EOS?
Over longer time periods, demand becomes more elastic as there is more time to adjust to potential alternatives.
