Topic 3: Elasticity

Question 1

Define price elasticity of demand and how it can be calculated

Answer 1

the responsiveness of the quantity demanded to changes in price, of greater importance to firms

Ed=(% change in Qd)/(% change in price)

Question 2

Describe the categories of Ed

Answer 2

­elastic demand

• when the percentage change in quantity demanded is greater than the percentage change in price (i.e. consumers are quite responsive to changes in price).
• Ed > 1 (in absolute values)

­inelastic demand

• when the percentage change in quantity demanded is less than the percentage change in price (i.e. consumers are relatively unresponsive to changes in price)
• Ed < 1

­unit elastic demand

• when the percentage change in quantity demanded is equal to the percentage change in price (consumers respond proportionately to changes in price)
• Ed = 1

Question 3

Describe the determinant of Ed

Answer 3

1. Availability of close substitutes
   * the more close substitutes there are, the more people will ‘switch’ if you raise your price i.e. Dominos pizza versus Pizza Hut pizza
2. Time
   * the more time that passes, the greater the opportunity to find suitable alternatives – in the short term Ed is more inelastic as it takes time to adjust spending and find suitable alternatives i.e. moving towards gas or electric if price of petrol increases
3. Necessities vs. luxuries
   * by definition luxuries we can do without, hence more responsive to changes in price while necessities are less responsive i.e. bread inelastic, demand for Tiffany watches elastic.
4. Definition of the market
   * the broader the definition of the market, the less elastic i.e. demand for Samsung TVs more elastic than overall demand for TVs as more substitutes
5. Share of income/budget spent on good
   * the smaller the fraction a good takes up the less elastic demand will be i.e. increase in the price of sugar versus a 50% rise in the price of cars.

Question 4

What is the midpoint method of calculating Ed?

Answer 4

used if given actual change

Question 5

Describe perfect elasticity

Answer 5

• demand curve is horizontal
• if price ↑ even slightly above its current equilibrium, the QD will fall to zero

Question 6

Describe perfect inelasticity

Answer 6

• demand curve is vertical
• the same quantity of the good will be demanded regardless of what the price is (that is, % Δ Qd = 0) i.e. insulin, a vital good

Question 7

Describe total revenue and elasticity

Answer 7

• Ed allows firms to see how changes in price will affect a firm’s total revenue (one person’s expenditureàfirm’s revenue – can use this to view consumer’s spending on a product as well)

TR = Price x Quantity

• i.e. when price decreases (i.e. P↓ and QD ↑)
  
  1. Sellers earn less revenue on each unit sold (loss of TR)
  2. Sellers earn more revenue as more units are sold (gain in TR).
• therefore the overall change in TR is the net result of these two effects

linear demand curve: elasticity varies along this curve

• if demand is elastic, then a decrease in price will increase total revenue
• if demand is inelastic, a decrease in price will decrease total revenue, decrease in Qd is greater than benefit from increase in price
• if demand is unit elastic, then there is no change in total revenue

Question 8

Describe income elasticity of demand

Answer 8

• def.*: responsiveness of demand to a change in income
  e. g. if income increases
• if demand decreases, Ei < 0, good is inferior
• if demand increases Ei > 0, good is normal

Question 9

Describe cross elasticity of demand

Answer 9

.: the responsiveness from a change in the price of one good, on the demand for another good

• Ex > 0: goods are substitutes
• i.e. if the price of apples (good B) falls, people buy more apples, and therefore fewer oranges (good A)
• Ex < 0: goods are complements

i.e. if the price of pasta (good B) falls, people buy more pasta, and therefore more pasta sauces

Question 10

Describe price elasticity of supply and its extremes

Answer 10

def.: measure of the responsiveness of the quantity supplied to a change in price

• perfectly inelastic (Es=0)
  
  • supply curve is vertical
  • generally short run i.e. production level in factory may be set on a weekly basis and the same Qs regardless of changes in prices during that week
  • also for goods that are finite in supply i.e. Picasso paintings
• perfectly elastic (Es= ∞)
  
  • supply curve is horizontal
  • often in mass production when marginal cost is constant

Question 11

What are determinants of Es?

Answer 11

1. Time

• the longer the time frame, the more chance firms have to adjust the production of their good. Therefore, the longer the time frame, the more elastic supply will be
• i.e. supply of crops fixed once planted, but can be increased or decreased next season

1. Cost of inputs

• how easily are inputs transferable / substitutable to other types of production? The easier it is, the more elastic will supply be i.e. unskilled labour to pick oranges
• in general, if marginal costs rise significantly as supply increases, then supply will be less elastic