Download elasticities study guide

1.2 Elasticity
Sub-topic
SL/HL Core – Assessment Objectives
Price Elasticity of Demand (PED)
Price
Price elasticity of demand involves responsiveness of quantity demanded to a change in price, along
elasticity of
a given demand curve.
demand and
AO4 – Calculate PED using the following equation.
its
PED = percentage change in quantity demanded /percentage change in price
determinants (Example $5 to $4.50, and 200,000 to 300,000. Remember, (b-a)/a *100 = % change.
& PED value is treated as if it were positive although its value is usually negative.)
(Same as PED of 5, since negative values for PED are treated as positives)
AO2 –Explain, using diagrams and PED values, the concepts of price elastic demand, price
inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic demand.
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Price elastic demand can be seen in the top middle diagram above where the slope is quite gentle
and PED is greater 1 but less than infinity. This means that a change in the price of a product leads
to a greater than proportionate change in quantity demanded of it. For instance, if the price of an
elastic product is raised, the quantity demanded will decrease so much so that the total revenue
generated by the producers would also decrease, despite making more money per product.
Price inelastic demand can be seen in the bottom left diagram above where the slope is steep and
PED is greater than 0 but less than 1. This means that a change in the price of a product leads to a
proportionally smaller change in the quantity demanded of it. For instance, if the price of an
inelastic product is raised, the change in the quantity demanded will be comparatively so small that
the total revenue generated by the producers would increase.
Unit elastic demand can be seen in the bottom right diagram above (it should be a curve) where the
graph is a curve so that PED is 1. This means that a change in the price of a product leads to a
perfectly proportional change in the quantity demanded of it. For instance, if the price of a unit
elastic product is raised, the quantity demanded will fall by the same percentage so that the producer
generates the same amount of total revenue as before the price change.
Perfectly elastic demand can be seen in the top left diagram above where the line is horizontal and
PED is infinity. This means than even the slightest price change would cause demand to drop to 0. Of
course this is a very theoretical situation and while PED for certain products may approach infinity
(e.g. a very specific, not widely known brand of chocolate because consumers would switch to
another brand if the price increased), no product is perfectly elastic.
Perfectly inelastic demand can be seen in the top right diagram above where the line is vertical and
PED is 0. This means that any price change would not affect the quantity demanded in the slightest.
Of course this is a very theoretical situation and while PED for certain products may approach 0
(e.g. insulin because consumers who needed it would die if they didn’t buy it), no product is perfectly
elastic.
AO2 –Explain the determinants of PED, including the number and closeness of substitutes, the
degree of necessity, time and the proportion of income spent on the good.
The determinants of PED include the number and closeness of substitutes (for instance if a Subway
store opens next to another sandwich shop, the demand for the sandwiches would become more
elastic as there is a close substitute), the necessity of the good (a necessity good like toilet paper
would have relatively inelastic demand as consumers are always in need of it and are not likely to
stop buying it, even if the price increases), how widely the good is defined (tissue paper in general
would have a more inelastic demand than a particular brand like Tempo), the amount of income
spent of the good (consumers’ willingness to buy a car if the price increased could be affected far
more than their willingness to buy tomatoes that increased in price) and the time period (if the price
of gasoline increased and remained that way for a long time, consumers would find an alternative
source of transport or adjust to the price change).
AO2 –Explain why PED varies along a straight-line demand curve and is not represented by
the slope of the demand curve.
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It is logical that the PED falls going down a demand curve. This is because low-priced products have
a more inelastic demand than high-priced products, because consumers are less concerned when the
price of a relatively inexpensive product rises than when the price of a relatively expensive product
rises. It is obvious that the slope does not represent PED because there is no change in a linear
demand curve.
Applications
of price
elasticity of
demand
AO2 – Examine the role of PED for firms in making decisions regarding price changes and
their effect on total revenue.
Firms producing inelastic products can raise the price of their product so that they maximize
revenue. Of course, governments might tax inelastic goods so that consumers can still have access to
necessary goods without spending unreasonable amounts and the firm would not find it in its
interests to raise the price too much, as very few products are perfectly inelastic.
Firms producing elastic products would have to careful in how much they raise the price of their
product, however lowering the price might cause such an increase in demand that the total revenue
would be maximized.
AO2 – Explain why the PED for many primary commodities is relatively low and the PED for
manufactured products is relatively high.
The PED for many primary commodities is low (meaning that the demand for primary commodities
is relatively inelastic) because there is a higher necessity of them since they often contribute to
making more manufactured products (that have an elastic demand) and also because primary
commodities tend to be more widely defined than manufactured products. For instance, there is little
differentiation that can be made between two different harvests of coffee beans in comparison to the
vast differences between two different types of phones.
AO2 – Examine the significance of PED for government in relation to indirect taxes.
If the PED of a product is quite low, so that consumers would buy the product even after a significant
increase in price (e.g. milk since it is a necessary ingredient as well as drunk on its own), the
government might indirectly tax the good so that the good would still be accessible to consumers
would could not afford paying a high price for everyday goods.
Cross price elasticity of demand (XED)
Cross price
Cross price elasticity of demand involves responsiveness of demand for one good (and hence a
elasticity of
shifting demand curve) to a change in the price of another good.
demand and
AO4 – Calculate XED using the following equation.
its
XED = percentage change in quantity demanded of good x /percentage change in price of good y.
determinants (Example: Quantity + 5%, Price – 10%)
XED = 5%/-10% = -0.5%
Substitute goods have a positive value of XED and complementary goods have a negative value of
XED. The (absolute) value of XED depends on the closeness of the relationship between two goods.
This means the two products from the example that have an XED of -0.5% are remote complements.
Application
of price
elasticity of
demand
AO2 – Examine the implications of XED for businesses if prices of substitutes or complements
change.
Firms need to be aware of the XED for the products that they produce. For instance, if the price of a
good B decreases then the quantity demanded of a substitute good A could also decrease. This means
that firm A would need to be come up with a way to differentiate their product from good B or also
lower the price. On the other hand, if the price of a good C decreases then the quantity demanded of
a complement good D might increase, since consumers’ demand for good C would increase and
would also buy more of good D, the complement.
Income elasticity of demand (YED)
Income
Income elasticity of demand involves responsiveness of demand (and hence a shifting demand curve)
elasticity of
to a change in income.
demand and
AO4 – Calculate YED using the following equation.
its
YED = percentage change in quantity demanded /percentage change in income
determinants (Example: Income rises from 50,000 to 55,000, demand rises 7%)
YED = 7%/10% = 0.7
AO2 –Explain, using YED values, the concepts of inferior good, normal good, necessity (income
inelastic) good, and luxury (income elastic) good.
The YED value of an inferior good is negative (as income rises, consumers are likely to decrease
demand of cheap substitutes), the YED value of a normal good is positive (as income rises,
consumers are able to increase purchase of these goods). Within normal goods, necessity goods have
a YED value between 0 and 1 (even if income rises, consumers will only increase purchase of
necessity goods to a certain extent), while luxury goods have a YED value greater than 1 (the
purchase of these goods will generally always increase with increasing income).
Applications
of income
elasticity of
demand
AO2 – Examine the implications for producers and for the economy of a relatively low YED for
primary products, a relatively higher YED for manufactured products and an even higher
YED for services.
A low YED for primary products means that even when the economy is in recession, they will still be
purchased; as it is likely they are inferior or necessity goods. Producers of primary products would
have relatively stable revenue. This also makes sense because primary products are more widely
defined and therefore have fewer substitutes. As a result, the demand for primary products is more
inelastic. A higher YED for manufactured products would mean that producers of these products
would make more money when the economy is doing well, because consumers can afford
manufactured products. However, during a recession producers of manufactured products would not
do as well and might lay off workers to reduce costs of production. This would negatively impact the
economy, as unemployment rates would rise. An even higher YED for services would make services a
luxury good. Similar to producers of manufactured goods, providers of services would experience
great increase in revenue if people’s incomes were to increase, but also a great drop in revenue if
people’s incomes were to decrease.
Price elasticity of Supply (PES)
Price
Price elasticity of supply involves responsiveness of quantity supplied to a change in price along a
elasticity of
given supply curve.
supply and
its
AO4 – Calculate PES using the following equation.
determinants PES = percentage change in quantity supplied /percentage change in price (Example: Price +2%,
Quantity +4%)
4%/2% = 2, PES is elastic
AO2 – Explain, using diagrams and PES values, the concepts of elastic supply, inelastic supply,
unit elastic supply, perfectly elastic supply and perfectly inelastic supply.
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Elastic supply is when the value of PES is greater than 1 and less than infinity. This means when a
product that has elastic supply experiences a change in the price, it leads to a greater than
proportionate change in the quantity supplied of it. For instance, newspapers have a fairly elastic
supply, meaning that production can increase significantly over a short period of time in response to
rising prices. This can be seen from diagram (d) since any straight-line supply curve starting from
the y-axis has a PES greater than 1.
Inelastic supply is when the value of PES is greater than 0 and less than 1. This means when a
product that has inelastic supply experiences a change in the price, it leads to a less than
proportionate change in the quantity supplied of it. For instance, airplanes have a fairly inelastic
supply because, if prices rise, it is difficult to significantly increase production over a short period of
time due to the large amount of capital goods employed. This can be seen from diagram (e) since any
straight-line supply curve starting from the x-axis has a PES value less than 1.
Unit elastic supply is when the value of PES equal to 1. This means when a product that has unit
elastic supply experiences a change in the price, it leads to a proportionate change in the quantity
supplied of it. This can be seen from diagram (c) since any straight-line supply curve starting from
the origin has a PES value of 1.
Perfectly elastic supply is when the value of PES is equal to infinity. This means that when a product
that has perfectly elastic supply experiences a change in the price, it leads to an infinite change in
the quantity supplied. As a result the percentage change in quantity supplied would be infinity and so
would the numerator in the PES equation. Since infinity divided by anything is infinity, the PES value
will be infinity. This is a very theoretical situation best seen from diagram (b). As it is a horizontal
line, at no price apart from the y-intercept can there be any production whatsoever.
Perfectly inelastic supply is when the value of PES is equal to 0. This means that when a product that
has perfectly inelastic supply experiences a change in the price, it leads to no change in the quantity
supplied. As a result the percentage change in quantity supplied would be zero and so would the
numerator in the PES equation. Since 0 divided by anything is 0, the PES value will be 0. This is a
very theoretical situation but some products are very close to having a PES of 0. Crops that are
seasonal can experience hardly any increase in production (even if the price rises) once the crops
have been planted. This can be seen from diagram (a) since it is a vertical line, so that at any price,
the quantity supplied remains constant.
AO2 – Explain the determinants of PES, including time, mobility of factors of production,
unused capacity and ability to store stocks.
The determinants of PES are mainly time (the shorter the time available for producers to increase
production, the more difficult it is an the more inelastic the PES of that good becomes), mobility of
factors of production (for instance, if the production of a product requires highly specialized
workers, PES for that product becomes more inelastic as it is difficult to find more highly specialized
workers), unused capacity (if there are extra capital goods, like an extra oven that is not used
frequently in a restaurant’s kitchen, it is easier to increase production, making the PES of that
product more elastic) and ability to store stocks (perishable goods like fresh fruits cannot be stored
for a long period of time; also if all the warehouses in which products are stored are full, stock
cannot be stored if production is increased, rendering the product’s PES more inelastic).
Applications
of price
elasticity of
supply
AO2 – Explain why the PES for primary commodities is relatively low and the PES for
manufactured products is relatively high.
Supply for primary commodities tends to be inelastic because they cannot suddenly change how
much is planted. The factors of production, mainly land, are not as mobile. Supply for manufactured
goods, on the other hand, tends to be elastic because it is easier to change production in a factory or
shop.