Economics- Elasticity – Flashcards
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Elasticity definition
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the responsiveness of one variable to a changes in another. Elasticity measures the extent to which demand will change.
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Price elasticity of demand
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The responsiveness of demand to changes in price
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Elastic demand
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1% change in price leads to a greater than 1% change in quantity demanded. Eg: When percentage change in demand is greater than percentage change in price. If the PED is greater than 1, then the relationship is elastic
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Inelastic Demand
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1% change in price leads to a lower than 1% change in quantity demanded. Eg: Where percentage change in demand is less than percentage change in price. If the PED is between 0 and 1, the relationship is inelastic.
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Formula for calculating PED
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%change in quantity demanded / % change in price
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Calculating percentage change
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((new - original) / original ) X 100
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Shape of demand curve
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The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. D1 = unitary elastic. D2 = Perfectly inelastic. D3= Perfectly elastic. D4= elastic. D5= inelastic.
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Importance of elasticity
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The importance of elasticity is the information it provides on the effect on total revenue due to changes in price
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Total revenue
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Price X quantity sold
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If a firm lowers prices on an inelastic good...
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Total revenue falls
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If a firm lowers prices on an elastic good...
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Total revenue increases
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Determinants of PED
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Substitutes (price/ availability) ; addictiveness ; necessity ; brand image ; income ; complimentary goods ; price (e.g. sales)
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What is PES?
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Price elasticity of supply is a measure of the responsiveness of quantity supplied to a change in price.
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Elastic Supply
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When supply is elastic, producers can increase production without a raise in cost or time delay
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Inelastic Supply
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When supply is inelastic, firms find it hard to change their production levels in a given time period, e.g. due to fixed supply such as a stadium, or increase in cost of production
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What is the equation for PES?
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% change in quantity supplie / % change in price
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Inelastic (result from formula)
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0-1
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Unitary (result from formula)
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1
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Elastic (result from formula)
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>1
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Perfectly elastic (result from formula)
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Infinite
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Spare capacity
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How much before you reach maximum ; capacity to produce/supply more goods
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Determinants of PES
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Time (overall time to make things) ; spare capacity ; level of stocks (in the warehouse - non-perishable goods) (time to supply) ; Production lags (esp. agricultural markets - excess time) ; substitutability of production (tennis rackets and badminton rackets) ; the number of firms in the industry
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Capital
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Machines for making goods
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Income elasticity definition
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Income elasticity of demand measures the responsiveness of demand to a change in income.
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Income elasticity of demand formula
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Percentage change in quantity demanded / percentage change in income.
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Income elastic
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If the value of IED is greater than 1, demand is said to be income elastic.
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Income inelastic
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If the value of IED is from 0 to 1, demand is said to be income inelastic.
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IED and normal and inferior goods
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The value of income elasticity can also show whether goods are normal or inferior.
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IED and normal goods
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For normal goods, where for example an increase in income results in an increase in demand, the value of income elasticity will be positive.
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IED and inferior goods
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For inferior goods, where for example, an increase in income results in a decrease in demand, the value of income elasticity will be negative
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Determinants of IED
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The main factors affecting IED is whether or not goods are necessities or luxuries.
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Determinants of IED: necessities
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Necessities are basic goods that consumers need to buy e.g. food, electricity and water. Demand for these types of goods will be income elastic. Another example of such a good is cigarettes.
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Determinants of IED: luxuries
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Luxuries are goods that consumers like to buy if they can afford then. Spending on these types of goods is discretionary, which means that it does not have to be undertaken. Demand for these goods is income lasts, Examples include air travel, satellite TV, fashion accessories and many goods & services in the leisure tourism industry. It is also argues that the demand for imported goods is income elastic.
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Discretionary Expenditure
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Non-essential spending that is not automatic.
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6-mark question Strategy
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Identify (define, and diagram). Explain (the theory - explain). Evaluation (affects on stake holders; advantages and disadvantages ; short-run vs long-run)
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Perfectly inelastic PED
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This is represented by a straight vertical line. This means that a price change will not affect demand, The value of price elasticity in this case is 0, because if the price increases there is no change in demand.
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Perfectly elastic PED
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This is represented by a horizontal demand curve. This means that consumers purchase as much as they possible can at price p1. However, if the price rises above p1 demand will fall to zero. The value of price elasticity in this case is infinite.
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Determinants of PED: Availability of substitutes
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Goods that have lots of close substitutes will tend to have elastic demand. This is because consumers can switch easily from one product to another. For example, if the price of strawberry am times, consumers can switch to other types of jams such as raspberry, blackcurrant, etc. Consequently the demand for strawberry ham is likely to be elastic. On the other hand, if there are few or no real substitutes for a product, demand will be inelastic.
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Determinants of PED: Degree of necessity
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Goods considered 'essential' by consumer will have inelastic demand. This is because if the prices of essentials such as fuel and food rise, consumers cannot reduce the amounts the purchase significantly - they are necessities. In contrast, goods that are not essential - e.g. luxury products like boats, sport cars and holidays- will have more elastic demand. If a products is habit forming it may become a necessity and therefore will have inelastic demand.
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Determinants of PED: Proportion of income spent on a product
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It may be argues that if consumers spend a large proportion of their income on a product, demand will be more elastic. For example, most consumers buying a flat screen television for 400$ will be using up a significant proportion of their monthly income. Consequently, price changes in such 'high value' items result in significant changes in demand. On the other hand, demand for products that cost very little in relation to income - eg postage stamps or pencils - are more price inelastic.
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Determinants of PED: Time period
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In the short run, goods have inelastic demand. This is because it can often take time for consumers to find substitutes when prices rises for example. In the long term, demand is more elastic because consumers can search for alternatives and are more prepared to switch.
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Perfectly Elastic PES
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This supply curve is represented by a horizontal line. It means that producers are prepared to supply any amount at a given price. The value of price elasticity in this case is infinite.
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Perfectly Inelastic PES
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This is represented by a vertical supply curve. This means that a price change will not affect supply at all. Supply is fixed and the value of price elasticity of supply in this case is zero.
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Time and PES - Elastic
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All producers can adjust output if they are given time so the more time producers have to react to price changes, the more elastic supply will be.
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Time, PES, Inelastic
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When a producer can not increase supply quickly in response to a price change, due to production constraints, supply will be inelastic.
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Time and PES
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The speed with which producers can react to price changes in the market is crucial for determining the price elasticity of supply. Many factors can affect the speed with which producers can react, e.g. stock levels, production speed, spare capacity, ease of entry into market.
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Stock levels, PES
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Producers that can hold stocks of gold can respond quickly to price changes so supple will be elastic. However, where it is impossible or expensive to hold stocks, supply will be inelastic. The supply of some perishable goods will be inelastic because they cannot be stored for very long.
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Production speed, PES
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Goods that can be produced quickly are likely to have elastic demand. Modern manufacturers can be quite flexible and can adjust production levels at short notice. For example, a shoe manufacturer could increase production quickly by stepping up the rate of output in the factory. On the other hand, producers of agricultural products are not able to react quickly to price changes, because crops require time to grow. As a result supply is inelastic.
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Spare Capacity, PES
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Supply will be more elastic if producers have spare capacity. With spare capacity producers have the ability to produce more with their resources. On the other hand, if firms are running at full capacity supply will be inelastic. This is because output cannot be increased at short notice. Given more time though, even firms running at full capacity can increase supply. This is because they can perhaps build a bigger factory.
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Ease of entry into market, PES
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Supply will be more inelastic if it is difficult for new firms to enter the industry. For example, if it is expensive to set up production to supply a particular product this will discourage entry. However, where it is easy for new firms to enter, such as in retailing supply will be more elastic.
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Producer substitutes and the mobility of production factors
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Some producers are able to supply a variety of goods. For example, a metal engineering company may be able to make components for the car, motorcycle and aircraft industries. This is because their production resources are flexible or mobile. The products they makes are made from similar materials requiring similar processes. As a result, supply of these substitute goods is elastic. The engineer in this example could increase the supply of components for the aircraft industry by producing less for the car and motorcycle industry.
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Applications of elasticity
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Price elasticity can provide useful information for firms and the government. For example, it can help firms predict the effect on total revenue of a price change. It can also help the government target goods for indirect taxation. Knowledge of income elasticity can help firms plan future production levels and may influence their decision on what products to sell.
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Unitary elasticity
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Where price elasticity of demand for a product is equal to 1. For such a product total revenue is exactly the same at all prices.
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Income elasticity and firms
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Some firms will be interested in income elasticity of demand, because changes in income in the economy may affect demand for their products. If firms know the income elasticity of demand for their products they can respond to predicted changes in income
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Product switching, IED
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Some manufacturers have flexible resources and can switch from the production of one good to another. A predicted rise in income may encourage a firm to make more of a certain good if demand for them was income elastic.
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Production planning, IED
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If incomes are expected to rise in the future, firms can make sure they have enough capacity. If a recession is predicted, incomes will fall and so firms will plan to cut output. In the case of a recession, producers of inferior goods will begin to build capacity.
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Price elasticity and the government
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Governments often raise revenue by imposing indirect taxes such as WAS and excise duties on products. It is important for governments to select products which have inelastic demand, because consumers will avoid heavily taxed products if demand for them is elastic. Therefore, governments target goods that are either necessities or have few substitutes. Most governments do not target goods such as food and water, which are essential to human survival.
