Fall 21 Business Economics Week 3

Chapter 5: Business in a market environment

Business issues/questions
1. How responsive is consumer demand to changes in the market price? How responsive is it to
changes in consumer incomes and to the prices of other products?
2. How is a firm’s sales revenue affected by a change in price?
3. How responsive is business output to changes in price?
4. How does the responsiveness (or ‘elasticity’) of demand and supply to changes in price affect the
working of markets?
5. Why are markets likely to be more responsive in the long run than in the short run to changes in
demand or supply?
6. What is the difference between stabilizing and destabilizing speculation and how does this affect
the volatility of market prices?
7. What is meant by ‘risk’ and ‘uncertainty’ and what is their significance to business?
8. How do firms deal with uncertainty about future market movements?

Section 5.1 Price elasticity of demand

The responsiveness of quantity demanded to a change in price
The demand for an individual firm
The responsiveness of market demand

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Fall 21 Business Economics Week 3

Defining price elasticity of demand

Pe = Proportionate change in quantity demanded ÷ Proportionate change in price
The use of proportionate or percentage measures
It is unit free so comparison is possible
The only way to see whether a price or quantity change is big or not

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The sign (positive or negative)

The value (greater or less than 1)
The determinants of price elasticity of demand
1. The number and closeness of substitute goods
2. The proportion of income spent on the good
3. The time period
Pause for thought: Will the price elasticity of demand for a Mehran be higher or lower than the price
elasticity of demand for all family cars? Explain.

Section 5.2. The importance of price elasticity of demand to business decision making

A firm’s sales revenue

Elastic demand and sales revenue
P rises; Q falls proportionately more; therefore TR falls
P falls; Q rises proportionately more; therefore TR rises

Pause for thought: What is the link between weather and elasticity of demand?
Inelastic demand and sales revenue
P rises; Q falls proportionately less; TR rises
P falls; Q rises proportionately less; TR falls.

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Special cases
Totally inelastic demand
Infinitely elastic demand
Unit elastic demand

Pause for thought: Two customers go to the fish counter at a supermarket to buy some cod.
Neither looks at the price. Customer A orders 1 kilo of cod. Customer B orders $3 worth of cod.
What is the price elasticity of demand for each of the two customers?
Box 5.1 The measurement of elasticity

Section 5.3 Other Elasticities

Income elasticity of demand
Income elasticity of demand and the firm
Pause for thought: Assume that you decide to spend a quarter of your income on clothes. What is
(a) your income elasticity of demand; (b) your price elasticity of demand?
Cross price elasticity of demand
Cpe = Proportionate change in demand for A ÷ Proportionate change in price of B

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Cross price elasticity of demand and the firm

Price elasticity of supply

Pes = Proportionate change in quantity supplied ÷ Proportionate change in price
Determinants of price elasticity of supply
The amount that costs rise as output rises
Time period

Section 5.4 The time dimension of market demand

Short run and long run adjustment

Price expectations and speculation

a. Stabilizing speculation
b. Destabilizing speculation
c. Conclusion

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Section 5.5 Dealing with uncertainty

Risk and uncertainty

Key Ideas:
12. Elasticity. The responsiveness of one variable (e.g. demand) to a change in another (e.g.
price).
13. People’s actions are influenced by their expectations. (It brings in the role of speculation).
14. People’s actions are influenced by their attitudes towards risk.