Chapter 3 - Elasticities

3.1

PRICE ELASTICITY OF DEMAND

– Negative relation between price and quantity demanded

– Higher price, lower quantity demanded and vice versa. Ceteris Paribus
– PED is the measure of responsiveness of the quantity demanded of a
product based on the changes in its price
– Calculated along a demand curve
– PED is ELASTIC when quantity demanded changes with price change
– PED is INELASTIC if quantity demanded does NOT change with
change in price

Formula

Range of values
– PED < 1 = inelastic demand (percentage change in quantity demanded
< percentage change in price)
– PED > 1 = elastic demand (percentage change in quantity demanded >
percentage change in price)
 – PED = 1 = unit elastic demand (percentage change in quantity =
percentage change in price)
– PED = 0 = perfectly inelastic demand (percentage change in quantity
demanded is 0, no matter the price the consumers will buy the
product)
– PED = infinity = perfectly elastic demand (infinite quantity demanded
and a specific price, if price changes, demand props to 0)

PED and the steepness of the demand curve

– When demand curves intersect, steeper demand curve = more
inelastic
– Flatter demand curve = more elastic
– This only applies to demand curves that intersect and not on separate
graphs because the scale may vary
– When PRICE FALLS: Quantity demanded of elastic goods > quantity
demanded or inelastic goods (which is why inelastic goods usually
don’t have sales - gasoline example)

Why PED varies

– Demand is elastic at high prices and low quantities

– Demand is inelastic at low prices and large quantities
– This is because the change in quantity % from 10-20 is 100% but
change from 70-80 is lower (14.3 %)
– Hence values in the formula get lower and PED is low which is why it is
inelastic
– Mid point of demand curve = unit elastic demand
– Elastic or inelastic should not be used to describe entire demand
curve, just portion of it (exception: unit elastic, perfectly elastic and
 –

perfectly inelastic)

Why PED varies along a straight line demand curve from a different
perspective
– Slope of demand curve = (change in price/change in quantity
demanded)
– PED = [(change in quantity demanded/initial quantity) / (change in
price/initial price)]
= [(change in quantity demanded / change in price) * (initial price /
initial quantity)]
= [(1 / slope) * (initial price / initial quantity)]

– Slope is constant so inverse of slope (1/slope) will be constant

– Initial price is decreasing and initial quantity is increasing so P/Q is
decreasing
– PED is decreasing since constant number is being multiplied by
decreasing number

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

ACRONYM: Say No To Plastic

Number and closeness of substitutes

– More substitutes, more elasticity
– Consumers can easily switch to another good (toothpaste example) if
the price of one rises
– Less substitutes, more inelastic
– Consumers cannot switch to cheaper alternatives because there aren’t
any (gasoline example)
– Narrower definition - higher the PED, more elasticity
– Food - fruit - apple example: apple has a higher PED than fruit in
general. Whereas fruit would have a lower PED than food in general

Necessities vs luxuries
– Necessities - essential goods or services that we cannot live without
– Luxuries - not necessary or essential
– Necessary products - inelastic demand (food, medicines)
– Luxuries - elastic (diamond rings, designer products)

Length of time
– More decision making time for customer - more elastic the demand
– When there is less time to make decision, not enough time to fo
research and look for alternatives - less elastic demand
– Heating oil example: if heating oil price rises, in the beginning the
 –
demand is inelastic but eventually customers will find cheaper
alternatives and demand for heating oil will become elastic

Proportion of income spent on a good

– Larger proportion of income spent on good - more elastic demand
– Demand for pen is inelastic because very small proportion of income is
spent on it in comparison to a car which would have a way more elastic
demand

APPLICATIONS OF PRICE ELASTICITY OF DEMAND

PED and total revenue

– Total revenue is the amount of money received by a firm when they
sell a good or service
– TR = price * quantity of the good

When demand is ELASTIC:

– INCREASE in price —> FALL in total revenue
– DECREASE in price —> RISE in total revenue
– INVERSE RELATION BETWEEN PRICE AND TOTAL REVENUE
– An increase in price results in a proportionally much larger decrease in
quantity demanded, if there is a 10% increase in price there will be a
much higher decrease in quantity demanded - reduced quantity
demanded has bigger effect on total revenue than increased price
– If there is a 10% decrease in price there will be a much higher increase
in quantity demanded - total revenue increases

When demand is INELASTIC:

– INCREASE in price —> INCREASE in total revenue
– DECREASE in price —> DECREASE in total revenue
– DIRECT RELATION BETWEEN PRICE AND TOTAL REVENUE

When demand is UNIT ELASTIC:

– Total revenue remains constant

Using diagrams to illustrate PED and the effects of price changes on

total revenue
 – Total revenue = area of the rectangles
– In diagram a, P1 and Q1 have the greater total revenue (rectangle B)
since price is lower and quantity demanded is higher (inverse relation)
– In diagram b, P2 and Q2 have the greater total revenue (rectangle C)
because the price and quantity demanded have a direct relation
– In diagram c, there is no change in total revenue with change in price
or quantity demanded

PED and firm pricing decisions

– Firms price their products based on elasticity of demand of their
products to maximise their total revenue
– Low price if elastic
– High price if inelastic
– No change in TR if unit elastic

PED and indirect taxes

– Lower PED - greater government tax revenues
– Inelastic demand: more taxation
– Elastic demand: less taxation

Why many primary commodities have a lower PED compared with the
PED of manufactured products
– Primary commodities: natural resources (agriculture, fishing, oil)
– Manufactured products: goods produced by labour, working together
with raw materials and capital (cars, computers, television)

– Primary commodities: less substitutes and are necessities hence low

PED, inelastic demand
– Manufactured commodities: many substitutes hence high PED, elastic
demand

Consequences of a low PED for primary commodities

– Low PED —> inelastic demand
 – When a good is inelastic, its price can be increased
– When there is a higher price and lower supply for a good, the
percentage increase in price is much higher than the percentage
decrease in quantity which leads to more revenue since the price does
not affect the sales of an inelastic good
– Farmer trip example - bad crop get farmer more revenue than a good
crop

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3.2

INCOME ELASTICITY OF DEMAND

– Measure of responsiveness of the quantity demanded of a good based

on the changes in income
– Causes demand curve shifts
– Provides information on the direction of change in income given the
change in income (increase or decrease) and the size of the change
(size of the shift)

Calculating YED
– Shows relation between percentage change in quantity demanded and
percentage change in income
Normal or inferior goods
– YED > 0 means that it is a NORMAL good. When income increases,
demand increases
– YED < 0 means that it is an INFERIOR good. When income increases,
demand decreases

– Shift towards the left means inferior good

– Shift towards the right means normal good
– This is because, when income is low, consumers will buy the cheaper
good to save money and when their income increases, they will can
afford to buy the better good which is why they stop compromising
and buying the inferior good (switch to normal good), so demand goes
down

The numerical value of income elasticity of demand: necessities,

luxuries and services
– 0 < YED < 1 : income inelastic demand (necessities)
– YED > 1 : income elastic demand (luxuries and services)
– Higher the YED, greater the elasticity
– Use formula to determine YED, when quantity demanded (numerator)
is not as affected by change in income, it means that it is a necessity -
people would buy it irrespective of how much they earn since it is a
priority. Hence the YED would be < 1 - numerator is only slightly bigger
 than denominator (change in income)
– Numerator for the income elastic goods are bigger because they are
luxuries, so as income increases the demand for them increases since
people can afford it after they have a higher income. Since the
numerator is relatively larger than the denominator, the YED would be
>1

The Engel curve

– Engel curve shows continuum: at very low incomes, good is

considered luxury; at medium income it is considered necessity and at
high income it is considered inferior

YED and producers: the rate of expansion of industries

– The industries that produce income elastic goods would grow at a
faster rate than the economy
– The industries that produce income inelastic goods would grow at a
slower rate than the economy
– Higher YED of a good/service - greater expansion of its market in the
future
– Lower YED, lower expansion
– In case of economic downfall, goods with high YED (income elastic
demand) will be the worst hit
– Income inelastic goods will not suffer major losses
– Inferior goods will experience increase in sales
YED and the sectoral structure of the economy
– 3 sectors of economy - primary (agriculture), manufacturing and
services
– Primary sector is income inelastic goods so grows the slowest as
economy grows
– Manufacturing is income elastic so grows faster than agriculture
industry
– Services is most elastic so grows faster than both of them
– Hence, over time, manufacturing and services takes over producing
the most output for the economy
– As economy grows, agriculture industry becomes less relevant in
producing output
– LEDCs dominated by primary sector, MEDCs dominated by services
sector
– Primary sector output is not falling, continues to grow just not as fast
as total output

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3.3

PRICE ELASTICITY OF SUPPLY

– PES is the measure of responsiveness of the quantity supplied of a

good to changes in its price
– Positive relation between price and quantity supplied
– Calculated along a given supply curve
– Large responsiveness in quantity supplied - elastic supply
– Low responsiveness - inelastic supply

Calculating PES
The range values of PES
– PES > 1 = elastic supply (quantity supplied is relatively responsive to
price)
– PES < 1 = inelastic supply (quantity supplied it relatively unresponsive
to price)
– PES = 1 = unit elastic supply (percentage change in quantity =
percentage change in price)
– PES = 0 = perfectly inelastic supply (quantity supplied is completely
unresponsive to price)
– PES = infinity = perfectly elastic supply (quantity supplied is infinitely
responsive to price)
DETERMINANTS OF ELASTICITY OF SUPPLY

ACRONYM: Too Much Storage Space Rain

Length of time
– The larger amount of time firms have to adjust their inputs increases,
the larger the PES
– When firms have more time to adjust their supply based on the
increase or decrease in price, the more elastic it gets
– When there is less time, it is inelastic
– Fish market example

Mobility of factors of production

– The more easily and quickly resources can be moved from producing
one good to the other, the greater the PES (greater responsiveness of
quantity supplied to changes in price)
– Strawberry to corn vs car example

Spare (unused) capacity of firms

– Firms have ability to produce more than is being used
– If this is the case, they can respond easily to price rises with increased
 –
output
– If capacity is full, more difficult to respond to price rises
– Greater the spare capacity of a company, the higher the PES

Ability to store stocks

– Some firms store the output they produce that they cannot sell
immediately
– The more they can store these stocks, the more quickly they can
respond to a change in price with increased quantity supplied, hence
higher PES
– If they cannot store, not enough stock to respond to change in price
with higher quantity supplied

Rate at which costs increase

– If costs to produce output increases rapidly, firm faces difficulty to
expand output because it requires large costs, hence demand
becomes inelastic (rate of responsiveness to change in price becomes
low)
– If costs increase gradually then demand will be elastic because firms
will have adequate time to expand their outputs and find alternatives

PES in relation to primary commodities and manufactured products

Why many primary commodities have a lower PES than manufactured
products
– This is because it takes a lot more time to source primary commodities
than manufactured ones so the response to changes in price is much
slower which results in a low PES
– Manufactured products can be manufactured much more quickly than
primary commodities which is why they have a high PES
– Examples: oil, agriculture - primary commodities - take time to
respond with change in quantity to change in price

Consequences for a low PES for primary commodities

– Causes price and income instability for primary goods producers
– When supply is elastic, there are less fluctuations in price and total
revenue

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Summary of PED, YED and PES