3. Elasticities

Elasticity

The responsiveness of a variable in response to changes in one of its determinants

What are the 3 types of elasticities in this topic? What are their variables

PED: price elasticity of demand (variable: quantity demanded, determinant: own price)

YED: price elasticity of income (variable: quantity demanded, determinant: income)

PES: price elasticity of supply (variable: quantity supplied, determinant: own price)

Price elasticity of demand (PED)

Measures the degree of responsiveness of a change in quantity demanded to a change in the product’s own price

• Shown in the slope of the demand curve

• Can fall between 0 and positive infinity

Formula for PED

% change in quantity demanded/% change in price

Note: a negative value will be obtained but only the absolute value is taken into account

What are the 5 different categories for PED?

Elastic: PED > 1 (high PED)

Inelastic: PED<1 (low PED)

Unit elasticity: PED = 1

Perfectly inelastic: PED = 0 (e.g. absolute necessities)

Perfectly elastic: PED = ∞ (note: theoretical phenomenon)

What does the demand curve look like for products with high and low PEDs, respectively?

High PED: flat curve with small slope

Low PED: steep curve with big slope

What does the demand curve look like for a perfectly elastic and inelastic PED look like?

Perfectly elastic: horizontal line

Perfectly inelastic: vertical line

On a straight-line demand curve, where is PED higher?

At the left side where the price is higher

Factors affecting the PED of a product

1. Degree of necessity: necessities tend to have low PEDs (inelastic)

2. Availability of substitutes: low availability of substitutes —> low PED

3. Proportion of income: if a good requires a greater % of income, its PED is greater (e.g. house)

4. Time: PED may increase over time as consumers become more sensitive to price changes (they may find substitutes)

How is total revenue calculated?

Price x quantity sold (= area of rectangle on demand curve)

Why do businesses prefer selling products with low PEDs?

They can increase the price and experience a relatively small decrease in quantity demanded, causing total revenue to increase.

Define primary commodities

Goods derived from natural resources which require minimal manufacturing

What is the PED for primary commodities usually like?

PED is usually low because primary commodities are necessities and have few substitutes

Why are revenues earned in the primary sector quite volatile?

The supply of primary commodities is dependant upon favourable climate conditions. Since the PED is quite low, a change in supply would cause a significant change in price. This would mean that the revenues earned can fluctuate significantly.

• Decrease in supply —> increase in revenue

• Increase in supply —> decrease in revenue

Define manufactured goods

More elaborate products created through combining primary goods with labour and capital

What is the PED like for manufactured goods?

PED is usually higher for manufactured goods than for commodities

• High availability of substitutes

• Generally not necessities

BUT: Manufactured goods like medicine, sanitary pads, and some demerit goods (cigarettes, alcohol) can have low PEDs

Define direct tax

A compulsory financial charge that is paid straight to the government by individuals or organisations, based on incomes earned.

E.g. Individual income tax, company tax, HECS, Medicare levy, inheritance tax

Define indirect tax

A financial charge placed on the sale of goods and services, which is initially paid by producers, but the cost is passed on to consumers through higher prices

E.g. GST, excise tax, tariffs

Why do governments prefer to tax products with low PEDs?

Since an increase in the price of a good with a low PED is unlikely to result in a significant change in quantity demanded, the government can maximise its revenue

Compare the amount of consumer tax vs. the amount of producer tax for products with high and low PEDs

Low PED: consumer tax > producer tax

High PED: consumer tax < producer tax

Income elasticity of demand (YED)

Measures the degree of responsiveness of a change in quantity demanded to a change in income.

YED formula

% change in Qd/% change in income (Y)