microeconomics pt3 / Elasticities

Elasticities

Measures the responsiveness of a variable to changes in price or any of the variable determinants.

Elastic demand

Responsiveness of change of price leads to proportionally greater change in quantity demand

Inelastic demand

Responsiveness in change of price leads to proportionally smaller change in quantity demand

Elastic supply

Elastic supply means that producers can easily and quickly change the amount of a good or service they offer for sale when the price changes. The key here is the high responsiveness of the quantity supplied to changes in price. If the quantity supplied increases significantly and quickly when prices rise, the supply is elastic.

Inelastic supply

Inelastic supply means that producers cannot easily or quickly change the amount of a good or service they offer for sale, even if the price changes. The key is the lack of responsiveness in the quantity supplied to changes in price. If the quantity supplied increases only a little or very slowly when prices rise, the supply is inelastic.

Following elasticities & importance in decision making for stakeholders…

PED (demand), YED (income), PES (supply)

Price elsaticity of demand (PED)

measures the responsiveness of consumers of a good or service to a change in price of that good or service. 

Formula to calculate PED:

PED= Qnew-Qold/Qold    /   Pnew-Pold/Pold

PED > 1 means…

demand is elastic (when QD is larger than price) - the more shallow or flatter the more elastic

PED < 1 means…

demand is inelastic (when QD is smaller than price) - the steeper the more inelastic

Special cases of PED coeffecient

PED=1 - unit elastic demand, QD is proportionally reponsive to a change in price (normal looking curve), PED=0 - perfectley inelastic demand, QD is not reponsive at all to a change in price (verticle line), PED=infinity - perfectly elastic demand, QD is infinitely responsive to a change in price (horizontal line at y axis)

One needs to be negative because…

law of demand is a negative causel relationship

Total revenue of an inelastic variables…

goes up as price goes up (bc quantity slightly decreases leading to TR increase), and goes down as price goes down (bc quantity slightly increases leading to TR decrease)

Total revenue of an elastic variables…

goes down as price goes up, and goes up as price goes down.

Determinants of elasticities

refer to the factors that influence how responsive the quantity supplied/demanded of a good or service is to a change in its price. The determinants explain why the PED might be high or low for a particular good (when coeffecient is already given).

Determinants of PED SPLAT

Substitues - more substitues=more elastic the demand, less=more inelastic demand

Proportion of income - if good/service takes up larger portion of income=more elastic demand, if smaller=more inelastic demand

Luxury or necessity - luxury good=more elastic demand, necessities=more inelastic demand

Addictiveness - if addictive=more inelastic demand

Time - further getting away from change in price=more elastic demand

How is PED important for firms and gov.?

For firms, knowledge of PED can help predict effects of changes in price on their quantity demand and total revenue.

For gov., knowledge of PED can help predict the effects of putting indirect taxes on goods and services. If a good or service has more inelastic demand, this will raise more revenue than if a good has more elastic demand.

PED primary commodities vs manufactured goods

Primary commodities are the raw materials such as copper that go into the making of other goods such as smart phone. Demand for primary commodities tends to be inelastic due to fewer substitues. 

Manufactured goods tend to have more elastic demand because there are more substitutes (brands, alternatives, etc.)

PES primary commodities vs manufactured goods

Primary commodities such as agricultural goods or oil tend to have lower PES than manufactured goods. Generally takes longer for those producing primary commodities to respond to changes in price. 

Primary commodities (e.g., coffee, oil, wheat):
generally inelastic supply due to:
Time needed for harvest/production
Limited ability to expand quickly
Storage difficulties

Manufactured goods: generally more elastic supply
(factories can adjust output more quickly).
Time: short run vs long run (more elastic in long run).

Income elasticity of demand (YED)

measures the responsiveness of demand to changes in income and involves demand curve shifts

Formula for YED

YED= Qnew-Qold/Qold    /   Ynew-Yold/Yold

YED > 0 means (coeffecient is positive)…

Good is a normal good

YED < 0 means (coeffecient is negative)…

Good is an inferior good

YED > 1 means (luxury good must be above income)…

Income is elastic and a luxury good, as there as demand increases and is proportionally more than income

0<YED < 1 /YED between 1 and 0 (necesary good must be less than income) means…

Income is inelastic and a neccesary good. Demand increases but proportionally less than income

Engel curve

Demonstrates the relationship between income and quantity demand of a good.

Importance of YED for firms?

As income rise so will demand for normal goods. If demand for normal goods is elastic, their demand will rise faster than incomes.

This means that indusrties that produce goods or services with income elastic demand(theatre tickets, foreign travel, new cars) will grow faster than rising incomes.

If demand for normal goods is inelastic, their demand will not rise quickly as incomes. INdustries that produce goods/services with income inelastic demand (food,clothing) will grow slower than rising incomes.

Importance of YED for explaining changes in the economy?

Primary sectors - agriculture, mining, forestry, fishing, and extractive industries

Since primary products tend to have income inelastic demand, means as incomes rise, the demand for primary goods will increase at a smaller rate.  Over time this will shrink the overall size of the primary sector in the economy. 

Secondary sectors (manufacturing) - cars, housing, infrastructure

tend to have relatively income elastic demand which means as incomes rise their demand will increase proportionally more than incomes.  

Tertiary sector (services) - entertainment, travel, banking, free health care

Price elasticity of Supply (PES)

a measure of responsiveness of the quantity of a good supplied to changes in its prices.

PES > 1 means…

Elastic supply - quantity supply is relativeles responsive to a change in price

PES < 1 means…

Inelastic supply - quantity supply is relativeles coresponsive to a change in price (cuts through the x axis)

Special cases:

PES=1 - unit elastic supply - quantity supply is not proportionally resposnive to a change in price

PES=0 - perfectly inelastic supply - quantity supply is not responsive to a change in pricen (could =0 in stadiums (fixed amount of seats), dead artists work (only a certain amount and more cannot be made), car park (fixed amount of spaces))

PES= infinity - perfectly elastic suppply - quantity suppls is infinitely responsive ot a change in price. 

Determinants of PES TRAUM

Time - More time to respond to changes in price, greater ability to have increase or decrease in quantity supply (more elastic supply)

Rate of cost of production - If cost of extra output increases rapidly - they will have difficulty expanding their output as they do not want to pay high costs, supply will be inelastic - if cost of extra output increases slowly, supply will be elastic.

Ability to store inventory - can store things longer/easier, supply is elastic - can barely store things, supply is inelastic

Unused capacity - more unused capacity means increase in quantity supple= more elastic supply.

Mobility of resources - If there is ability to switch to making something similar, supply is elastic, - if there is no ability to make something similar, supply is inelastic