(MICROECONOMICS) - Elasticity (copy)

Why We Study Elasticities?

Elasticity examines the responsiveness of consumers or producers to a change in a variable in the marketplace.

• how much one factor changes in response to a change in a different factor.

• Helps consumers + produces know how to set prices accordingly

Price Elasticity of Demand (PED)

A measure of the responsiveness of the quantity of a good demanded to changes in its price.

PED formula

PED = (Percentage change in Quantity) / (Demanded Percentage change in Price)

PED = (% ΔQuantityDemanded) / (% ΔPrice)

PED = ((Qf-Qi) / (Pf - Pi)) x (Pi / Qi)

Signs & values of PED

Always look at absolute value of PED: IPEDI

• PED = 0: Perfectly inelastic demand

• 0 < PED < 1: Inelastic demand

• PED = 1: Unit elastic demand

• 1 < PED < ∞: Elastic demand

• PED = ∞: Perfectly elastic demand

High PED

Demand is elastic: greatly influenced by price changes (high responsiveness)

Low PED

Inelastic: demand stays the same regardless of price change (low responsiveness: consumer needs it)

Shrinkflation

Producers reducing the size, quantity, or weight of a product while keeping the same price

Elasticities on a demand curve

Elasticity varies not only between different goods, but also along the demand curve for any specific good portrayed using a straight- line demand curve.

Perfectly inelastic demand diagram

Perfectly elastic demand diagram

6 Determinants of PED

• Number of Substitutes

  • Most substitutes = more elastic

  • e.g. coffee barely has good substitutes, however, any coffee shop has many substitutes

• Complements (Joint Demand)

  • Elasticity of 1 good is influenced by elasticity of other good (both inelastic or elastic)

• Proportion of Income

  • Change in price of car VS toothpick (for rich VS poor person)

• Luxury or Necessity

  • Luxury not needed VS necessity needed

• Addictive or not

  • Addicted consumers = inelastic (need that good)

• Time to respond

  • People won’t change immediately → need time to find substitute/not immediately see price change

Applications of PED

Revenue of a firm

Taxes imposed:

• Flat rate tax

  • Applies same rate to all taxpayers regardless of income

• Ad valorem tax (VAT)

  • based on value of good

  • tax is percentage of sale value of good

• Indirect tax

  • imposed on manufacturers & service providers

Cross elasticity of demand (XED)

Measures the relative sensitivity of a change in the quantity demanded of Good X with respect to a change in the price of Good Y.

Closeness of substitutes & relevance of complements

XED formula

XED = (Percentage change in Quantity Demanded of Good X) / (Percentage change in Price of Good Y)

XED = (%ΔQuantityDemanded X) / (% ΔPrice Y)

XED = ((Qxf-Qxi) / (Pyf - Pyi)) x (Pyi / Qxi)

XED > 0

Substitute goods:

• proportional: price x increases = demand y increases

• Larger value XED = greater substitutability: more similar

XED < 0

Compliment goods:

• Inverse: price x increases = demand y decreases

• Larger absolute value of XED = more complimentary

XED = 0

If cross-price elasticity of demand is zero (XED = 0) or close to zero, this means that two products are unrelated or independent of each other.

Income elasticity of demand (YED)

Measure of the responsiveness of demand to changes in income, and involves demand curve shifts.

YED formula

YED = Percentage change in Quantity / Demanded Percentage change in Income
YED = (% ΔQuantityDemanded) / (% ΔIncome)

YED = XED = ((Qf-Qi) / (Yf - Yi)) x (Yi / Qi)

YED > 0

The good is normal: income increases = demand increases

YED < 0

The good is inferior: income increases = demand decreases

Numerical value of YED

0 < YED < 1: income inelastic demand, e.g. necessities

YED > 1: Income elastic demand, e.g. luxury goods

YED & producers

If national income increases,

• goods/services with elastic demand will increase

• goods/services with inelastic demand will decrease

Price elasticity of supply (PES)

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

PES formula

PES = ((Percentage change in Quantity Supplied) / (Percentage change in Price)) × 100

PES = ((%ΔQuantitySupplied) / (% ΔPrice)) ×100

PES = ((Qf-Qi) / (Pf - Pi)) x (Pi / Qi)

Values of PES

• PES = 0: Perfectly inelastic supply

• 0 < PES < 1: Inelastic supply

• PES = 1: Unit elastic supply

• 1 < PES < ∞: Elastic supply

• PES = ∞: Perfectly elastic supply

Inelastic supply curve

Elastic supply curve

perfectly elastic supply curve

perfectly inelastic supply curve

Determinants of PES

• Length of time

  • Amount of time producers have to adjust output in regards to price changes

• Mobility of factors of production

  • Ease/speed firms can shift resources/production (easier to move capital)

• Spare (unused) capacity of firms

  • How much a firm can produce without needing to expand inventory

• Ability to store stocks

  • Buffer stocks