PM P2: Elasticities and its Applications

What is Elasticity? (General Definition)

A measure of degree of responsiveness of a variable (e.g. quantity demanded or quantity supplied) to a change in one of its determinants, ceteris paribus.

What does Elastic mean? (General Interpretation)

High degree of responsiveness; magnitude of elasticity coefficient > 1.

What does Inelastic mean? (General Interpretation)

Low degree of responsiveness; magnitude of elasticity coefficient < 1.

What is Price Elasticity of Demand (PED)?

A measure of the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus.

What is the PED Formula?

% change in quantity demanded / % change in price of good itself.

What is the Sign of PED?

Normally negative (inverse relationship between P and Qd); often dropped, absolute value used.

What is Price Inelastic Demand? (|PED| < 1)

Qd is less than proportionately responsive to price changes. P ↑ -> TR ↑; P ↓ -> TR ↓.

What is Price Elastic Demand? (|PED| > 1)

Qd is more than proportionately responsive to price changes. P ↑ -> TR ↓; P ↓ -> TR ↑.

What is Unitary Price Elastic Demand? (|PED| = 1)

Qd is equally proportionately responsive. P change -> TR unchanged. Demand curve is a rectangular hyperbola.

What is Perfectly Price Inelastic Demand? (|PED| = 0)

Price changes have no effect on quantity demanded (vertical demand curve).

What is Perfectly Price Elastic Demand? (|PED| = ∞)

Qd has huge effects on price changes; at exactly Po, consumers buy any quantity (horizontal demand curve).

What is Substitutes availability and closeness? (Determinant of PED)

More close substitutes -> more price elastic demand.

What is Habituality of consumption? (Determinant of PED)

Good consumed habitually -> more price inelastic demand.

What is Proportion of income spent on the good? (Determinant of PED)

Higher proportion of income spent -> more price elastic demand.

What is Period (time)? (Determinant of PED)

Longer time period -> consumers have more time to find alternatives -> more price elastic demand.

How is PED applied? (Explaining Qty/Price changes when supply shifts)

Helps explain extent of P & Q changes when supply shifts (e.g., supply fall with inelastic demand leads to large P increase, small Q fall).

How is PED applied? (Firm behavior)

Firms use PED to make pricing/output decisions (e.g., raise prices for inelastic demand, lower for elastic demand to increase TR).

What is Price Elasticity of Supply (PES)?

A measure of the degree of responsiveness of the quantity supplied of a good to a change in its price, ceteris paribus.

What is the PES Formula?

% change in quantity supplied / % change in price of good itself.

What is the Sign of PES?

Normally positive (direct relationship between P and Qs).

What is Price Inelastic Supply? (0 < PES < 1)

Qs is less than proportionately responsive to price changes.

What is Price Elastic Supply? (PES > 1)

Qs is more than proportionately responsive to price changes.

What is Unitary Price Elastic Supply? (PES = 1)

Qs is equally proportionately responsive. All straight-line supply curves from the origin.

What is Perfectly Price Inelastic Supply? (PES = 0)

Price changes have no effect on quantity supplied (vertical supply curve).

What is Perfectly Price Elastic Supply? (PES = ∞)

Qs has huge effects on price changes; at exactly Po, producers produce any quantity (horizontal supply curve).

What are Stock/inventory levels? (Determinant of PES)

Higher stock -> more price elastic supply.

What is Availability of spare capacity? (Determinant of PES)

More spare capacity -> more price elastic supply.

What is Length of production? (Determinant of PES)

Longer production period -> more price inelastic supply.

What is Time period? (Determinant of PES)

Short run -> relatively price inelastic supply. Long run -> more price elastic supply.

How is PES applied? (Explaining Qty/Price changes when demand shifts)

Helps explain extent of P & Q changes when demand shifts (e.g., demand rise with inelastic supply leads to large P increase, small Q increase).

What is Cross Elasticity of Demand (CED)?

A measure of the degree of responsiveness of the quantity demanded of a good to a change in the price of another good, ceteris paribus.

What is the CED Formula?

% change in quantity demanded of good A / % change in price of good B.

What is the Sign of CED?

Indicates the type of relationship between goods (positive for substitutes, negative for complements).

What does CED > 0 mean?

Goods are substitutes. PB ↑ -> QdA ↑.

What does CED < 0 mean?

Goods are complements. PB ↑ -> QdA ↓.

What does CED = 0 mean?

Goods are unrelated.

What is the Magnitude of CED?

Indicates strength/closeness of relationship. Larger magnitude -> closer substitutes/complements.

What is Closeness of the relationship between goods? (Determinant of CED)

The main determinant of CED.

How is CED applied? (Related markets)

Helps explain and predict direction and extent of demand shifts in related markets when price of a related good changes.

How is CED applied? (Policy/Firm behavior)

Used by policymakers to anticipate market shifts (e.g., sugar taxes) and by firms for business decision-making (e.g., product differentiation, pricing).

What is Income Elasticity of Demand (YED)?

A measure of the degree of responsiveness of the quantity demanded of a good to a change in consumers' income, ceteris paribus.

What is the YED Formula?

% change in quantity demanded / % change in income.

What is the Sign of YED?

Indicates the type of good (positive for normal, negative for inferior).

What does YED > 0 mean?

Goods are normal goods. Income ↑ -> Qd ↑.

What is a Luxury Good? (YED > 1)

Normal good, income elastic (more than proportionate change in Qd).

What is a Necessity? (0 < YED < 1)

Normal good, income inelastic (less than proportionate change in Qd).

What is an Inferior Good? (YED < 0)

Demand is negatively related to income. Income ↑ -> Qd ↓.

What does YED = 0 mean?

Demand is independent of income changes.

What is Level of income and perceived/real quality? (Determinant of YED)

Determines whether good is normal or inferior.

What is Degree of necessity? (Determinant of YED)

Determines magnitude of YED for normal goods (necessity vs. luxury).

How is YED applied? (Market demand)

Helps explain and predict changes in demand patterns for different goods during economic booms/recessions.

How is YED applied? (Policy/Firm behavior)

Used by governments for planning expenditure/policies and by firms for business decision-making (e.g., output planning, market segmentation).

What are the Limitations of Elasticity Concepts?

Computation issues, issues with prediction, cost concerns, and unrealistic ceteris paribus assumption.

What are Computation Issues? (Limitation of Elasticity Concepts)

Challenges in collecting accurate data -> unreliable elasticity values.

What are Issues with Prediction? (Limitation of Elasticity Concepts)

Outdated estimates, dynamic markets, new technologies -> past data irrelevant for future predictions.

What are Cost Concerns? (Limitation of Elasticity Concepts)

Elasticity only provides revenue info, not profit info (which also depends on costs).

What is the Ceteris Paribus Assumption? (Limitation of Elasticity Concepts)

Unrealistic in real world; multiple factors change simultaneously, making static analysis inaccurate