ELASTICITIES_2022 (11)

Elasticities Real-World Issue

• Discussion on how consumers and producers choose to meet economic objectives.

Key Learning Topics

• Price Elasticity of Demand (PED) and its determinants.

• Cross Elasticity of Demand (XED).

• Income Elasticity of Demand (YED).

• Price Elasticity of Supply (PES) and its determinants.

• Calculations for PED, XED, YED, and PES.

Elasticity of Demand

• Definition: Measures responsiveness of demand to changes in factors affecting demand.

Types of Elasticity

Income Elasticity

• Defines how demand changes with consumer income changes.

Price Elasticity

• Measures how much quantity demanded changes with price changes.

Elasticity of Demand

• General term encompassing various types of demand elasticity.

Cross Elasticity

• Relates to how demand changes for a product due to price changes of another product.

Price Elasticity of Demand (PED)

• Formula: 𝐏𝐄𝐃 = %∆ in quantity demanded / %∆ in price.

• Example: If price increases from $4 to $5 and quantity demanded decreases from 20 to 10:

  • %∆Qd = (-50%)

  • %∆P = (25%)

  • PED = 2.

Interpretation of PED

• PED indicates the percentage change in quantity demanded from a 1% price change.

Types of Demand based on PED

Perfectly Inelastic Demand

• Quantity demanded does not change with price changes.

• PED = 0.

Inelastic Demand

• Quantity demanded changes less than price changes.

• PED between (0,1).

Unit Elastic Demand

• Quantity demanded changes exactly proportionately with price changes.

• PED = 1.

Elastic Demand

• Quantity demanded changes more than price changes.

• PED > 1.

Perfectly Elastic Demand

• A rise in price causes quantity demanded to drop to zero.

• PED = ∞.

Demand Curves and their Slopes

• Different slopes indicate various elasticities of demand.

Determinants of PED

• Availability of substitutes.

• Necessity vs luxury categorization of goods.

• Time frame for consumption.

• Proportion of income spent on the good.

• Habits, addictions, and tastes.

Total Revenue (TR)

• Defined as total earnings from sales (Price * Quantity).

• Without intervention, TR equals consumer expenditure.

Effects of PED on Total Revenue

When Price Increases

• If Demand is Elastic (PED > 1): TR decreases.

• If Demand is Inelastic (PED < 1): TR increases.

• If Demand is Unit Elastic (PED = 1): TR remains the same.

When Price Decreases

• If Demand is Elastic (PED > 1): TR increases.

• If Demand is Inelastic (PED < 1): TR decreases.

• If Demand is Unit Elastic (PED = 1): TR remains unchanged.

Importance of PED for Firms and Government Decision Making

• Predicting effects of pricing strategies on total revenue.

• Analyzing impacts of indirect tax imposition.

PED and Primary Commodities

• Primary sector goods (e.g., copper, oil) usually have inelastic demand due to lack of substitutes.

PED and Manufactured Goods

• Goods in the secondary sector (e.g., cars, electronics) are generally more elastic as they often have substitutes.

Cross Elasticity of Demand (XED)

• Measures changes in demand due to price changes in another good:

  • Formula: XED = %A in demand for good X / %A in price of good Y.

  • Interpretation: XED > 0 (substitutes), XED < 0 (complements), XED = 0 (unrelated).

Income Elasticity of Demand (YED)

• Measures demand changes due to changes in consumer income:

  • Formula: YED = %A in income / %A in demand for good X.

• Interpretation:

  • YED > 0 (normal good), 0 < YED < 1 (necessity), YED > 1 (luxury good), YED < 0 (inferior good).

Importance of YED for Firms

• Varies with economic conditions:

  • YED > 1 indicates significant demand increase during economic expansions.

  • YED < 0 suggests demand increases during recessions.

Sectors of Industry

Primary Sector

• Involves extraction of raw materials (e.g., mining, agriculture).

Secondary Sector

• Concerns production of goods (manufacturing).

Tertiary Sector

• Provides services to consumers and businesses.

Quaternary Sector

• Knowledge-based industries (e.g., ICT).

YED and Sectoral Changes

• Increasing income generally leads to higher demand in different sectors predominantly:

  • Primary: 1 > YED > 0.

  • Secondary: YED > 1.

  • Tertiary: YED > 1.

Price Elasticity of Supply (PES)

• Measures how quantity supplied responds to price changes:

  • Formula: PES = %∆ in quantity supplied / %∆ in price.

Interpretation of PES

• PES shows percentage change of quantity supplied when price changes by 1%.

Types of Supply based on PES

Perfectly Inelastic Supply

• Quantity supplied does not change with price (PES = 0).

Inelastic Supply

• Quantity supplied changes less than price (PES < 1).

Unit Elastic Supply

• Quantity supplied changes proportionately with price (PES = 1).

Elastic Supply

• Quantity supplied changes more than price (PES > 1).

Perfectly Elastic Supply

• Supply drops to zero with any price decrease (PES = ∞).

Determinants of PES

• Marginal cost of production.

• Availability of unused capacity.

• Mobility of factors of production.

• Time period for supply adjustments.

• Ability to store stocks.

PES and Primary Commodities

• Supply for primary commodities tends to be price inelastic due to the nature of production.

PES and Manufactured Goods

• Supply for manufactured goods generally exhibits price elasticity.