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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.