AS Economics (Micro) Chapter 3: Elasticities

• Elasticities are the focus of AS Economics (Micro) Chapter 3.
• The chapter will cover Elasticity of Demand and Elasticity of Supply.
• The types considered will be PED, YED, XED, and PES.
• The topics covered in the chapter include definitions and formulas, types, determinants of PED and PES, uses of all elasticities to firms and government, and methods of changing PED and PES.

Price Elasticity of Demand (PED)

• Price Elasticity of Demand measures the responsiveness of quantity demanded to changes in price.
• PED is always negative because of the inverse relationship between price and quantity demanded.
• The formula for PED is:
  • % change in Quantity Demanded / % change in Price.
• % change in Quantity Demanded Calculation: ((Q2 - Q1) / Q1) * 100.
• % change in Price Calculation: ((P2 - P1) / P1) * 100.
• PED Calculation: (Change in Quantity Demanded / Change in Price) * (Price1 / Quantity1).

Types of Price Elasticity of Demand

• Price elastic: A small change in price causes a large proportionate change in quantity demanded, PED > 1 (e.g., -2.5, -5).
• Unitary elastic: The same change in price causes an equal proportionate change in quantity demanded, PED = 1.
• Price inelastic: A large change in price causes a small proportionate change in quantity demanded, PED < 1 (e.g., 0.5, 0.75).
• Price elastic goods are luxuries e.g cars and AC's
• Price inelastic goods are necessities and addictive e.g. wheat and cigarettes
• Flatter demand curve as ∆P < ∆Q for elastic goods, while steeper curve as ∆P > ∆Q for inelastic goods. Unitary elasticity is a hyperbola.
• Price decreases lead to Total Revenue/Total Expenditure increases, and producers should decrease price to increase revenue, for elastic goods. This leads to TR increases.
• With unitary elasticity, TR/TE remains unchanged whether price increases or decreases, so price should remain constant.
• For Inelastic goods Price increase leads to Total Revenue/Total Expenditure increase, and producers should increase price to increase revenue - TR increases.
• In the extreme cases
  • Perfectly elastic demand has PED=∞, resulting in a horizontal demand curve, and price remains same when quantity changes.
  • Perfectly inelastic demand has PED=0, resulting in a vertical demand curve, and change in price causes no change in demand.
• The formula for the hyperbola demand curve, or unitary elastic demand, uses the midpoint approach, called arc elasticity of demand.
  • PED = (%∆ in Quantity Demanded) / (%∆ in Price) where %∆ in Quantity Demanded = (Change in Quantity / ((Q1 + Q2) / 2)) × 100 and %∆ in Price = (change in Price / ((P1 + P2) / 2)) × 100
• Along a straight line demand curve:
  • The upper part is elastic (PED > 1)
  • The lower part is inelastic (PED < 1)
  • The midpoint is unitary elastic (PED = 1).

Relationship of Price and Total Revenue

• Unitary cases: As the Price rises there is no difference in Total Revenue. The Total Revenue remains constant as the Price changes.
• Inelastic cases: has a positive relation between Price and Total Revenue as when the Price rises the Total Revenue also increases.
• Elastic cases: has a negative relation between Price and Total Revenue as when the Price decreases the Total Revenue increases.

Determinants of PED

• Nature of Product: Necessities are inelastic, while luxuries are elastic because demand for necessities changes less when the price changes.
• Number of substitutes: Products with fewer substitutes are inelastic, while products with more substitutes are elastic. More substitutes mean consumers have more choice, leading to more elastic demand.
• Time: In emergencies (Short Run), goods are inelastic. When there is more time (Long Run), goods are elastic because consumers have more time to choose the product.
• Proportion of Income Spent: Goods that take up a small proportion of income are inelastic, while goods consuming a large proportion of income are elastic.

Price Elasticity of Supply (PES)

• Price Elasticity of Supply (PES) measures the responsiveness of quantity supplied to changes in price and is always positive.
• PES = % change in Quantity Supplied / % change in Price.
• PES: Short Run vs. Long Run
  • SR: Only labor can change (FoP fixed)
  • LR: All FoP can change. can change elastic supply.

Characteristics of Price Elasticity of Supply

• Price elastic: Small changes in price cause larger % change in quantity supplied.
• PES > 1 (e.g., 2.5, 5).
• Unitary elastic: Same change in price causes equal proportionate change in quantity supplied (PES = 1).
• Price inelastic: Large change in price causes smaller % change in quantity supplied, with PES is < 1 (e.g., 0.5, 0.75).
• Shape of supply curve:
  • Elastic: Flatter curve, ∆P < ∆Q
  • Unitary Elastic: Starts from origin
  • Inelastic: Steeper curve, ∆P > ∆Q
• PES when supply curve starts from y axis: PES keeps on falling as the curve moves up, but overall it's elastic.
• PES when supply curve starts from x axis: PES keeps on rising as the curve moves up, but overall, it's inelastic.

Determinants of Price Elasticity of Supply

• Level of Capacity: If excess capacity is available, supply is elastic. If capacity is full, supply is inelastic.
• Time Period: Supply is inelastic in the Short Run and elastic in the Long Run because producers have more time to adjust production.
• Storability: More storable and durable goods have more elastic supply because their supply can be easily changed.
• Level of Employment: Supply is inelastic at full employment (as no extra workers are available) and elastic during unemployment.
• Ability to Import Inputs: Greater ability to import increases supply elasticity, even at full employment, as the supply capacity can increase easily.
• Time Taken for a Good to Finish: The more time required to complete a good, the more inelastic the supply is because it can't be changed quickly.

Income Elasticity of Demand (YED)

• Income Elasticity of Demand measures the responsiveness of quantity demanded to changes in income, results may be positive, zero, or negative.
• YED = % change in Quantity demanded / % change in Income
• YED = ((Change in Quantity Demanded / Quantity1) / (Change in Income / Income1)) x 100
• Positive:
  • As Income rises the quantity demanded also rises (YED > 0).
  • These goods are called Normal Goods.
  • There is a positive relationship between income and quantity demanded as people's willingness and ability to buy both rise
  • Super Normal/Luxuries (YED>1 / elastic ). Important goods/necessities (YED<1 / inelastic).
• Zero:
  • As income rises the quantity demanded remains the same.
  • There is no relationship between income and quantity demanded.
  • These goods are the essentials of life (e.g., water).
• Negative:
  • As Income rises the quantity demanded falls (YED < 0).
  • These goods are called inferior goods (e.g., bus travel).
  • There is a negative relationship as when income rises, people prefer normal goods since their affordability has increased and so the willingness to buy inferior goods falls

Cross Price Elasticity of Demand (XED)

• Cross Price Elasticity of Demand measures the responsiveness of the quantity demanded of one product (Good A) to changes in the price of another product (Good B). It can be positive, negative, or zero.
• XED = % change in quantity demanded of A / % change in price of B
• XED Calculation: (Change in Quantity Demanded of A / Change in Price of B) * (Price of B / Quantity of A)
• Positive:
  • Increase in price of good B causes an increase in demand of good A.
  • These goods are called substitutes or alternately demanded goods (e.g., Coke and Pepsi)
    • Coke Price increases, Pepsi Quantity increases.
  • XED > 1: Close substitutes (elastic) (e.g., Pepsi and Coke).
  • XED < 1: Bad substitutes (inelastic) (e.g., Pepsi and Tea).
• Zero:
  • Increase in price of good B causes no change in the demand of good A.
  • There exists no relationship between these goods.
  • These are unrelated goods (e.g., salt and sugar or shoes and tv).
• Negative:
  • Increase in price of good B causes a decrease in demand of good A.
  • These goods are complementary goods/goods in joint demand (e.g., cars and petrol).
  • XED > -1: Close complements (elastic) (e.g., fuel and car).
  • XED < -1: Bad complements (inelastic) (e.g., pepsi and chips).

Uses/Practical Applications PED & PES for Firms and Government

• Determination of Total Revenue for Firms and Government:
  • Firms should lower prices for goods with elastic demand and governments should lower taxes to increase total revenue.
  • Firms should raise prices and governments should increase taxes for goods with inelastic demand to increase total revenue.
• Determinants of Investment Prospects and Price Stability:
  • PED helps determine the price stability of an industry, giving an idea of whether to invest. In elastic demand industries, supply increases lead to small price decreases.
  • Businesses invest in industries with elastic demand.
  • Governments should subsidize elastic industries for the biggest impact on output.
  • Subsidies to inelastic industries may lead to large price decreases, achieving government aims.
• Incidence of Indirect Tax means burden of a tax on a good.
  • PED or PES can help consumers and producers determine who will bear the greater tax burden.
  • When PED = PES: Consumer and seller bear equal burdens, with the tax burden is shared.
  • When PED < PES: The consumer bears a greater portion of the tax - incidence of tax is greater on the consumer.
  • When PED > PES: The seller bears a greater portion of the tax - if demand is more elastic.
• Intuition: Consumer burden is greater when demand is inelastic because consumers' demand won't change much when price changes. Seller passes the burden to him. Seller burden is greater when supply is inelastic
• For consumer, P increases and Quantity decreases. For producer, P decreases and Quantity increases.

Price Elasticity and Subsidies Benefits

• For PED is more than PES:
  • Subsidy benefit greater on the seller as A < B (subsidy prices stay high to maximize seller profits)
• When PED is less than PES:
  • Subsidy benefit will be greater for consumer as A > B (reduced sales forces the producer to pass subsidy to consumer).
• If a firm wants to make demand elastic
  • Advertise product as a luxury to change perceptions; will take over its competitors via mergers etc
• If wants to take advantage of elastic supply
  • Train workers for productivity and lower trade barriers to import cheap raw materials.
• The Boom versus Bust argument is used in YED by both government and firms.
  • Boom is when the economy is growing meaning that GDP is increasing; bust is when the economy is going through a recession.

Summary of the uses of PED/PES

• Summary in the provided image shows when Total Revenue, Investment Prospects, Tax burden, Subsidies increase, and how much sales will increase due to increase in demand.
• Key: E=Elastic, I=Inelastic, D=Demand, S=Supply, IDT=Indirect Tax, IP=Investment prospects, CB=Consumer burden/benefit, SB=Seller burden/benefit. Good to focus on elastic goods

Limitations of Elasticity

• Difficult to calculate when variables are volatile, and formulas based on ceteris paribus which doesn't hold in the real world.

• Biased samples: Elasticities calculated through statistical samples

• PED is most helpful elasticity for firms and Income Elasticity of Demand is better for the government because they can change price and their policies according to change in income levels in an economy respectively.