3: Elasticities Flashcards

1
Q

What is elasticity?

A

A measure of responsiveness of a variable to changes in price or any of the variable’s determinants.

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2
Q

What is price elasticity of demand (PED)?

A

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

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3
Q

What does it mean to be price elastic/inelastic?

A

If there is a large responsiveness of quantity demanded, demand is referred to as price elastic. If there is a small responsiveness, demand is inelastic.

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4
Q

How do you calculate PED?

A

%∆Qd/%∆P

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5
Q

How can you calculate PED if you simplify the formula?

A

%∆Qd/%∆P = ∆Q/Qd1 * P1/∆P

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6
Q

Can you have a negative PED?

A

Yes, PED will usually be negative. We treat it as if it is positive however. This is done to avoid confusion as they are easier to compare.

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7
Q

Why is PED a percentage?

A
  1. It is independent of units. Using units of oranges or currencies would be unhelpful.
  2. A change in price is only meaningful when you consider the original price.
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8
Q

Can PED be negative?

A

Yes it is usually negative but we take the absolute value to avoid confusion.

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9
Q

When is demand considered to be price inelastic?

A

When PED < 1 but > 0.

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10
Q

When is demand considered to be price elastic?

A

When PED > 1.

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11
Q

When is demand considered to be unit elastic?

A

When PED = 1.

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12
Q

When is demand considered to be perfectly elastic?

A

When PED = ∞

%∆P = 0 and anything /0 = infinity.

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13
Q

When is demand considered to be perfectly inelastic?

A

When PED = 0.

%∆Qd = 0 and 0/anything = 0

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14
Q

How does PED vary on a demand curve?

A

On a downwards sloping, straight-line demand curve, demand is price-elastic at high prices and low quantities, and price inelastic at low prices and large quantities.

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15
Q

Why does PED vary on a demand curve?

A

A higher percentage of income is spent on the good when the price is high meaning an increase in price will lead to a larger number of people not buying it.

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16
Q

What is the relationship between PED and the slope?

Explain this:

A

PED = slope x P/Q

The slope = ∆QD/∆P

PED = %∆Qd/%∆P = ∆Q/∆P * P1/Qd1 = slope * P1/Qd1

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17
Q

Determinants of PED:

A
  1. Number and closeness of substitutes
  2. Necessities vs luxuries
  3. Length of time
  4. Proportion of income spent on the good
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18
Q

How is length of time a determinant of PED?

A

The longer the consumer has to make a purchasing decision, the more elastic the demand. For example, if the price of heating oil changes, the consumer has little time to change their habits as it requires substitute research and firm comparison. In the short term therefore demand is relatively inelastic. In the long term however the consumer has time to switch to other forms of heating, making it more elastic.

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19
Q

How does the steepness of the demand curve relate to elasticity?

A

The flatter the demand curve, the more elastic. The steeper the demand curve, the more inelastic.

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20
Q

What is total revenue (TR)?

A

The amount of money received by firms when they sell a good or service.

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21
Q

How do you calculate TR?

A

Price * Quantity demanded

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22
Q

When demand is elastic, how do changes in prices change revenue?

A

When demand is elastic an increase in price will decrease revenue and a decrease in price will increase revenue.

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23
Q

When demand is inelastic, how do changes in prices change revenue?

A

When demand is inelastic, an increase in price will increase total revenue and a decrease in price will decrease total revenue.

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24
Q

When demand is unit elastic, how do changes in prices change revenue?

A

When demand is unit elastic a change in price does not cause any change in total revenue.

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25
Q

When is TR at a maximum?

A

TR is maximised when price is at the point where demand is unit elastic.

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26
Q

What is profit?

A

Total revenue minus total costs.

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27
Q

What are primary commodities?

A

Goods arising directly from the use of natural resources. Essentially the “land” factor of production.

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28
Q

Explain PED in relation to primary commodities and manufactured products:

A

Many primary commodities have a relatively low PED (inelastic) because they are necessities and have no substitutes (such as oil). The PED of manufactured products have relatively high PED (elastic) because they usually have no substitutes.

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29
Q

Why do inelastic products have volatile prices?

A

The demand curve is steep as quantity demanded changes a small amount when price changes large amounts. Thus, when the supply curve shifts left or right, the price changes drastically whilst the quantity demanded does not.

30
Q

What does volatile prices for inelastic products mean?

A
  1. Producers incomes fluctuates widely as a result of fluctuating prices.
  2. A fall in the supply of a good with inelastic demand leads to an increase in total revenue for producers because although the Qd decreases, the P increases.
31
Q

Implications of unstable primary product prices:

A

A bad yield would mean supply shifts to left which could increase total revenue. If agricultural products are considered inelastic because they are so necessary, then a lower yield could be good for farmers. Government intervention may be necessary.

32
Q

What is the relation between PED and indirect taxes?

A

The lower the price elasticity of demand for a taxed good, the greater the government tax revenues.

33
Q

Show using graphs why the government should implement taxes on inelastic products for the most revenue:

A

Show two demand curves, one steep and one flat. Show two parallel supply curves on each graph, one labelled S and the one on the left S + t. Label the vertical distance between them tax per unit. label QE and PE and Qt (the q where D and St intercept) and Pt (the p where D and St intercept). shade this area on both. This is tax revenue. It should be bigger with the steeper demand curve, which should be labelled inelastic demand.

You can explain that with inelastic demand an increase in price for the consumer due to the newly added tax, decreases the Qd less than with the elastic demand. More are bought, and so more revenue is received.

34
Q

What is cross elasticity of demand?

A

A measure of responsiveness of demand for one good to a change in the price of another good.

35
Q

How do you calculate XED?

A

%∆Qdx/%∆Py

36
Q

Simplify the XED calculation:

A

%∆Qdx/%∆Py
= ∆Qdx/Q1x / ∆Py/Py1
= ∆Qdx/Q1x * Py1/ ∆Py

37
Q

What does a positive XED value mean?

A

The price for one good and the demand for another move in the same direction. Therefore these goods are substitutes in consumption.

38
Q

What does the size of the XED value insinuate?

A

The greater the XED value, the greater the substitutability between the goods, and the larger the demand curve shift in the event of a price change, ceteris peribus.

39
Q

What does a negative XED value mean?

A

When the price of one good and the demand for another move in opposite directions, the goods are complements in consume

40
Q

What does a XED value of 0 mean?

A

The goods are independent of each other.

41
Q

What information should two competing firms try to acquire?

A
  • The PED for that good so they can determine whether rising the price will lead to an increase or decrease in TR.
  • the XED value of the closest substitute.
42
Q

What might the XED indicate a firm should do?

A

Two competing firms may consider merging, which means to unite to form a single firm. This would eliminate

43
Q

Why would XED be useful for two complimentary products?

A

If products have a low absolute value of a negative XED they are weakly complimentary, but a high absolute value of a negative XED means that lowering the price of one good could result in a large increase in sales for another. Businesses that have largely complimentary goods often collaborate, such as charter flights and hotels.
In addition, XED could be used to predict the effects of indirect taxes on one good will effect another. For example a large tax on petrol may decrease the sales of large cars.

44
Q

What is income elasticity of demand?

A

A measure of the responsiveness of demand to changes income.

45
Q

Formula for YED?

A

%∆Qd/%∆Y

46
Q

Formula for YED (simplified)?

A

%∆Qd/%∆PY

= ∆Qd/Qd1 * Y1/∆Y

47
Q

What does it mean when YED is positive?

A

The good is normal.

48
Q

What does it mean when YED is negative?

A

The good is inferior.

49
Q

What does it mean when YED < 1?

A

The good is a staple good (a necessity), it has income inelastic demand.

50
Q

What does it mean when YED > 1?

A

The good is a luxury, it has income elastic demand.

51
Q

What are the uses of YED for producers?

A

YED can be used to measure the rate of expansion of industries. If the total income in an economy grows by 3% for example, the demand for income elastic goods will grow at a rate higher than 3%. Demand for income inelastic goods will rise at a rate lower than 3%. The higher the YED for a good or service, the greater the expansion of its market is likely to be in the future. Producers may want to know the YED of various goods and services before producing, so that profit can be predicted.

52
Q

What are the uses of YED for economists?

A

The economy can be split into three sectors: agriculture, manufactoring and services. The relative size of the three sectors can be explained in terms of YED. The growth of the agricultural sector is likely to be slower than the growth of manufactured output increases, shifting the total share. Services experience the most growth in developed countries.

53
Q

Explain the long term impacts on primary commodity prices using YED:

A

Low YED for food means that as income rises, a relatively smaller proportion of income is spent on food and a relatively larger proportion on manufactured products and services. The result is that prices of these goods and services rise more rapidly than the price of agricultural products. This has implications for economically less developed countries, as they are more focused on agriculture, so their GDPs are lower.

54
Q

What is price elasticity of supply?

A

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

55
Q

What is the formula for PES?

A

%∆Qs/%∆P

56
Q

What is the simplified formula for PES?

A

%∆Qs/%∆P

= ∆Qs/Qs1 * P1/∆P

57
Q

What does it mean when PES<1?

A

Supply is price inelastic.

58
Q

What does it mean when PES > 1?

A

Supply is price elastic.

59
Q

What does it mean when PES = 1?

A

Supply is unit elastic.

60
Q

What does it mean when PES = 0?

A

Supply is perfectly inelastic because %∆Qd = 0

61
Q

What does it mean when PES = ∞?

A

Supply is perfectly elastic because the price never changes.

62
Q

When supply is perfectly inelastic what does the supply curve look like? Examples of goods?

A

It is vertical at the quantity supplied. For example Picasso paintings will have a perfectly inelastic demand because there is a fixed number.

63
Q

When supply is perfectly elastic what does the supply curve look like?

A

A horizontal line.

64
Q

How can you compare two intercepting supply curves?

A

They share one price and quantity combination but you can compare their PES’s by the steepness of the curve. The flatter curve is more elastic at any given price.

65
Q

How can you tell when supply curves have a constant PES?

A

They go through the origin, so they are unit elastic.

66
Q

When comparing supply curves what should you do?

A

Only compare PES at certain points as PES varies.

67
Q

Determinants of PES:

A
  1. Length of time
  2. Mobility of factors of production
  3. Spare capacity of firms
  4. Ability to store stocks
68
Q

How does length of time determine PES?

A

It depends on how much time firms have to adjust their inputs. Over a short time period, the firm may be unable to increase or decrease any of its inputs to change the quantity it produces. For example a fishing boat upon return from a fishing trip only has so many fish to supply in the market. Even if the price increases, they cannot increase the fish quantity. In a longer period, the owner can buy more fishing boats and workers.

69
Q

How does ability to store stocks determine PES?

A

Some firms store stocks of output they produce but do not sell right away. Firms that have a larger ability to store stocks are likely to have a higher PES for their products. This only effects PES over relatively short periods of time however.

70
Q

Why do primary commodities have a lower PES compared to manufactured products?

A

The time needed for the Qs to respond to price changes is longer for agriculture. Farmers need at least a planting season to be able to respond to higher prices and there is often a limited availability of new land to cultivate on, particularly with environmental destruction. To increase crop yields, technological advancement is required.

71
Q

What are the consequences of a low PES for primary commodities?

A

Demand fluctuations with inelastic supply leads to more volatile price fluctuations. The curve is steeper. This leads to large revenue fluctuations.