01–DECEMBER 2013
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SpotNomics
Department of Economics
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Mr Andrew Brincat
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and
A HAPPY NEW YEAR
This Issue
Great Economic Thinkers
Examination Success
Elastictiy— Q & A
Great
Economic
Thinkers
Alfred Marshall
Alfred Marshall was born in Clapham, England on
July 26, 1842. Despite his father’s pressure on him to
become an Evangelist minister, he studied mathematics at Cambridge University and harboured a profound
interest in philosophy and economics. He lectured on
political economics at Bristol university and along
with Walras, he is considered as the ‘father’ of modern microeconomic theory.
In his most important book, Principles of Economics
(1890), Marshall forged the now well-known idea that
the supply and demand for goods and services determine the market clearing price. Like two ‘scissor
blades’, supply and demand curves intersect each
other at an at equilibrium. The concept of price elasticity of demand, which quantifies buyers’ sensitivity
to price, is also credited to Marshall, as are the concepts of consumer and producer surplus.
Wanting to understand how markets adjust to changes
in supply and demand over time, Marshall introduced
the concept of three time periods: the market period in
which the stock of a commodity is fixed, the short run
period in which supply can be increased by adding
variable inputs such as labour, but not capital, and the
long run period, that is the amount of time needed for
capital to be increased. With diminishing returns, a
business operating in a perfectly competitive market
would increase labour and output up to the point
where price would equal marginal cost, thus achieving
maximum efficiency.
Marshall’s ideas have been developed and refined by
his students, economists such as John M. Keynes and
Arthur Pigou. Other works published by Marshall
include: The Economics of Industry (1879), Industry
and Trade (1919) and Credit and Commerce which
appeared in 1923, a year before his death.
Source: http://historyofeconomicthought.wikispaces.com,
http://www.econlib.org/index.html
Price Elasticity of Demand
The price elasticity of demand (PED) indicates the responsiveness
or sensitivity of quantity demanded of a commodity to a change in
its own price. It is the proportional change in quantity demanded
brought about by a proportional change in price and is expressed as
a coefficient found through the formula:
Percentage change in quantity demanded of Good X
Percentage change in the price of Good X
The price elasticity of demand is always negative, showing the
negative relationship between price and quantity demanded.
It is the magnitude of the coefficient that is interpreted to indicate
the elasticity. This shows the extent to which a change in price affects quantity demanded. If the coefficient is smaller than one, then
the demand is said to be inelastic - where the percentage change in
quantity demanded is smaller than the percentage change in price.
If the magnitude of the coefficient is equal to one, then demand is
said to be unitary elastic; if the coefficient is greater than one, the
demand is elastic, or very responsive to a change in price.
While price is considered to be the most important determinant of
the demand, other determinants are relevant, having their own elasticities. The most important of these factors are the income elasticity (YED) and the cross price elasticity of demand (XED). Other
elasticities can be the advertising and population elasticities.
Examination Tips
Be careful to distinguish between the determinants of demand and
the determinants of the price elasticity of demand.
Remember that price elasticity of demand is measured at a price or
over a defined range of prices.
Although the price elasticity of demand is based on the slope of the
demand curve, it is not the gradient, but the gradient multiplied by
the ratio of price to quantity.
For clarity’s sake, it is usually better to use multiple graphs to compare elasticities rather than using different curves on the same
graph.
Once you know the formula of one type of elasticity, it is usually
easy to understand and draw up other formulae.
Elasticity - Q & A
What are the main determinants of the price elasticity of demand?
1. Number and availability of close substitutes within the market - The more substitutes available in the market, the more
elastic the demand will be in response to a change in price. In this case, the substitution effect will be quite strong.
2. Luxuries and necessities - Necessities tend to have a more inelastic demand, whereas luxury goods and services tend to
be more elastic. For example, the demand for opera tickets is more elastic than the demand for urban rail travel.
3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with
purchasing the good or service the more inelastic demand will be.
4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic. Preferences are such that habitual consumers of certain products become insensitive to price changes.
5. The category of the good - the more generalized the good, for example food, the more inelastic; the more specific, such
as meat, the more elastic
6. Time period under consideration - Demand tends to be more elastic in the long run rather than in the short run. For example, after the two world oil price shocks in the 1970s - the "response" to higher oil prices was modest in the immediate
period after price increases, but as time passed, people found ways to consume less petroleum and other oil products. This
included measures to get better mileage from their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil became more elastic in the long-run.
Adapted from Tutor2u
How may the Price Elasticity of Demand be interpreted?
If the PED > 1, the good is price elastic. Demand is responsive to a change in price. If for example a 15% fall in price leads
to a 30% increase in quantity demanded, the price elasticity = (-)2.0
If the PED < 1, the good is inelastic. Demand is not very responsive to changes in price. If for example a 20% increase in
price leads to a 5% fall in quantity demanded, the price elasticity = (-)0.25
If the PED = 1, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change
in price. Demand changes proportionately to a price change.
If the PED = 0, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical.
If the PED = ∞ (infinity), the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This
demand curve is associated with firms operating in perfectly competitive markets, and the demand curve will be perfectly
horizontal.
Adapted from Tutor 2u
How does the Price elasticity of demand affect Total Revenue to a firm?
If the PED > 1, then demand for the good is elastic, that is the %∆Qd > %∆P and:
If price rises and quantity demanded falls, then Total Revenue falls
If price falls and quantity demanded rises, then Total Revenue rises
If the PED = 1, then demand for the good is unitary elastic, tthat is the %∆Qd = %∆P and:
If price rises and quantity demanded falls, then Total Revenue remains the same
If price falls and quantity demanded rises, then Total Revenue remains the same
If the PED < 1, then demand for the good is inelastic, that is the %∆Qd < %∆P and:
If price rises and quantity demanded falls, then Total Revenue rises
If price falls and quantity demanded rises, then Total Revenue falls