Unit 2.2 – Elasticity
Resources
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TextBook – IB Companion; Chapters 5 and 6
Powerpoint – see StudyWiz
Websites – Elasticity http://www.s-cool.co.uk/alevel/economics/elasticities.html
Class wiki - http://wiki.iss.edu.sg/groups/economics/
Revision Notes - http://welkerswikinomics.com/downloads/Unit%202.2%20Elasticities.pdf
Assessment
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One inclass writing test – end of unit
A one week homework task – see Study Wiz
One contribution to blog
Participation in group work
Duration of topic – About 3 weeks will be finished before activity week
2.2 Elasticity - Content
Price elasticity of demand (PED)
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Formula
PED = % change in QD
% change in P
We can determine the price elasticity of demand by either looking at the angle of the demand curves, or
by calculating the coefficient using the above formula.
*Calculations done on notebook
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Definition
Measures the responsiveness of the quantity demanded to a given price change
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Possible range of values
The possible range of values for price elasticity of demand usually goes from zero to infinity. In order to
simplify matters, economists usually ignore the negative value that comes from the equation and simply
give the answer as a positive figure.
o PED=0 – A change in the price of a product will have no effect on the quantity demanded at all. In
this case, demand is said to be perfectly inelastic, it is completely unresponsive to price changes.
o
PED=infinity – Demand is said to be perfectly elastic. At a specific price, the demand curve goes on
forever and so the quantity demanded is infinite.
o
0<PED<1 – Inelastic demand, a change in the price of the product leads to a proportionally smaller
change in the quantity demanded of it. If the price is raised, the quantity demanded will not fall by
much in comparison, and so the total revenue gained by the firm will increase.
o
1<PED<infinity – Elastic demand, change in the price of the product leads to a greater than
proportionate change in the quantity demanded of it. Thus, in contrary to inelastic demand, the
firm should not raise the price of the product if it wishes to increase total revenue.
o
PED=1 – Unit elastic demand/Unitary demand, a change in the price of the product leads to a
proportionate, opposite, change in the quantity demanded of it. If price is raised by a certain
percentage, then the quantity demanded will fall by the same percentage, and so the total
revenue gained by the firm will not change.
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Diagrams illustrating the range of values of elasticity
*Illustrated on notebook
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Varying elasticity along a straight-line D curve
For a straight-line, downward-sloping demand curve, the value of PED falls as price falls (the value of PED
falls as we move down a demand curve. *Low-priced products have a more inelastic demand than highpriced products; because consumers are less concerned when the price of an inexpensive product rises
than they are when the price of an expensive product rises.
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Determinants of price elasticity of demand
Different products will have different values for PED
 The number and closeness of potential substitutes: (important determinant)
The more substitutes, the more elastic will be the demand for a product. Also, the closer the
substitutes available, the more elastic will be the demand. E.g. brands of household products,
types of meat, and types of fruit, will tend to have elastic demand. Oil will tend to have relatively
inelastic demand, with the demand falling relatively little as the price goes up.
 The necessity of the product and how widely the product is defined:
For necessary products such as food, we would expect the demand for food to be very inelastic. If
we define food more narrowly, we would expect the demand to be less inelastic, since there are
many alternatives. Necessity goods will change from consumer to consumer, since different
people have different tastes. Habit-forming goods like cigarettes, alcohol, or hard drugs tend to
have inelastic demand.
 The time period considered:
As the price of a product changes, it often takes time for consumers to change their buying and
consumption habits. PED thus tends to be more inelastic in the short term and then becomes ore
elastic, the longer the time period it is measured over.
E.g. elastic – chocolate milk, orange, apple, iPod nano
Inelastic – milk, fruit
Cross-elasticity of demand (XED)
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Definition
If we change the price of one good, QD of the other will change, but only if they are related goods.
XED measures the responsiveness of the quantity demanded of one good with respect to a given price
change in a different good, ceteris paribus.
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Formula
XED = % change in QD of product X
% change in P of product Y
Calculations done on notebook
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Significance of sign with respect to complements and substitutes
The value of XED may be positive or negative and the sign is important, since it tells us what the
relationship between the two goods in question is.
o XED=positive – the two goods are substitutes for each other. Products that are very close
substitutes will have higher positive value than products that not so close. Two types of
margarine may be very close substitutes and so a rise in the price of one will lead to a significant
fall in the demand for it and a large increase in the demand for the competitor’s margarine.
o
XED=negative – the two goods are complements for each other. Products that are very close
complements will have a lower negative value than products that are not so close.
o
Sometimes the change in price of one product will have a positive effect on quantity demanded of
another product (Price of apples goes up, then QD of oranges go up) – substitutes +ve
o
Sometimes the change in price of a good will have a negative effect on QD (Price of movie tickets
goes up, then QD of popcorn will go down) – complements -ve
*The value of XED for two goods that are unrelated would be zero.
Income elasticity of demand (YED)
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Definition
It measures the responsiveness of demand to a change in consumer’s real income.
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Formula
YED = % change in QD
% change in income
*Calculations done on notebook
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Range of values for YED
The sign of YED tells us whether the product we are looking at is a normal good or an inferior good. The
demand for a normal good rises as income rises and the demand for an inferior good falls as income rises.
o Normal goods – the value of YED is positive. A product with a YED value between zero and one is
said to be income-inelastic. A product with a YED value greater than one is said to be incomeelastic.
o
Inferior goods – the value of YED is negative. For example, the demand for inexpensive jeans falls
as income rises because people switch to buying branded jeans.
o
Necessity goods – The demand for them will change very little if income rises so they have lowincome elasticity.
o
Superior goods – The demand for them changes significantly if income rises so they have highincome elasticity. For example, the demand for holidays in foreign countries is likely to be incomeelastic.
Price elasticity of supply
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Definition
Identifies how quickly or slowly a firm can either expand or contract the quantity supplied to the market
In the very short run, the firm is unable to increase production until the factors of production (land, labor,
capital) can be changed
The QS of…. Haircuts are very easily changed. If the price increases then the firm would ask workers to
work longer hours, use more raw materials
Thus QS is very responsiveness to change in the price – elastic
The QS of…. large aircraft, MRT trains is more complex. In the short run it is difficult to expand QS if price
changes. The level of capital or technology is more expensive to change
Thus QS is less responsiveness to change in the price – inelastic
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Possible range values
ELASTIC
UNTI ELASTIC
INELASTIC
Define
A change in the price of
the product leads to a
greater than
proportionate change in
the quantity supplied of it.
1 < PES < infinity
A change in the price of
the product leads to a
proportionate change in
the quantity supplied of it.
PES = 1
A change in the price of
the product leads to a less
than proportionate
change in the quantity
supplied of it. 0 < PES < 1
Explain the slope of ‘S’
curve
Any straight line supply
curve starting from the yaxis
Any straight-line supply
curve passing through the
origin
Any straight-line supply
curve starting from the xaxis
Define the coefficient
1 < PES < infinity
PES = 1
0 < PES < 1
Why is supply either
elastic/inelastic
Refer pg 62
(determinants)
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Formula
PES = % change in QS
% change in P
*Calculations done on notebook
Refer pg 62
(determinants)
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Diagrams illustrating the range of values of elasticity
*Illustrated on notebook
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Determinants of price elasticity of supply
How much costs rise as output is increased
When supply increases, total costs rise significantly, thus producers refuse to increase supply. As a
result the product has a relatively inelastic supply. On the other hand when supply increases, total
costs don’t rise quickly (either because the firm has a lot of space capacity or costs of factor
inputs don’t rise quickly as the firm uses more of them), thus producers continue to increase
supply. As a result the product makes more profit as it benefits from higher prices.
Time period considered
The longer the time period the more elastic the supply will be.
Immediate – the PES is very inelastic
Short run – the PES is more elastic than immediate
Long run – PES is very elastic
Applications of concepts of elasticity
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PED and business decisions: the effects of price changes on total revenue
o 0<PED<1 – Inelastic demand. If the price is raised, the quantity demanded will not fall by much in
comparison, and so the total revenue gained by the firm will increase.
o
1<PED<infinity – Elastic demand. Thus, in contrary to inelastic demand, the firm should not raise
the price of the product if it wishes to increase total revenue.
o
PED=1 – Unit elastic demand/Unitary demand. If price is raised by a certain percentage, then the
quantity demanded will fall by the same percentage, and so the total revenue gained by the firm
will not change.
**We use PED to make essential pricing decisions and to predict the impact of forced price changed on
revenue and ultimately profit.
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PED and taxation
If the demand for the product is very elastic, than a price increase as a result of the imposition of a tax on
the product will lead to a relatively large fall in the demand for the product. This means that the demand
for production workers in the industry is likely to fall significantly, increasing unemployment in the
economy. Since governments are not usually keen to increase unemployment, they normally place taxes
on products where demand is relatively inelastic, so that the demand for the product will not fall by a
significant amount, and will not thus lead to high unemployment.
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Cross-elasticity of demand: relevance for firms
It is essential that firms are aware of the possible impact on the demand for their products that may arise
if there is a change in the price of a close rival’s products (vice versa). Complementary products have a
similar relevance for firms.
Higher-level IB topics:
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Flat rate and ad valorem taxes
Specific tax (flat rate) is a fixed amount of tax that is charged upon a product. On the other hand, an ad
valorem tax is a percentage of the selling price of a product.
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Incidence of indirect taxes and subsidies on the producer and consumer
*Some illustrations and explanations done on notebook
Subsidy is a per unit payment to firms by the government aiming at
Lowering the market price
Increasing production at each price
Increasing consumption
Result is that firms receive more than the price at which the product is sold. Producers receive for each
unit. Even though consumers only pay.
Now the government is paying a per unit amount of money to firms. Production costs are lower by the
amount of the subsidy so supply shifts vertically downward by that amount (the marginal cost of
producing each unit of output is now lower).
Both the producer and the consumer of a product, benefit from a subsidy. How the subsidy is split
between the two parties again depends on the price elasticity of demand and the price elasticity of
supply. Only now the ratio on the left is the ratio of the percentage benefit from the subsidy consumers
enjoy over the percentage benefit form the subsidy producers enjoy.
Given PES, the producers benefit more, the more price-elastic demand for the good is.
Subsidies are often granted to farmers to increase their income as well as to protect them from imports
(imported farm products automatically become relatively more expensive). The lower price of domestic
farm products may not only block imports but also may lead to the creation of an artificial comparative
advantage and thus penetrate foreign markets.
Subsidies may also be granted to encourage production and consumption of goods with positive
consumption or production externalities and of course in the case of merit goods and services such as
health and education.
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Implication of elasticity of supply and demand for the incidence (burden) of taxation
**Illustrations with explanations done on notebook