essay questions on elasticity of demand

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AP®︎/College Microeconomics

Course: ap®︎/college microeconomics   >   unit 2, introduction to price elasticity of demand.

• Determinants of price elasticity of demand
• Determinants of elasticity example
• Price Elasticity of Demand and its Determinants
• Perfect inelasticity and perfect elasticity of demand
• Constant unit elasticity
• Total revenue and elasticity
• More on total revenue and elasticity
• Determinants of price elasticity and the total revenue rule

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Video transcript

Understanding Elasticity

Elasticity is a concept which involves examining how responsive demand (or supply) is to a change in another variable such as price or income.

• Price Elasticity of demand (PED) – measures the responsiveness of demand to a change in price
• Price elasticity of supply (PES) – measures the responsiveness of supply to a change in price
• Income elasticity of demand (YED) – measures the responsiveness of demand to a change in income
• Cross elasticity of demand (XED) – measures the responsiveness of demand of good A to a change in the price of good B

Price Elasticity of Demand

The most common elasticity is Price Elasticity of Demand . This measures how responsive demand is to a change in price.

• If price of tomatoes increase 20%, and quantity falls by 4%, then the PED = -0.2

Inelastic Demand 

If a change in prices causes a smaller % change in demand, then we say demand is price inelastic.

In the above example, the price increased 40% and demand fell 10%.

• Therefore the PED would be -10/40 = -0.25
• In other words, the higher price does little to reduce your demand.
• Other examples of inelastic goods might involve:
• oil, petrol, coffee, cigarettes.

Characteristics of Inelastic Demand

With goods which have inelastic demand, there will be a few characteristics:

• Few if any substitutes, gold, diamonds, petrol, sugar
• Goods which are necessities. E.g. if you drive a car to work, it is a necessity to buy petrol. Therefore, if the price of petrol goes up you are likely to keep buying it.
• Addictive. If you are addicted to cigarettes/drugs, you will keep buying even if the price goes up.
• Bought infrequently and small percentage of income. If salt increases in price, most people wouldn’t mind.

Elastic demand

Demand is said to be price elastic – if a change in price causes a bigger % change in demand.

In the above example, the price rises 20%. Demand falls 50%. Therefore PED = -50/20 = -2.5

Elastic demand means that you are sensitive to changes in price. For example, if the price of Sainsbury’s Caledonian mineral water increases, you would probably switch to other varieties of mineral water. Therefore a change in price causes a bigger % change in demand and your demand is quite elastic.

• Calculating Elasticity of Demand 
• Formulas for Elasticity 

Goods vs particular brand

• If the price of chocolate in general increased, demand would be quite price inelastic – there are no close substitutes for chocolate
• However, if a particular brand like “Wispa” or ‘Dairy Milk’ increased in price, consumers could switch to other brands of chocolate. Therefore demand is more elastic for individual brands.

Making Use of Elasticity 

Effect on demand. If a firm knows demand is price elastic, raising the price is likely to cause a significant fall in demand and a fall in revenue.

The effectiveness of a tax . If demand is price inelastic, a tax would only cause a small fall in demand. Though it would lead to an increase in tax revenue.

In the diagram on left, demand is inelastic. Higher tax leads to a big increase in price and small fall in demand.

Elasticity and price discrimination  Elasticity can be used to explain and understand the decisions of firms such as price discrimination . A firm may have two groups of consumers – adults and students. Because students have low income, their demand is more price elastic. This means that if you cut prices for students, you get a bigger % increase in demand. Therefore, a firm will try to increase profits by cutting the price for students and keeping them higher for adults.

In the above example, firms set a much higher price for a ‘flexible’ ticket bought on the day. Some business users will have an inelastic demand so will be willing to pay this price. However, students or those on low-incomes will be more sensitive to changes in price and will be willing to book in advance – to save money.

• Price discrimination

Elasticity can vary over time

Often elasticity can vary over time. In the short-term, demand is price inelastic – because people don’t have time to look for alternatives. However, over time, people try harder to find alternatives and so demand becomes more price elastic.

For example, if the oil price increases, demand will be inelastic in the short-term. But, over time, consumers will consider buying more fuel-efficient engines or electric cars – to avoid the expensive petrol.

Other types of elasticity

• Cross elasticity of demand

If goods are complements, the XED will be negative

Income elasticity of demand

If income rises 10%

• Demand for Tesco bread falls 5%. YED = -0.5 (inferior good)
• Demand for butter increases 8%. YED = 0.8
• Demand for organic bread increases 17%. YED = 1.7

Price elasticity of supply (PES)

If price of potatoes rises 10% and quantity supplied increases 1%, the PES = 0.1

Elasticity of supply is determined by factors such as

• Levels of spare capacity
• Can the firm employ more factors of production
• Time period – supply often inelastic in the short-term
• Effect of tax depending on elasticity of demand
• Elasticity of food

 More Types of Elasticity

• Price Elasticity of Supply
• Cross Elasticity of demand
• Income Elasticity of demand

3 thoughts on “Understanding Elasticity”

• Pingback: Elasticity in Economics — Economics Blog
• Pingback: Difference between Point and Arc Elasticity of Demand | Economics Blog

Explain why the following situations would occur in terms of the factors that affect elasticity. a. Demand for cellular service is inelastic in the short run, but more elastic in the long run

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Module 5: Elasticity

Elasticity of demand, learning objectives.

• Describe and give examples of elasticity

Figure 1 . Mr. Fantastic is elastic.

Think about the word elastic . It suggests that an item can be stretched. In economics, when we talk about  elasticity ,  we’re referring to how much something will stretch or change in response to another variable. Consider a rubber band, a leather strap, and a steel ring. If you pull on two sides of a rubber band (or Mr. Fantastic), the force will cause it to stretch a lot. If you use the same amount of force to pull on the ends of a leather strap, it will stretch somewhat, but not as much as the rubber band. If you pull on either side of a steel ring, applying the same amount of force, it probably won’t stretch at all (unless you’re very strong). Each of these materials (the rubber band, the leather strap, and the steel ring) displays a different amount of elasticity in response to being pulled, and all three fall somewhere on a continuum from very stretchy (elastic) to barely stretchy (inelastic).

There are different kinds of economic elasticity—for example, price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross-price elasticity of demand—but the underlying property is always the same: how responsive or sensitive one thing is to a change in another thing.

Elastic and Inelastic Demand

Let’s think about elasticity in the context of price and quantity demanded. While the law of demand does tell us that more of a good will be bought at a lower price, it does not tell us how much the quantity demanded will increase because of the price change. For example, if a store owner raises prices, she can expect that the quantity demanded will drop, but she might not know how sensitive customers will be to the change. How many people will buy her products despite the price increase and how many people will be driven away?

If a small change in price creates a large change in the quantity demanded, then we would say that the demand is very elastic —that is, the demand is very sensitive to a change in price. If, on the other hand, a large change in price results in a very small change in demand in the quantity demanded, then we would say the demand is inelastic . As we will see later, elastic and inelastic are relative concepts.  Here’s a way to keep this straight: demand is in elastic when consumers are in sensitive to changes in price.

Consider the example of cigarette taxes and smoking rates—a classic example of inelastic demand. Cigarettes are taxed at both the state and federal level. As you might expect, the greater the amount of the tax increase, the fewer cigarettes are bought and consumed. While the taxes are somewhat of a deterrent, demand doesn’t decrease as much as the price increase, though. We can say, then, that the demand for cigarettes is relatively inelastic.

You might think that elasticity isn’t an important consideration when it comes to the price of cigarettes. Surely any reduction in the demand for cigarettes would be a good thing, right? Does it really matter whether the demand is elastic or inelastic? It does. The reason is that taxes on cigarettes serve two purposes: to raise tax revenue for government and to discourage smoking. On one hand, if a higher cigarette tax discourages consumption by quite a lot—meaning a very large reduction in cigarette sales—then the cigarette tax on each pack will not raise much revenue for the government. On the other hand, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government (but not have much impact on smoking rates). Thus, when Congress tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity of cigarettes consumed. In other words, understanding the elasticity of cigarette demand is key to measuring the impact of taxes on government revenue AND public health.

This issue reaches beyond governments and taxes; every firm faces a similar challenge. Every time a firm considers raising the price that it charges, it needs to know how much a price increase will reduce the quantity of its product that is demanded. Conversely, when a firm puts its products on sale, it wants assurance that the lower price will lead to a significantly higher quantity demanded.

• Revision and adaptation. Provided by : Lumen Learning. License : CC BY-SA: Attribution-ShareAlike
• Price Elasticity of Demand and Price Elasticity of Supply. Authored by : OpenStax College. Located at : https://cnx.org/contents/[email protected]:EpNx8345@4/Price-Elasticity-of-Demand-and . License : CC BY: Attribution . License Terms : Download for free at http://cnx.org/contents/[email protected]
• Cigarette Taxes in the U.S.. Provided by : Wikipedia. Located at : https://en.wikipedia.org/wiki/Cigarette_taxes_in_the_United_States . License : CC BY-SA: Attribution-ShareAlike
• Mr. Fantastic. Authored by : Javi M. Located at : https://www.flickr.com/photos/84578994@N07/7801525384 . License : CC BY-SA: Attribution-ShareAlike

Elasticity of Demand Practice Problem

How to calculate income, price, and cross-price elasticities

• U.S. Economy
• Supply & Demand
• Archaeology
• Ph.D., Business Administration, Richard Ivey School of Business
• M.A., Economics, University of Rochester
• B.A., Economics and Political Science, University of Western Ontario

In microeconomics , the elasticity of demand refers to the measure of how sensitive the demand for a good is to shifts in other economic variables. In practice, elasticity is particularly important in modeling the potential change in demand due to factors like changes in the good's price. Despite its importance, it is one of the most misunderstood concepts. To get a better grasp on the elasticity of demand in practice, let's take a look at a practice problem.

Before trying to tackle this question, you'll want to refer to the following introductory articles to ensure your understanding of the underlying concepts:  a beginner's guide to elasticity and using calculus to calculate elasticities .

Elasticity Practice Problem

This practice problem has three parts: a, b, and c. Let's read through the prompt and questions .

Q: The weekly demand function for butter in the province of Quebec is Qd = 20000 - 500Px + 25M + 250Py, where Qd is quantity in kilograms purchased per week, P is price per kg in dollars, M is the average annual income of a Quebec consumer in thousands of dollar, and Py is the price of a kg of margarine. Assume that M = 20, Py = $2, and the weekly supply function is such that the equilibrium price of one kilogram of butter is $14.

a. Calculate the cross-price elasticity of the demand for butter (i.e. in response to changes in the price of margarine) at the equilibrium. What does this number mean? Is the sign important?

b. Calculate the income elasticity of demand for butter at the equilibrium .

c. Calculate the price elasticity of demand for butter at the equilibrium. What can we say about the demand for butter at this price-point? What significance does this fact hold for suppliers of butter?

Gathering the Information and Solving for Q

Whenever I work on a question such as the one above, I first like to tabulate all of the relevant information at my disposal. From the question we know that: M = 20 (in thousands) Py = 2 Px = 14 Q = 20000 - 500*Px + 25*M + 250*Py With this information, we can substitute and calculate for Q: Q = 20000 - 500*Px + 25*M + 250*Py Q = 20000 - 500*14 + 25*20 + 250*2 Q = 20000 - 7000 + 500 + 500 Q = 14000 Having solved for Q, we can now add this information to our table: M = 20 (in thousands) Py = 2 Px = 14 Q = 14000 Q = 20000 - 500*Px + 25*M + 250*Py Next, we'll answer a  practice problem .

Elasticity Practice Problem: Part A Explained

So far, we know that: M = 20 (in thousands) Py = 2 Px = 14 Q = 14000 Q = 20000 - 500*Px + 25*M + 250*Py After reading using calculus to calculate cross-price elasticity of demand , we see that we can calculate any elasticity by the formula:

Elasticity of Z With Respect to Y = (dZ / dY)*(Y/Z)

In the case of cross-price elasticity of demand, we are interested in the elasticity of quantity demand with respect to the other firm's price P'. Thus we can use the following equation:

Cross-price elasticity of demand = (dQ / dPy)*(Py/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side is some function of the other firm's price. That is the case in our demand equation of Q = 20000 - 500*Px + 25*M + 250*Py.

Thus we differentiate with respect to P' and get:

dQ/dPy = 250

So we substitute dQ/dPy = 250 and Q = 20000 - 500*Px + 25*M + 250*Py into our cross-price elasticity of demand equation:

Cross-price elasticity of demand = (dQ / dPy)*(Py/Q) Cross-price elasticity of demand = (250*Py)/(20000 - 500*Px + 25*M + 250*Py)

We're interested in finding what the cross-price elasticity of demand is at M = 20, Py = 2, Px = 14, so we substitute these into our cross-price elasticity of demand equation:

Cross-price elasticity of demand = (250*Py)/(20000 - 500*Px + 25*M + 250*Py) Cross-price elasticity of demand = (250*2)/(14000) Cross-price elasticity of demand = 500/14000 Cross-price elasticity of demand = 0.0357

Thus our cross-price elasticity of demand is 0.0357. Since it is greater than 0, we say that goods are substitutes (if it were negative, then the goods would be complements). The number indicates that when the price of margarine goes up 1%, the demand for butter goes up around 0.0357%.

We'll answer part b of the practice problem on the next page.

Elasticity Practice Problem: Part B Explained

b. Calculate the income elasticity of demand for butter at the equilibrium.

We know that: M = 20 (in thousands) Py = 2 Px = 14 Q = 14000 Q = 20000 - 500*Px + 25*M + 250*Py After reading  using calculus to calculate income elasticity of demand , we see that (using M for income rather than I as in the original article), we can calculate any elasticity by the formula:

In the case of income elasticity of demand, we are interested in the elasticity of quantity demand with respect to income. Thus we can use the following equation:

Price Elasticity of Income: = (dQ / dM)*(M/Q)

In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side is some function of income. That is the case in our demand equation of Q = 20000 - 500*Px + 25*M + 250*Py. Thus we differentiate with respect to M and get:

dQ/dM = 25

So we substitute dQ/dM = 25 and Q = 20000 - 500*Px + 25*M + 250*Py into our price elasticity of income equation:

Income elasticity of demand : = (dQ / dM)*(M/Q) Income elasticity of demand: = (25)*(20/14000) Income elasticity of demand: = 0.0357 Thus our income elasticity of demand is 0.0357. Since it is greater than 0, we say that goods are substitutes.

Next, we'll answer part c of the practice problem on the last page.

Elasticity Practice Problem: Part C Explained

We know that: M = 20 (in thousands) Py = 2 Px = 14 Q = 14000 Q = 20000 - 500*Px + 25*M + 250*Py Once again, from reading  using calculus to calculate price elasticity of demand , we know that we can calculate any elasticity by the formula:

In the case of price elasticity of demand, we are interested in the elasticity of quantity demand with respect to price. Thus we can use the following equation:

Price elasticity of demand: = (dQ / dPx)*(Px/Q)

Once again, in order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side is some function of price. That is still the case in our demand equation of 20000 - 500*Px + 25*M + 250*Py. Thus we differentiate with respect to P and get:

dQ/dPx = -500

So we substitute dQ/dP = -500, Px=14, and Q = 20000 - 500*Px + 25*M + 250*Py into our price elasticity of demand equation:

Price elasticity of demand: = (dQ / dPx)*(Px/Q) Price elasticity of demand: = (-500)*(14/20000 - 500*Px + 25*M + 250*Py) Price elasticity of demand: = (-500*14)/14000 Price elasticity of demand: = (-7000)/14000 Price elasticity of demand: = -0.5

Thus our price elasticity of demand is -0.5.

Since it is less than 1 in absolute terms, we say that demand is price inelastic, which means that consumers are not very sensitive to price changes, so a price hike will lead to increased revenue for the industry.

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• Using Calculus to Calculate Elasticities
• Determining Price Elasticity
• A Primer on Arc Elasticity
• Income Elasticity of Demand
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• How Slope and Elasticity of a Demand Curve Are Related
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• 10 Supply and Demand Practice Questions
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Essay: Elasticity of demand

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The economic concept that is being displayed in this article is (Elasticity of Demand). Elasticity of demand is the responsiveness of demand to a change in the price of a good or service. To determine whether this is a inelastic or elastic demand we need to analyse the characteristics of each type of demand.

Elastic good or service will tend to have a large variety of substitutes meaning that when the price of increases the consumer has many substitutes to change to. Most of the time elastic goods or services are luxury good and a large proportion of the consumer’s income is spend on it. When measuring the elasticity of demand the equation that is utilised is: % change in quantity demanded divided by % change in price. Hence when the coefficient is greater than one then we can identify it is an elastic good.

On the AD/AS curve this could be graphed as a very flat demand curve becoming flatter the more elastic it gets up to the point where the demand curve is horizontal which indicates perfectly elastic demand. Another characteristic of elastic demand is that it is not a habit forming good or service which means that the consumer will not get addicted to it or be in need of it allowing them to respond comprehensively to a change in price.

A further concept of PED is price discrimination, which is the “microeconomic pricing strategy where the consumers are being charged different prices for the same god or service.” Businesses are able to discriminate inelastic goods and services as they know for sure that the consumers will be obligated to continue purchasing it. This discrimination often takes place on different days of the week (e.g petrol, airfares) or different times of the day (e.g Bus fares). Looking at petrol we can see that the prices are at their lowest on Tuesday and Saturday. As its regional fuel tax, different regions will have deferred tax rates which can also be considered price discrimination.

This graph gives us a scenario in which relatively flat demand curve represents an elastic demand change. There is a relatively small increase in prices (20%), which resulted in a large decrease (30%) in quantity demanded. This would have occured due to a high number of substitutes to switch to. The proportionate change in quantity demanded is greater than the proportionate change in price, hence portraying how responsive elastic demand is.

Inelastic goods or services are tend to have a small to no number of substitutes in a monopolistic market and are necessities. Since it is a necessity consumers will have no choice but to continue purchasing. A small proportion of the consumer’s income is spent on inelastic goods or services and when being calculated with the formula above, the coefficient will be less than one resulting in a very steep demand curve up to the point where it is vertical meaning it is perfectly inelastic. Another characteristic of inelastic demand is that it is very habit forming, meaning that the consumer of these goods and services will often get addicted to them eg. Alcohol, Drugs etc. Although petrol is not addicting, it is still habit forming as we rely on it to drive to work, school or elsewhere and without it we wouldn’t be able to continue doing so. In addition to this the government will in most cases enforce a tax on inelastic products as the majority of the tax will fall down on the consumer rather than the producer.

This graph indicates that the demand is inelastic. This can be seen through its steep gradient and how a large increase in price (30%), resulted in almost no change in demand (10%). This means that there was no choice but to continue purchasing this good or service. The proportionate change in price is larger than the proportionate change in quantity demand which is due to the unresponsive nature of inelastic demand.

MR= Marginal Revenue

AR= Average Revenue

In this case the product is fuel for motor vehicles that leaves consumers unsatisfied with petrol stations across New Zealand. The prices of petrol have increased by 5% in the year ended march 2018 according to Stats Govt NZ and people have been seeking ways to reduce their petrol consumption ever since. This indicates that the elevated prices are clearly causing the demand of the consumers to diminish. It is likely that the government will be enforcing the tax of petrol as it is considered a inelastic good and the majority of the the the tax will be passed on to the consumer since they are more or less forced to continue purchasing the product. When the prices of crude oil elevate, the petrol companies tend to increase the prices very quickly. They are able to do so as a result of their product (petrol) being inelastic forcing the consumer to buy it. This rapid increase in petrol prices is so that a maximum amount of profit can be made on the petrol companies side. This is emphasised in the scenario where the petrol prices need to be decreased to gain an advantage over a competing petrol station. This change will take place in very small steps as the firm is trying to still get the most money out of it as possible rather than instantly lowering their prices to a certain amount and missing out on the money they could have made if slowly dropping the prices.

The two major events that resulted in the increase of fuel prices are:

The increase in GST to 15% on the 1st of October 2010 added 4 cents to the original prices of fuel.

The introduction of regional fuel tax in Auckland on the 1st of July 2018 which caused the price of petrol and diesel to elevate by 10 cents per litre.

In order to get a realistic understanding of the change of the fuel prices we will have to look at the changes that have been occuring.

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Calculating the elasticity of demand practice questions.

Principles of Economics Microeconomics

Introduction

Supply, demand, and equilibrium, elasticity and its applications, taxes and subsidies, the price system, price ceilings and price floors, externalities, costs and profit maximization under competition, competition and the invisible hand, price discrimination, labor markets, public goods and the tragedy of the commons, asymmetric information, consumer choice, bonus topics.

Macroeconomics: Price Elasticity of Demand Essay

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Price elasticity of demand is a good area in economics that needs to be understood in order to understand the changes that happen on our markets. It also ensures that good decisions are made.

Price elasticity of demand refers to the “…responsiveness of changes in the quantity of goods and services demanded in relation to the changes in their prices” (Schumpeter & Elizabeth, 1994, p.44). According of Perloff (2008), “The four factors, which influence the price elasticity of demand, include the availability of substitutes, specific nature of the goods available on the market, part of income spent on the goods and the time when the consumers buy particular goods and services” (p.21).

Last month I purchased a pair of leather shoes from a shoe-shop in town, which I believe that the demand of the shoe played a key role in setting up of the price.

The four factors aforementioned may have contributed to the price elasticity of demand of the pair of leather shoe I bought. For instance, the availability of substitutes played a key role in the pricing of the shoes.

The kind of the shoe I bought was a new design that was new in the market, durable and of its own kind. Demand of the shoes was high leading to increase in price. Although other shoes substitutes were available in the markets, the new shoe design was more appealing compared to other types of shoes hence increasing its elasticity.

Nature of the shoes was unique. They were durable and comfortable, which made its elasticity high. As a result, many people or consumers preferred the shoes irrespective of the price changes due to its advantages compared to its disadvantages. Therefore, its nature also led to the increase in demand elasticity hence increase in its price.

Because of the great desire and need to purchase the shoes, the price was a bit high because of the high demand; hence, I spent a considerable amount of my income in purchasing the shoes. The demand did not change to a higher magnitude regardless of the fact that the prices had increased significantly.

Time is also a crucial consideration when it comes to price elasticity in relation to demand of a product (Schumpeter & Elizabeth, 1994, p.34). During the month when I bought the shoes, the rate of economic growth was high and the income of the people was slightly high.

This therefore necessitated spending, hence leading to a hike in prices. Therefore, the time of purchasing the shoes also played a key role in increasing the prices of the shoes. At that time, the shoes were in high demand due to the changes in weather; those shoes were the best option in dealing with such climate.

Hence, the time the consumers’ buy certain products should be of concern in order to weigh the right prices of certain commodity. Therefore, the shoes I bought at that time can be considered as inelastic. This follows in the sense that changes in price had a relatively slight effect or impact on the demand of the shoes. The consumers will buy the shoes irrespective of the changes in prices.

In duration of a month, various aspects have changed and therefore, the current supply has reduced since the current demand reduced drastically. The reduction in demand is attributed to changes in weather, introduction of new designs going at relatively cheaper price than the design I bought, changes in income among other reasons have lead to these shifts. People will always want to buy new fashions and therefore, in the last one month various changes has been seen which shifted the earlier status.

Perloff, J. (2008). Microeconomic Theory & Applications with Calculus . New York: Pearson Press.

Schumpeter, J., & Elizabeth, B. (1994). History of economic analysis . London: Routledge.

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1. IvyPanda . "Macroeconomics: Price Elasticity of Demand ." June 6, 2018. https://ivypanda.com/essays/macroeconomics-2/.

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IvyPanda . "Macroeconomics: Price Elasticity of Demand ." June 6, 2018. https://ivypanda.com/essays/macroeconomics-2/.

Questions on elasticity

• Define price elasticity of demand (PED).
• Give the equation for PED.

Questions 3-7 require you to work out the PED for each case (to the nearest decimal point).

• The price of a brand of smartphone today is £600, and the quantity demanded is 4m. Next year the price falls to £570 and the quantity demanded rises to 6m.
• The price of pens today is £1, and the quantity demanded is 1m. Next year the price rises to £1.10 and the quantity demanded falls to 950,000.
• TThe price of the Financial Times newspaper today is £3.00p, and the quantity demanded is 2m. Next year the price falls by 25p and the quantity demanded rises to 2.2m.
• Football boots are priced at £80 a pair, and currently 200,000 pairs are sold each year. The price falls to £75, and demand increases to 250,000 per year.
• Train journeys between two major cities currently cost £35, and daily demand is 10,000. Following a price rise to £45 demand falls to 9,500.
• Identify four determinants of PED.
• Explain how PED varies down a linear demand curve.
• What is meant by 'perfectly elastic' and 'perfectly inelastic' demand?
• Explain the connection between PED and a firm's total revenue (TR).
• What is the shape of a demand curve that has 'unit' elasticity over its whole length?

• In the above example, what is the PED for a price increase from £30 to £40? (In all calculations, give the answer to 2 decimal places).
• In the above example, what is the PED value for a price reduction from £70 to £60?
• Define price elasticity of supply (PES).
• Give the equation for PES.
• Identify three determinants of PES.
• What is meant by 'perfectly elastic' and 'perfectly inelastic' supply?
• Using the above schedule, calculate PES over the price range £40 to £50.
• Using the above schedule, calculate PES over the price range £60 to £70.
• Draw sketch graphs to show a perfectly elastic and perfectly inelastic supply curve.

Check your progress

10 questions on elasticity. Submit one at a time. Result at end.

Economics Model Essay 1

This question will be discussed in economics tuition in the fifth week of term 1..

(a) Distinguish between the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand. [10] (b) Discuss the usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product. [15]

Introduction

(a) The elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded or the demand to a change in a determinant of demand, ceteris paribus. There are three concepts of elasticity of demand each relating to one of the determinants of demand: price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED).

Definitions and Formulas

There are different definitions and formulas for PED, YED and XED. The PED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. Mathematically, it can be expressed as

           % Δ Quantity Demanded PED = ————————————- % Δ Price

The YED for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus. Mathematically, it can be expressed as

         % Δ Demand YED = ———————– % Δ Income

The XED for a good with respect to another good is a measure of the degree of responsiveness of the demand for the first good to a change in the price of the second good, ceteris paribus. Suppose that the two goods are good A and good B. Mathematically, it can be expressed as

         % Δ Demand for Good A XED AB = ————————————– % Δ Price of Good B

Interpretation of the Values of PED, YED and XED

There are different implications of the values of PED, YED and XED. The PED for a good is negative due to the law of demand and the common practice among economists is to drop the negative sign. If the PED for a good is greater than one, such as in the case of private cars, the demand is price elastic, which means that a change in the price will lead to a larger percentage change in the quantity demanded. If the PED for a good is less than one, such as in the case of food, the demand is price inelastic, which means that a change in the price will lead to a smaller percentage change in the quantity demanded. In the case of PED, economists are concerned with whether the value is greater or less than one. However, in the case of XED, they look at whether the value is positive or negative. If the XED AB is positive, such as in the case of Coke and Pepsi, good A and good B are substitutes, which means that the two goods are consumed in place of one another. If the XED AB is negative, such as in the case of cars and petrol, good A and good B are complements, which means that the two goods are consumed in conjunction with one another. While XED distinguishes between substitutes and complements, YED distinguishes between normal goods and inferior goods. If the YED for a good is positive, such as in the case of clothing, the demand will rise when consumers’ income rises and goods of this nature are known as normal goods. A normal good with a YED greater than one is known as a luxury and a normal good with a YED less than one is known as a necessity. If the YED for a good is negative, such as in the case of public transport, the demand will fall when consumers’ income rises and goods of this nature are known as inferior goods.

Determinants of PED, YED and XED

There are different determinants of PED, YED and XED. The PED for a good will be higher the larger the number of substitutes, the closer the substitutes, the lower the degree of necessity, the larger the proportion of income spent on the good and the longer the time period under consideration. For example, the demand for a brand of smartphones is likely to be price elastic due to the large number of substitutes, the demand for oil is price inelastic due to the high degree of necessity and lack of close substitutes and the demand for private cars is likely to be price elastic due to the large proportion of income spent on the goods as they are generally expensive. The YED for a good will be higher the more luxurious the good and the lower the level of income. For example, the YED for high-end private cars is higher than those for mid-range and low-end private cars as high-end private cars are more luxurious than mid-range and low-end private cars, and the YED for private cars in the Philippines is higher than that in Singapore as the level of income in the Philippines is lower than that in Singapore. The XED for two goods will be higher the more closely they are related. For example, the XED for Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer substitutes than coffee and tea are.

In conclusion, PED, YED and XED differ in terms of their definitions, formulas, determinants and the implications of their values.

(b) The usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product can be discussed in terms of how they can aid the firm in making pricing and capacity decisions with reference to price elasticity of demand, cross elasticity of demand and income elasticity of demand. Assume that the fashionable product is smartphones.

Usefulness of the Concept of PED

The concept of PED allows a firm that produces smartphones to determine how to change the price to increase the total revenue. The demand for smartphones produced by a firm is likely to be price elastic due to the large number of substitute brands in the market such as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc. Therefore, the firm can decrease the price to increase the total revenue as the quantity demanded will rise by a larger percentage.

In the above diagram, the initial total revenue is area A plus area B and the new total revenue is area B plus area C. Area C is the gain in revenue resulting from the increase in the quantity demanded (Q) from Q 0 to Q 1 and area A is the loss in revenue resulting from the fall in the price (P) from P 0 to P 1 . Since area C is greater than area A, the gain in revenue exceeds the loss and hence the total revenue rises. However, if the firm has no or little excess capacity or if rival firms follow suit in order to avoid losing sales to the first firm, a fall in its price may not lead to an increase in its total revenue. Although the demand for smartphones produced by a firm is likely to be price elastic, it may be price inelastic because the smartphones may have some special features that are not found on other smartphones. For example, Apple’s smartphones have voice recognition and fingerprint-password authentication features which many other smartphones do not include. In this case, the firm can increase the price to increase the total revenue as the quantity demanded will fall by a smaller percentage.

In the above diagram, the initial total revenue is area B plus area C and the new total revenue is area A plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P 0 to P 1 and area C is the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q 0 to Q 1 . Since area A is greater than area C, the gain in revenue exceeds the loss and hence the total revenue rises. However, if the firm also sells a complementary good, such as applications for the smartphones, due to the negative XED for complements, a rise in the price of its smartphones will decrease its revenue from the sale of the applications which may lead to a decrease in its total revenue. For example, in addition to smartphones, Apple Corporation also sells applications for its smartphones.

Usefulness of the Concept of XED

The concept of XED also allows a firm that produces smartphones to determine how a change in price by a rival firm will affect the demand for its good. If a rival firm decreases its price, the demand for the smartphones produced by the first firm will fall due to the positive XED for substitutes. To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead to a price war, the firm may consider engaging in non-price competition such as product promotion and product development instead of decreasing its price. If a rival firm increases its price, the demand for the smartphones produced by the first firm will increase if it keeps its price constant. However, the firm may not experience an increase in sales if it has no or little excess capacity.

Usefulness of the Concept of YED

The concept of YED allows a firm that produces smartphones to determine the future size of the market for its good and hence its production capacity. The YED for smartphones is positive which means that they are a normal good. Therefore, if a firm that produces smartphones predicts an economic expansion which is a period of time during which national output and hence national income is rising, it should increase its production capacity in order to be able to meet the higher demand when the economic expansion comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence the larger the extent the firm should increase its production capacity. Conversely, if the firm predicts an economic contraction which is a period of time during which national output and hence national income is falling, it should decrease its production capacity to minimise excess capacity when the economic contraction comes.

Limitations of the Concepts of Elasticity of Demand

The concepts of elasticity of demand may not be useful to a firm that produces smartphones as they are subject to several limitations. The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from past records may no longer be relevant to calculating elasticities of demand as some of the determinants of demand may have changed. Although data from current market surveys are relevant to calculating elasticities of demand, they may not be reliable as the respondents may not be truthful in their responses. Furthermore, if the sample sizes of the market surveys are small, the results may not be reliable as they may not be reflective of the actual markets for the goods. The assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold in reality. In reality, many factors such as the level of income, the price of the good and the prices of related goods are changing simultaneously. Although PED may be useful for increasing total revenue, this is not true for increasing profit due to the omission of total cost. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, if total cost rises by a larger extent, profit will fall. PED and XED do not take production capacity into consideration. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, total revenue will not rise if there is no excess capacity to increase production.

In the final analysis, for a firm that produces a fashionable product such as smartphones, PED is likely to be more useful than YED and XED for making business decisions. This is because although PED can be useful for making proactive business decisions which is of great importance in the business world, YED and XED can only be useful for making reactive business decisions. In other words, unlike the use of PED which does not have a precondition, the use of YED and XED requires a change in consumers’ income and the price of a related good respectively. However, if the firm also sells a complementary good such as applications for the smartphones, XED can also be useful for making proactive business decisions which has been explained earlier. Although PED can be more useful than YED and XED to a firm that produces a fashionable product such as smartphones for making business decisions, its usefulness depends on several factors such as the objective of the firm. For example, if a firm wants to increase sales revenue as it is the key performance indicator of the management, PED is likely to be useful. However, if a firm is a new entrant in the market, it may want to increase market share to compete with the incumbent firms. In this case, PED is likely to be of limited use to the firm. For example, when StarHub entered the telecommunications market in Singapore in 2000, its initial objective was to induce mobile phone users to switch service providers so that it could capture sufficient market share to compete with SingTel and M1.

The question will be discussed in greater detail in economics tuition by the Principal Economics Tutor .

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