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20 Elasticity |
Elasticity
Explain the concept of elasticity. Elasticity is measure of the extent to which one variable
re...
| Elasticity 21
What factors determines own price elasticity of demand? Main determinants include:
 Availability and clos...
22 Elasticity |
Income elasticity of demand
Define income elasticity of demand (YED). YED measures the extent to which of ...
| Elasticity 23
Price elasticity of supply
Define price elasticity of supply (PES). The responsiveness of supply to a chan...
24 Elasticity |
Cross elasticity of demand
Define cross elasticity of demand (XED). XED measures responsiveness of demand ...
| Elasticity 25
Business Use of Elasticity
How can firms make use of elasticity estimates? Elasticity estimates predict ho...
26 Elasticity |
area of loss. However, if price elasticity of demand is elastic, the gain effect of selling more units
out...
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EdExcel Micro Economics Unit 1 Slide 1 EdExcel Micro Economics Unit 1 Slide 2 EdExcel Micro Economics Unit 1 Slide 3 EdExcel Micro Economics Unit 1 Slide 4 EdExcel Micro Economics Unit 1 Slide 5 EdExcel Micro Economics Unit 1 Slide 6 EdExcel Micro Economics Unit 1 Slide 7
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EdExcel Micro Economics Unit 1

  1. 1. 20 Elasticity | Elasticity Explain the concept of elasticity. Elasticity is measure of the extent to which one variable responds to a change in a second variable. For instance a variable such as demand can be either sensitive to a change in price (price elastic) or unresponsive (price inelastic) Why is elasticity important? Elasticity estimates predict how consumers and producers are likely to respond to a change in market conditions. Accurate elasticity data helps a firm estimate the likely impact of, say, a price rise on demand for the product and for substitutes List the main types of elasticity. Type of elasticity Price elasticity of demand The responsive of demand to a change in its own price Income elasticity of demand The responsive of demand to a change in income Price elasticity of supply The responsive of supply to a change in its own price Cross elasticity of demand The responsive of demand for one product to a change in the price of another item What is an elasticity value? An elasticity estimate has a number value eg -0.5. 0, +2, etc. An elasticity value greater than 1 means a variable such as demand is elastic ie responsive Price elasticity of demand Define price elasticity of demand (PED). The responsiveness of demand to a change in the price of the product. How are price and quantity changes compared? Price is measured using £s; quantity in units sold. Comparisons is made possible by contrasting the percentage in price and amount How is PED calculated? Like all elasticity values, PED is a number. PED is estimated by dividing the percentage change in demand by the percentage change in price, using the equation: PED = percentage change in demand/ percentage change in price, ie PED= %ΔQd/ %ΔP. Eg if a 10% fall in price results in a 5% increase in quantity demanded, PED = 5%/10% = -0.5 How are percentage changes in a variable calculated? To calculate a percentage change (%Δ) in one variable (A), use the equation: %ΔA = (new A – old A) / old A x 100 where A is a variable such as price or quantity demanded. Give a worked example of calculating PED. Suppose a price fall from £15 to £10 results in an increase in quantity demanded from 20 to 45  %ΔP = (new P – old P) / old P x 100 = (10-15)/15 x 100 = -5/15 x 100 = -33%  %ΔQ = (new Q – old Q) / old Q x 100 = (45-20)/20 x 100 = 25/20 x 100 = 125%  PED = % change in quantity demanded / % change in price = 125%/33% = -3.8 What is the range of PED estimates? PED can lie between zero and infinity. If PED is less than 1, demand is price inelastic ie quantity demanded is unresponsive to price changes. If PED is greater than 1, demand is price elastic ie quantity demanded is responsive to a price change. Why do PED estimates usually minus values? Price and quantity demanded are almost always inversely related: they move in opposite directions. This means PED is a negative value What does the phrase demand is price elastic mean? Demand is price sensitive ie responsive to a change in price. This means a given change in price brings about a greater percentage change in demand. Eg a 10% fall in price results in a 20% increase in demand. PED is -2. What does the phrase demand is price inelastic mean? Demand is price insensitive ie unresponsive to a change in price. A given change in price brings about a smaller percentage change in demand. Eg a 10% price rise results in only a 4% fall in demand. PED is -0.4.
  2. 2. | Elasticity 21 What factors determines own price elasticity of demand? Main determinants include:  Availability and closeness of substitutes. The greater the number of alternative products, the easier it is for consumers to switch if prices change. Demand becomes price elastic  Definition of the market. The narrower the definition of a product eg sliced white bread, the greater the number of substitutes eg unsliced white bread. This means the demand for sliced white bread is more price elastic than the demand for all types of bread  Proportion of income spent on a good. Usually the smaller the proportion of income taken up purchasing the good or service the more price elastic demand  Habit forming products such as cigarettes and drugs are price inelastic in demand.  Consumers take time to adjust to price changes. This means PED becomes more price elastic in the long run as consumers have time to find and switch products. How can PED affect a demand curve? The gradient (slope) of a demand curve generally reflects its PED: A product with perfect substitutes PED = ∞ at all points on the curve A product with no substitutes PED = 0 at all points on the curve Special case: PED is -1 at all points on the curve Demand is perfectly price elastic at all points on the curve D1; perfectly price inelastic at all points on the curve D2; and always unitary (1) on D3 Demand is mainly own price elastic on most points on the curve D4 and price inelastic at most points on the curve D5 A product with many close and available substitutes PED<1 at almost all points on the curve As price rises quantity demanded normally becomes more elastic A product with few close and available substitutes PED>1 at almost all points on the curve Is PED constant along all a straight-line demand curve?  Yes: perfectly price elastic (D1), perfectly price inelastic (D2) and unit elastic D3  No: for relatively price elastic (D4) or relatively price inelastic demand curves (D5) in the above diagrams. PED becomes more price inelastic as you move down a demand curve Quantity (Qd) price(P) D1 Perfectly price elastic demand curve Quantity (Qd) price(P) D2 Perfectly price inelastic demand curve Quantity (Qd) price(P) D3 Unit price elastic demand curve Quantity (Qd) price(P) D4 Relatively price elastic demand curve Quantity (Qd) price(P) D5 Relatively price inelastic demand curve
  3. 3. 22 Elasticity | Income elasticity of demand Define income elasticity of demand (YED). YED measures the extent to which of demand for a product responds to a change in income. How is YED calculated? The YED estimate is found by dividing the percentage change in demand by the percentage change in income, using the equation: YED = % change in demand / % change in income. Eg if a 10% rise in income results in a 8% increase in demand YED = 8%/10% = 0.8 Give a worked example of calculating YED. Suppose an increase in income from £105 to £125 results in an increase in demand of Good X from 75 to 110  %ΔY = (new Y – old Y) / old Y x 100 = (125-105)/105 x 100 = 20/105 x 100 = 19%  %ΔQ = (new Q – old Q) / old Q x 100 = (110-75)/75 x 100 = 35/75 x 100 = 47% YED for Good X = percentage change in demand of good X / percentage change in income = 47%/19% = 2.5. Demand is income elastic. What does a positive YED value means? Income and demand are positively related. A rise in income results in a rise in demand. Items with a positive YED value are called normal goods. Explain the term income elastic. Income elastic products have a YED estimate greater than 1. A change in income leads to a proportionately bigger increase in demand eg if YED = 2 a 10% rise in income leads to 20% rise in demand Explain the term income inelastic. Income elastic products have a YED estimate less than 1. A change in income leads to a proportionately smaller increase in demand eg if YED = 0.2 a 10% rise in income leads to 2% rise in demand Explain the term normal good. A normal good is a product with have a positive YED estimate. Consumers use an increase in income to buy more of the good. Can YED have a negative value? Inferior goods have a negative YED and are only bought because consumers cannot afford normal goods. For instance some consumers use an increase in income results to switch from an inferior good (eg spam) to a normal good (eg meat). What is the range of YED values? If YED is positive, the product is a normal good.  If YED is positive but less than 1, demand is income inelastic. A change in income results in a proportionately smaller change in demand – a characteristic of necessities eg bread  If YED is positive and greater than 1, demand is income elastic. A change in income results in a proportionately larger change in demand. This is the characteristic of luxury goods eg cars  If YED is negative, an increase income leads to fall in demand. The item is an inferior good What is a superior good? If YED is positive and greater than one, then the good is a luxury item. Consumers use a given increase in income to buy proportionally more of the product. How do incomes change over time? Overtime economies enjoy economic growth. Economic growth increases income as households earn more from creating extra output. How does the economic cycle affect income? Many economies experience an economic cycle. A boom means output and income is growing, while output and income fall in a recession. How does a recession affect demand? A recession means falling output and incomes. The impact on demand for particular products depends on their YED. The higher the YED estimate the greater the volatility of sales during an economic cycle.
  4. 4. | Elasticity 23 Price elasticity of supply Define price elasticity of supply (PES). The responsiveness of supply to a change in the price of the product. How is PES calculated? PES is a numerical estimate. The PES value is found by dividing the percentage change in quantity supplied by the percentage change in price, using the equation: PES = percentage change in quantity supplied / percentage change in price Eg if a 10% fall in price results in a 2% decrease in quantity supplied, then PES = 2%/10% = 0.2. What is the range of PES estimates? PES can lie between zero and infinity. If PES is less than 1 then supply is price inelastic ie quantity supplied is unresponsive to price changes. If PES is greater than 1, then supply is price elastic ie quantity supplied is responsive to a price change. Price and quantity supplied are directly related which means they move in the same direction. This means PES has a positive value What factors determines price elasticity of supply? The following factors affect the ability of firms to adjust output in response to a change in price:  Manufacturing lead time: the amount of time take to make an item varies between industries. Eg the time lags in agriculture can be a year before extra field yield crops  Availability of stocks: Stocks are stored components, and goods held ready for future use or sale. Non-perishable goods can be added to stock following a price fall. Firms with large of stocks of finished products can respond quickly to a price increase. As services cannot be stored their price elasticity of supply is perfectly price inelastic  Availability of resources: supply is price elastic if staff are willing to work overtime or if currently idle machines are bought into use.  Capacity: Firms operating at capacity can only increase output by investing in new equipment and hiring extra staff thus making PES inelastic  Time period: firms take time to adjust production to price changes. PES becomes more price elastic in the long run as producers have time to hire staff, install new capital etc How can PES affect the slope of a supply curve? The slope of a supply curve reflects its PES. Supply is always perfectly price elastic at all points on the curve S1 and perfectly price inelastic at all points on the curve S2 Always unit PES for any straight line supply curve passing through the origin eg S3 or S4 Relatively elastic at all points on any linear supply curve intersecting the y axis eg S5 and relatively inelastic at all points on any linear supply curve cutting the x axis eg S6 Quantity price(P) S1 Perfectly price elastic supply curve supply curve Perfectly price inelastic supply curve Quantity price(P) S2 Quantity price(P) S3 Unit price elastic supply curves S4 Quantity price(P) S5 Relatively price elastic supply curve Quantity price(P) S6 Relatively price inelastic supply curve
  5. 5. 24 Elasticity | Cross elasticity of demand Define cross elasticity of demand (XED). XED measures responsiveness of demand for one product to a change in the price of another product. This means XED measures the strength of relationship between two different products How is XED calculated? XED is a numerical estimate. The XED value is found by dividing the percentage change in quantity demanded of one product (A) by the percentage change in price of a second product (B), using the equation: XED = percentage change in quantity demanded for good A / percentage change in price of good B. Eg if a 10% rise in price of good B results in a 5% rise in demand for good A, then XED = 5%/-10% = 0.5 What does XED = +1.2 mean? The positive sign means the two goods are substitutes. 1.2 means the demand for this product is responsive to a change in the price of the other item. The two items are strong substitutes What does XED = -0.8 mean? The negative sign means the two goods are complements. 0.8 means the demand for this product is unresponsive to a change in the price of the other item. The two items are weak complements What does XED=0 mean? A change in the price of one item has no effect of the demand for the second product because they are not substitutes or complements. They are independent goods What is the range of XED estimates? XED estimates can be positive negative or zero XED value Relationship between products A and B a 10% rise in the price of this product causes a proportionately Positive and greater than one eg +2 Strong substitutes: demand is responsive to a price change larger rise in demand for a substitute product eg 20%. XED = 20%/10% = +2 Positive and less than one eg 0.5 Weak substitutes: demand is unresponsive to a price change smaller rise in demand for a substitute product eg 5%. XED = 5%/10% = +0.5 Zero Independent goods no change in demand for the other item Negative and less than one eg -0.8 Weak complements: demand is unresponsive to a price change smaller fall in demand for a complement product eg 8%. XED = -8%/10% = -0.8 Negative and greater than one eg -1.5 Strong complements: demand is responsive to a price change Larger rise in demand for a complement product eg 20%. XED = -15%/10% = -1.5
  6. 6. | Elasticity 25 Business Use of Elasticity How can firms make use of elasticity estimates? Elasticity estimates predict how consumers and producers are likely to respond to a change in market conditions. This means elasticities are a useful tool in decision making. What is decision making? Decision making is the process of selecting a course of action between several alternatives. For instance whether or not to cut price to increase revenue Why does decision making necessarily involve uncertainty? Decisions are taken on the basis of available data and assumptions about the future. Incomplete or inaccurate data, faulty assumptions, or unexpected future events, eg economic downturn or a new competitor, means there is a risk a decision may not work out as expected or have unintended consequences. How can risk and uncertainty be reduced? Research, planning and the use of decision making tools such as elasticity forecasts can reduce but not eliminate risk and uncertainty. How do firms estimate elasticities? Firms use market research to gather the data needed to measure the response of consumers and producers to changes in market conditions. Eg  Undertake a survey of a representative sample of the population to ask how they might respond to a change in price of this product or a substitute.  Interrogate secondary data to identify price demand relationships or data on elasticity estimates published by government agencies or universities Are elasticity estimates reliable? Elasticity values are estimates and treated with caution. Sampling errors can make market research findings biased and unrepresentative. Past data trends may not be hold true over time. Eg consumer buying patterns change with fashion and the state of the economy How can firms make use of PED? Firms can use PED estimates to predict the impact of a price change on 1) quantity demanded and 2) total revenue Give an example of PED used to predict sales. If a shop estimates the PED for cake is 1.5 it can predict that it needs to increase output by 15% if it runs a 10% price reduction special offer What is total revenue? The total amount a firm receives from selling a given level of output How is total revenue calculated? Total revenue (TR) is found by multiplying price (P) by the number of units sold (Q). TR = P x Q. Eg selling 50 items at £4 each generates £200 of TR How are total revenue and price linked? Price and quantity demanded are inversely related. A change in price has an uncertain effect on total revenue. A fall in price means each item is sold at a lower price, reducing revenue. But more items are sold which acts to raise revenue. The overall impact of a price change depends on which effect is bigger How does PED affect revenue? The impact of a price change on revenue depends on PED. When PED is elastic, price and revenue move in opposite directions. When PED is inelastic price and revenue move in the same direction. P1 and Q1 are the initial equilibrium market price and quantity traded. Initial revenue = P1 x Q1. Assume a price fall from P1 to P2. There are two impacts on revenue:  more units are being sold: (Q2-Q1) at the lower price of P2, the shaded area of gain  at a lower price: Q1 units are being sold at for (P1 –P2) less, the shaded area of loss Total revenue falls as the area of gain is smaller than the
  7. 7. 26 Elasticity | area of loss. However, if price elasticity of demand is elastic, the gain effect of selling more units outweighs the loss effect of selling at a lower price. Give an example of how businesses use PED in pricing decisions. Some businesses like train operating companies or electricity suppliers charge different prices in peak and off peak markets to maximise total revenue. Given few close, available substitutes the demand for peak time use is price inelastic. Revenue is increased by raising price. Where off peak demand is price elastic, price cuts increase total revenue. How can the government make use of PED? Governments raise revenue through indirect taxes on spending eg VAT and duties on tobacco and petrol. Taxing relatively price inelastic, luxury or harmful products, raises price but has a minimal impact on quantity demanded. How do businesses make use of YED? YED helps firms predict the effect of economic growth or the economic cycle on sales.  Upturn. Assume predicted growth means a 10% rise in incomes over the next year. Firms producing superior goods experience a proportionately larger increase in demand eg if YED is 2, the 10% increase in growth and income results in a 20% increase in demand.  Recession Firms producing necessities with a low YED are less exposed to a slowdown in the economy eg if YED for product is 0.3, a 10% fall in growth and income results in just a 3% fall in demand. Does the economic cycle affect all firms equally? Superior products with high YED experience greater sales volatility over the economic cycle than necessities. Inferior products see a rise in sales during a recession as some consumers can no longer afford normal items. How does YED affect government spending? Public services such as health and education have high positive YEDs. As incomes rise over time, the demand for better health and education rises by a larger percentage putting increased pressure on government to raise its spending. Gove examples of how a business can use of XED estimates in pricing decisions?  Firms can use (XED) estimates to predict the impact of pricing strategies on demand for substitute products made by rivals. If XED is high and positive eg +3 then a 10% price cut sees a 30% fall in demand for rival’s product. However raising prices leads to a significant loss of sales to rivals – assuming they do not match the price increase  Pricing strategies for complements that maximise revenue. For example, popcorn and cinema tickets have a high negative XED value – they are strong complements. Popcorn has a very high mark-up ie popcorn costs pennies to make but sells for pounds. If firms have a reliable estimate for XED they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The additional profit from extra popcorn sales may more than compensate for the lower cost of cinema entry.
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