Econ HL- Elasticities Notes

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08 Fall

Topic 1.2: Elasticity Instructor:

Reagan Chan

Sub-‐topics:

1. PED

2. XED

3. YED

4. PES

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Price elasticity of demand Definition: The responsiveness of quantity demanded to a change in price PED= % change in quantity/ % change in price Note to teacher: Explain to the student that they can think of PED as the percent change in quantity demand per percent change in price. For example, if PED=2, it means that for every percent change in price there is 2 percent change in quantity demanded. If PED=0.2, it means that every percent change in price lead to 0.5 percent change in quantity demand Note to teacher: PED is always expressed as a positive value. However, it is always the case that there is an inverse relationship between quantity demanded and price

PED value Terminology Given a change in P PED>1 Price elastic Greater % change in Qd 0<PED<1 Price inelastic Smaller % change in Qd PED=1 Unitary elastic Equal % change in Qd PED -> infinity Perfect elastic No change in P is possible PED=0 Perfectly inelastic No change in Qd

Numerical example Find the PED P1= 24 Q1=2000 P2=28 Q2=1300

Note to teacher: Step 1: calculate percent change in Qd by using “new minus old divided by old” Step 2: calculate percent change in price by using “new minus old divided by old” Step 3: Divide


PED and total revenues • PED affects how firm can set prices to maximize total revenue

Common exam question on paper 3: Why does PED increase as price increase? Many students believe that PED is constant along a demand curve, but this is not true. As price increases, the percent change in price for any given price change is smaller. As price rises, quantity demanded falls. As quantity demanded falls, the percent change in price for any given price change is bigger. Thus, as price rise, PED rises When PED>1, the producers should lower price to increase total revenue This is because the percentage increase in quantity demanded will exceed the percentage fall in price When PED<1, the producers should raise price to increase total revenue This is because the percentage increase in price will exceed the percentage fall in quantity demanded


Determinants of PED 1. The number and closeness of available substitutes The more substitutes a good has, the more easily below can switch to alternatives when price rises. Thus PED will be higher. For example, cigarettes have low PED while Marlbaro cigarettes only will have high PED. This is because Marlbaro have more substitutes

2. Proportion of income spend on good The higher the proportion of income spent on the good, the more consumers are forced to lower consumption when price increases. In other words, the income effect is stronger, which results in higher PED. For example, Li Ka shing will have a very low PED for all sorts of good because he is so rich

3. Time period considered The longer the time period considered, the more time consumers have to switch consumption patterns, which result in higher PED. For example, after a tax is imposed on cigarettes, in the short run, most smokers will continue to smoke. But in the long run, they will have more time to find substitutes to cigarettes and hence, there will be a greater fall in quantity demanded.

4. The necessity of the product Necessities tend to be price inelastic. For example, water is very price inelastic

5. Addictiveness Addictive goods tend to have low PED. For example, cigarettes are price inelastic


PED Exam question 1 Explain why PED is useful for businesses to maximize total revenue (5 mark) Note: This question is half of a 10 mark question on IB exams. Thus, this question above is worth 5 marks.

- Student needs to draw a diagram to show relationship between total revenue and PED

- Explain how PED is useful for businesses to set prices to maximize total revenue (Same as above)


PED Exam question 2 Explain why PED is low for primary commodities (5 mark) Note: This question is half of a 10 mark question on IB exams. Thus, this question above is worth 5 marks.

• Student must first understand that primary commodities are used to

produce secondary products • The first reason is that primary commodities are neccesities for

manufacturers • The second reason is that it is hard to find substitutes for primary

commodities. This is because all manufactured goods require a very specific type of primary commodity. For example, to make a wooden sofa, there are no substitutes to wood


Cross-price elasticity of demand

Definition: The responsiveness of demand for one good to a change in the price of another good

XED= % change in quantity of good x/% change in Price of good y Note to teacher: Explain to students the table below, instead of just giving them to answer

XED value Terminology Given an increase in Py XED>0 Substitutes Qd of X rise XED<0 Compliments Qd of X falls XED=0 No relationship No change

Diagrams


Real-life applications of XED 1. Allow firms to identify its closest competitors and even indirect competitors * All goods/services that have a positive XED with the goods/services sold by a firm will be the firm’s competitors * This is because positive XED indicates that two goods are substitutes * The higher the XED, the more close substitutes two goods are. Hence, goods and services with high XED to a firm’s goods/services will be its closest competitors * For example Pepsi have a high XED with coke. Hence, Pepsi is a close competitor with Coke * The lower the XED, the less close substitutes two goods are. Hence, goods and services with low XED to a firm’s goods/services will be its distant competitors * For example, textbooks and tutoring will have a low XED. Hence, textbook and tutoring are distant competitors 2. Allow firms to estimate how change prices of one good will affect sales of other goods * If a firm lowers the price of a good, it can expect the sales of substitute product it sells to fall. For example, if Apple lowers price of iPhone, the sales of iPod will fall. This is because the demand of iPod will fall (Opposite for price increase) * If a firm lowers the price of a good, it can expect the sales of complement product it sells to rise. For example, if Apple lowers price of iPhone, the sales of Apple Watch will rise. This is because the demand of Apple watch will rise (Opposite for price increase) 3. Firms can take advantage of complementary relationship between two goods for promotional strategy * When the price of a good fall, the demand and hence the sales of complementary goods will rise. Firms often take advantage of this to increase sales * For example, time square offers parking discount for shoppers who have purchased a certain amount of goods. This parking discount helps to increase the sales of shopping mall * For example, Travel agencies offers air-line ticket discount for travelers who also book hotel rooms. This airline ticket discount helps to increase the sales from hotel room bookings


XED Exam Question 1 Explain what determines whether XED is positive or negative (10 marks) Paragraph 1

- Define Paragraph 2

- Draw a diagram for negative XED and explain how it is for complementary goods

- Use real world Example Paragraph 3

- Draw a diagram for positive XED and explain how it is for substitute goods - Example


XED Exam Question 2 Explain why XED is useful for businesses to maximize total revenue (5 mark) Note: This question is half of a 10 mark question on IB exams. Thus, this question above is worth 5 marks. State that XED allows firms to identify the relationship between different goods. And then, just repeat all the real life applications of XED


Income elasticity of demand

Definition: responsiveness of demand when customer income changes

YED= % change in quantity demanded of good x/% change in income

YED value Terminology Given an increase in income YED>0 Normal goods Demand rise YED<0 Inferior good Demand fall YED>1 Luxary good Greater percent rise in

demand 0<YED<1 Neccesity Smaller percent rise in

demand


Real world application of YED

1.YED affects how producers’ revenue changes in different economic phases * During a recession: producers of inferior good earn higher revenues, producers of neccesities earn slightly lower revenue, while luxary producers suffer significantly lower revenues * During Economic growth: producers of inferior good earn lower revenues, producers of neccesities earn slightly higher revenue, while luxary producers suffer significantly higher revenues * Producers of luxary goods will have greater demand fluctuations 2.YED affects how the relative importance of different industries change * Over the long run there is economic growth in most economies due to improvement in factors of production (technology tend to improve, education improve) * Industries with high YED will expand the most over the long run. Moreover, the percentage increase in spending will exceed the percentage increase in income. Thus, a larger proportion of income will be spend on goods with high YED. Thus, relative importance of industries with high YED will rise * Industries with low YED will expand the least over the long run. Moreover, the percentage increase in spending will be less the percentage increase in income. Thus, a smaller proportion of income will be spend on goods with low YED. Thus, relative importance of industries with low YED will fall * This is the reason why as economies grow, it tends to diversify away from the agricultural sector (low YED) and expand its tertiary sector (high YED)


YED Exam question 1 Discuss the importance of YED to primary, secondary and tertiary producers (15 marks) Note to teacher: Primary producers have lowest YED, while tertiary producers have highest YED Based on this information, just apply the real life application explained above to this question


Price elasticity of supply

Definition: the responsiveness of quantity supplied when the price of the good changes Equation= percent change in quantity supplied/ percent change in price

PES value Terminology Given a change in P PES>1 Price elastic Greater % change in Qs 0<PES<1 Price inelastic Smaller % change in Qs PES=1 Unitary elastic Equal % change in Qs PES -> infinity Perfect elastic No change in P is possible PES=0 Perfectly inelastic No change in Qs

Diagrams to show varying elasticity of supply Note to teacher: Student just need to memorize diagrams below. No need understand why

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Determinants of PES Note to teacher: most students have trouble understanding determinants of PES. You need to explain to them that they can think of it as how easy it is for producers to increase quantity supplied. If it is very difficult, the PES will be low. For example, hotel rooms will have a low PED

1. Time period The longer the time period considered, the more time producers have to adjust the production to changes in price.

2. Output gap from full capacity The further away output is from full capacity, the more easily it is to increase output. Thus, PES is higher. If output is far from full capacity, the producer can simply increase quantity supplied by employing more resources.

3. Time lags in the production process If there are more time lags in the production, then it will require more time for producers to increase output, resulting in lower PES. For example, the PES of rice is zero for any time period less than a year. This is because it takes a year to producer rice 4. Variable cost If variable cost is higher, then it will take a larger increase in price in order for producers to be willing to increase output. Thus, PES will be lower.

5. Flexibility of factors of production The higher the flexibility, the more easily it is for producers to adjust supply according to price changes, resulting in higher PES. For example, it is difficult for farmers to increase quantity supplied because it is hard to find fertile land. 6. Ability to store A good that can be stored will have a higher PES. This is because producers can store the good and supply it into the market when price rises. For example, since milk cant be stored for long, it has low PES. The only way to increase Qs is to produce more.

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PES Exam question 1 Explain why PES of primary commodities is low (5 mark) Note: Half of a 10 mark question Main reasons are as follows:

• long time to produce • cannot be stored • factors of production are always fixed by nature

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PES Exam question 2 With reference to PED and PES, explain why the price of primary commodities fluctuate significantly

- Price fluctuate often because supply is unstable and is affected by random factors such as weather

- PED and PES of primary commodity is low. Thus, when supply changes, there is a big change in equilibrium price

- Draw diagram with steep demand and supply curve and a shift in supply - For example: when supply rise, there is excess supply at original price.

Price will fall, causing Qd to rise and Qs to fall until market reaches equilibrium where Qd=Qs. Since PED and PES are low, it will take a big drop in price until market reaches equilibrium

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Econ HL- Elasticities Notes