Yukihiro MurakamiEconomics – Elasticity

Sub-topic SL/HL Core – Assessment ObjectivesPrice Elasticity of Demand (PED)

Price Elasticity of Demand and its determinants

AO2 - Explain the concept of price elasticity of demand, understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve.

PED is a measure of how much the quantity demanded of a product changes when there is a change in the price of the product.

AO4 - Calculate PED using the following equation.

PED = Percentage change in quantity demandedPercentage change in price

AO1 - State that the PED value is treated as if it were positive although its mathematical value is usually negative.

The negative value indicates that there is an inverse relationship between price and the quantity demanded, but to simplify matters, the negative signs are usually ignored.

AO2 - Explain, using diagrams and PED values, the concepts of price elastic demand, price inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic demand.

Perfectly inelastic demand: When a price change does not alter the quantity demanded.Price inelastic demand: When a price change alters the quantity demanded by a fewer amount than the proportionate amount.Unit elastic demand: When a price change alters the quantity demanded by a proportionate amount.Price elastic demand: When a price change alters the quantity demanded by a greater amount than the proportionate amount.Perfectly elastic demand: When a minimal price change changes the quantity demanded to 0.

AO2 - Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.

The number and closeness of substitutes: If close multiple substitutes are present, the demand for the product is elastic.The necessity of the product: If the product is considered a necessity good, its demand for the products is usually inelastic.The time period: In the short term, demand for a product may be inelastic while in the long term, demand for a product may be more

Yukihiro Murakamielastic.

AO4 - Calculate PED between two designated points on a demand curve using the PED equation above.

AO2 - Explain why PED varies along a straight line demand curve and is not represented by the slope of the demand curve.

When a line is steep, its slope may be about 5. When a line is steep when measuring the PED, it is considered inelastic, and is between 1 and 0. They are different.

Applications of price elasticity of demand

AO3 - Examine the role of PED for firms in making decisions regarding price changes and their effect on total revenue.

Firms should increase price on products with inelastic demand so that a price change would only decrease consumers minimally.

AO2 - Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high.

The PED for many primary commodities is relatively low because they are necessities for consumers and they have few or no substitutes.The PED for manufactured products is relatively high because there are more substitutes available for customers.

AO3 - Examine the significance of PED for government in relation to indirect taxes.

Governments should consider PED values when imposing indirect taxes so that firms don't go out of business. Imposing an indirect tax on products with inelastic demand would be the wise choice as most of the tax burdens then would be on the consumers.

Cross price elasticity of demand (XED)

Cross price elasticity of demand and its determinants

AO1 - Outline the concept of cross price elasticity of demand, understanding that it involves responsiveness of demand for one good (and hence a shifting demand curve) to a change in the price of another good.

XED is the measure of how much the demand for a product changes when there is a change in the price of another product.

AO4 - Calculate XED using the following equation.

AO4 - Show that substitute goods have a positive value of XED and complementary goods have a negative value of XED.

Substitute goods have a positive value of XED because when the price of product x falls, demand for product x will increase, and demand for product y would decrease. There is a decrease in quantity demanded for

Yukihiro Murakamiproduct y, and a decrease in price of product x and thus, a positive value of XED indicates a substitute good.

When the price of good a falls, the demand for good a would increase, and its complement good b would also increase in demand. Increase in good b divided by decrease in the price of good gives a negative XED value, showing that good b is a complement to good a.

AO2 - Explain that the (absolute) value of XED depends on the closeness of the relationship between two goods.

Assuming Xboxs and PS3s are close substitute goods.

Absolute value of XED depends on the closeness of the relationship between two goods because if the price of Xbox rises a bit, everyone would switch over to the PS3 and the sales of PS3 may skyrocket. Thus if a small change in price increases/decrease the sales of another product by a significant amount, the absolute value of XED would be high.

Applications of cross price elasticity of demand

AO3 - Examine the implications of XED for businesses if prices of substitutes or complements change.

If prices of substitutes from firm B increases/decreases, firm A should increase/decrease the number of products they produce so that excess demand or excess supply can be evaded.

If prices of complements from firm B increases/decreases, firm A should decrease/increase the number of products they produce.

Income elasticity of demand (YED)Income elasticity of demand and its

determinantsAO1 - Outline the concept of income elasticity of demand, understanding that it involves responsiveness of demand (and hence a shifting demand curve) to a change in income.

YED is the measure of responsiveness of how much the demand for a product changes when there is a change in the consumer’s income.

AO4 - Calculate YED using the following equation.

AO4 - Show that normal goods have a positive value of YED and inferior goods have a negative value of YED

Normal goods have a positive value of YED because when a consumers’ income increases/decreases, the normal good consumption should increase/decrease, thus creating a positive YED value.

Inferior goods have a negative value of YED because when a consumer’s income increases/decreases, the inferior good consumption decreases/increases, thus creating a negative YED value.

AO2 - Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods.

Necessity goods refer to products that a consumer needs whether they have an increased income or a decreased income. The quantity

Yukihiro Murakamidemanded for this type of product should not change dramatically when there is increase/decrease in consumer income. On the contrary, luxury goods can be bought if and only if there is increase in consumer income.

Applications of income elasticity of demand

AO3 - Examine the implications for producers and for the economy of a relatively low YED for primary products, a relatively higher YED for manufactured products and an even higher YED for services.

Price elasticity of Supply (PES)Price elasticity of supply and its

determinantsAO2 - Explain the concept of price elasticity of supply, understanding that it involves responsiveness of quantity supplied to a change in price along a given supply curve.

PES is a measure of responsiveness of how much the supply of a product changes when there is a change in the price of the product.

AO4 - Calculate PED using the following equation.

AO2 - Explain, using diagrams and PES values, the concepts of elastic supply, inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply.

Perfectly inelastic supply: When a change in price has no effect on the quantity supplied.Inelastic supply: When a change in price leads to a less than proportionate change in supply.Unit elastic supply: When a change in the price of the product leads to a proportionate change in the quantity supplied.Elastic supply: When a change in price leads to a greater than proportionate change in the quantity supplied.Perfectly elastic supply: When a change in price causes the quantity supplied to fall to 0.

AO2 - Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to store stocks.

In the short run, the value of PES should be inelastic and in the long run, it becomes much more elastic.

If factors of production are easily moved from one productive use to another then PES will be relatively elastic.

If a firm has a lot of unused capacity, they will be able to increase output with ease and thus the elasticity of supply is relatively high.

If a firm is able to store high levels of stock of their product, the PES would be relatively elastic.

Applications of price elasticity of supply

AO2 - Explain why the PES for primary commodities is relatively low and the PES for manufactured products is relatively high.

The PES for primary commodities is relatively low because a change in

Yukihiro Murakamiprice cannot lead to a proportionately large increase in quantity supplied.The PES for manufactured products is relatively high because it is easier to increase or decrease quantity supplied in response to a change in price.

PED

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PES

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XED

Yukihiro MurakamiIf Goods A and B are substitute goods for each other, and if the price of Good A

rises,

If Goods A and C are complement goods, and if the price of good A rises,

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YED: The Engel curve

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