ECONOMICS SL

chapter three - elasticities

3.1 Price elasticity of demand (PED)

PED The PED measures the responsiveness of quantity demanded of a good to price changes. PED when calculated results in a negative number, but it is dropped and the absolute value is taken instead. CASES Price inelastic when 0 < PED < 1 Qd % change is less than the % price change, and so Qd is relatively unresponsive. Price elastic when 1 < PED < Qd % change greater than % change in price. Qd is relatively responsive. Unit elastic when PED = 1 Qd % change is equal to % price change. Perfectly inelastic when PED = 0 Qd % does not change even if price changes. Demand curve is vertical. Perfectly elastic when PED = The demand curve is horizontal. An increase in price will decrease Qd to 0, and a decrease will raise Qd infinitely.

% Qx PED = % Px

VARYING CURVES On a straight-line demand curve, the PED changes down the curve. At high prices and low quantities, the Q change is large while the P change is small, so the PED is usually elastic. At lower regions, the PED is usually low (inelastic). However, the special cases (unit elastic, perfectly in/elastic) remain constant. DETERMINANTS If a good has many substitutes, the demand for the good tends to be more elastic because people can switch to a substitute. If a good does not have many substitutes, the demand for the good is usually inelastic. Substitutability is how close two substitutes are. The closer they are the greater the PED because its easier for people to change to the other good. The more specific something is defined, the more close substitutes it has. (fruit/food) Necessities are goods that we need in our lives, and luxuries are not necessary. Necessity PED is usually inelastic because we need it, but luxuries are more elastic. A good someone is addicted to would be more inelastic.
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 The demand for a good becomes more elastic the longer the time period it takes for the consumer to make a decision. They are able to decide whether they really need it or not. Demand is more elastic if the good takes a larger proportion of ones income. STEEPNESS OF CURVE (SUPPLEMENT) One does not simply conclude whether the demand is more/less elastic in different curves. Two curves may not be drawn to scale. PED is not constant along demand curves. PED can only be compared if the demand curves intersect at some point. APPLICATIONS (REVENUE) Total revenue - amount of money received by firms when a good or service is sold. Equal to P x Q. If demand is elastic, and increase in price will cause a fall in total revenue. This is because the price change will cause a greater Qd decrease. If demand is inelastic, a price increase will cause an increase in total revenue. If demand is unit elastic, TR does not change because the change is fixed. Total revenue is maximized at the point where demand is unit elastic. APPLICATIONS (COMMODITIES) Primary commodities goods that come from natural resources. usually have lower PED than manufactured goods Fishing, agricultural, forestry, etc. Have low PED and is inelastic because its a necessity and has no substitutes. This, with supply issues can cause problems, as the price fluctuations will be greater. Exceptions: medication, as its manufactured but is inelastic. Indirect taxes The lower the PED for a taxed good, the greater the govt tax revenues.

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3.2 Cross-price elasticity of demand (XED)

XED The XED measures the responsiveness of demand for one good to a change in the price of another good. The value and the sign of the XED are both important.

% Qx XED = % Py

SUBSTITUTE GOODS If the XED of two goods is positive, these two goods are substitutes. An increase in price of a good will result in the increase of demand of the other good. EXAMPLE: Tea and coffee. If the price of coffee rises, people may switch to tea. In two pairs of substitute goods, the pair with a larger XED are stronger substitutes. EXAMPLE: 0.7 > 0.3 COMPLEMENTARY GOODS If the XED of two goods is negative, these two goods are complements. an increase in price of a good will result in the fall of demand of the other good. EXAMPLE: If the price of tennis balls increase, people might not buy tennis rackets as much. In two pairs of complementary goods, the pair with the larger absolute value XED are stronger complements. EXAMPLE: |-1.2| > |-1.0| UNRELATED GOODS If the XED of two goods is zero or close to zero, the two products are unrelated. EXAMPLE: potatoes and energy drinks APPLICATIONS Substitutes in a single business - If a company produces two goods that are substitutes, they may want to consider the impacts if the price of one of them dropped. Substitutes by rival businesses - A company can lower prices of a good if it will impact the demand of a rival substitute. Substitutes and mergers - A merger is when two firms join to become one firm. Those producing goods with a high +XED may want to eliminate competition. Can be illegal. Complementary goods - Companies work together if they produce complementary goods. Lowering of the price of plane tickets can increase the demand for hotel bookings.
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3.3 Income elasticity of demand (YED)

YED The YED measures the responsiveness of demand to a change in income. Income is abbreviated as Y. The sign and the value of YED provide the necessary info.

NORMAL OR INFERIOR GOODS (SIGN OF YED) If YED > 0, the good is a normal good. An increase in income results in a demand increase. If YED < 0, the good is inferior. An increase in income results in a demand decreases.

% Qx YED = % Y

NECESSITIES AND LUXURIES (VALUE OF YED) If 0 < YED < 1, the good has income inelastic demand, and are necessities. An increase in income causes a smaller Qd increase. If YED > 1, the good is a luxury. A percentage increase in income causes a larger Qd increase. APPLICATIONS YED and producers The income of a society increases as countries experience economic growth. A higher YED may result in more expansion of the market of the good because income increases. A lower YED may result in slower expansion; YED and economy There are 3 sectors in the economy: Primary sector: agriculture, fishing, extractive industries Manufacturing sector Services sector Agriculture is income inelastic. Most primary products have low income elasticity. Manufactured goods are usually income elastic. Causes agricultural output to shrink, and manufacturing output to increase. Services sector increases but lowers both the primary and the manufacturing sector In less developed countries, there is usually an increased primary sector because agriculture is more important than services and manufacturing. Economic growth usually causes the importance of the primary sector to decrease. YED and long term impacts (HL) HL only. This is an SL guide.
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3.4 Price elasticity of supply (PES)

PES The PES measures the responsiveness of the quantity supplied of a good to price changes. PES is positive because of the relationship between price and Qs. INTERPRETATION Price inelastic when PES < 1. Small percentage change in Qs compared to percentage change in P. The end point of the supply curve cuts the horizontal axis. Price elastic when PED > 1. Percentage change in Qs greater than change in price. The end point of the supply curve cuts the vertical axis. Unit elastic when PES = 1 Percentage change in Qs equal to change in P End point pass through the origin. Perfectly inelastic when PES = 0 No change in Qs even if price changes. Vertical line. Completely unresponsive to price. Perfectly elastic when PES = Percentage change in Qs is infinite. Horizontal line. Infinitely responsive to price. We can compare supply curves when they intersect, and the flatter curve is more elastic. They should be done only at a specific price range. DETERMINANTS Length of time Firms have to adjust resources and Qs in response in price changes. Inelastic over short period but becomes more elastic as they have more time. Mobility of factors of production The PES is greater if firms are able to shift resource use to a good with a rising price. Spare capacity of firms The PES is greater if a firm has more spare capacity so it can respond easily. Ability to store stocks Some firms can store output that they do not sell yet. As a result, they have a higher PES. Firms that cannot store stocks usually have a lower PES.
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APPLICATIONS Primary commodities have lower PES compared to manufactured products. Farmers need a season to respond to prices, land destruction, new tech needed Other primary commodities like oil require time to start production. Consequences of low PES If supply is inelastic, there are greater price fluctuations. This makes revenue unstable for producers. A small demand increase will greatly shift the equilibrium price upward. Short-run and long-run PES is larger for agricultural goods over a longer period of time.

Summary
PED XED % change Qd / % change P % change Qdx / % change Py 0<PED<1 Inelastic +XED Substitutes 1<PED< Elastic XED close substitutes PED = 1 Unit elastic XED Complements PED = 0 Perfectly inelastic |XED| close complements PED = Perfectly elastic XED = 0 Unrelated Determinants Applications # and closeness of substitutes Substitutes in single business Necessities inelastic Substitutes in rival businesses Luxuries more elastic Mergers Purchase decision time Complementary goods Proportion of income Total Revenue = P*Q Elastic: Price TR Inelastic: Price TR Unit: Price doesnt affect TR YED % change Qd / % change Y YED > 0 Normal good YED < 0 Inferior good YED < 1 Necessities (Inelastic) YED > 1 Luxuries (Elastic) Applications Primary products: Low YED Manufactured products: Higher Services: Even higher YED PES % change Qs / % change P PES < 1 Inelastic PES > 1 Elastic PES = 1 Unit elastic PES = 0 Perfectly inelastic PES = Perfectly elastic Determinants Length of time Mobility of factors of productions Spare capacity of firms Ability to store stocks Applications Primary commodities: low PES Short-run ; long-run

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