Flashcards in 1.2 Elasticity Deck (51):
What is price elasticity of demand?
Measures the degree of responsiveness of quantity demanded for a product following a change in its price.
How is PED calculated?
(percentage change in quantity demanded)/(percentage change in price)
Why is PED always negative?
Because of the law of demand.
What does the PED of a product depend on?
The degree of customers ability and willingness to pay.
When is demand price inelastic?
If a change in price causes a relatively small change in quantity demanded.
What does the inelastic demand curve look like?
When is demand price elastic?
If a change in price causes a relatively large change in the quantity demanded.
What does the elastic demand curve look like?
When is demand perfectly price inelastic?
If a change in price has no impact on the quantity demanded PED = 0.
What does perfectly price inelastic demand suggest?
There are no substitutes for the product?
What does perfectly price inelastic demand curve look like?
When is demand perfectly price elastic?
If a change in price leads to no demand
PED = infinity.
What does perfectly price elastic demand suggest?
Customers switch to buying other substitutes if firms increase their price.
What does perfectly price elastic demand curve look like?
When is demand unit elastic?
If a given price change leads to the same percentage change in the quantity demanded PED = 1.
What does unit price elastic demand curve look like?
A negative exponential.
On a normal downwards sloping demand curve how does the value of PED change and why does this occur?
The value of PED increases as the price level rises, this occurs because customers will be more responsive to changes in prices at higher levels.
What are the determinants of PED?
Substitution - the greater the number, availability and price of close substitutes there are for a good the higher the value of its PED tends to be. Products with few substitutes have price inelastic demand.
Income - the greater the proportion of consumers income spent on a good or service the more price elastic demand will be.
Necessity - products that are regarded as essential tend to be price inelastic as households will continue to purchase these even if price rise. By contrast the demand for luxuries is relatively price elastic.
Habits, addiction and fashion - if a product has a habit forming tendency or is highly fashionable PED tends to be price inelastic.
Advertising and brand loyalty - effete advertising for certain products can reduce the PED for the product and make it more price inelastic.
Time - the more time people have to change their preferences the more price elastic demand for the product will be.
Durability - the more durable a product is the more price elastic its demand is since there is no urgency to replace these if prices are high.
Costs of switching - if there are high costs involved for customers to switch between brands or products then demand tends to be price inelastic.
What are some applications of PED?
A firm that faces price inelastic demand can increase its prices to earn more total revenue, similarly if a device has price elastic demand it can reduce its prices to earn more revenue.
Assuming that the PED for a firms exports is price elastic it will generally benefit from lower exchange rates as export prices fall so the firm becomes more price competitive.
Firms with different PED values fro their products can use price discrimination to change different customers different prices for essentially the same product.
Firms can pass on most of the incidence of indirect taxes on products that are highly price inelastic.
Governments use PED to determine taxation policies.
What should a firm do if the demand of the good is price inelastic to get more revenue?
Increase the price of the good.
What should a firm do if the demand of the good is price elastic to get more revenue?
Decrease the price of the good.
What is cross price elasticity of demand?
measures the degree of responsiveness of demand for one products following a change in price of another product.
What are complements?
Products that are jointly demanded.
What are substitutes?
products that can be used as alternatives.
How is XED calculated?
(percentage change in quantity demanded of product A)/(percentage change in price of product B)
What XED do complements have?
Negative XED since a fall in the price of one product leads to an increase in the demand for the complementary products. The more negative the XED the stronger the complement.
What XED do substitutes have?
Positive XED since an increase in the price of one product leads to a rise in the demand for the alternative product. The more positive the XED the stronger the substitute.
What XED do unrelated products have?
Zero because the change in the price of one product does not directly affect the demand for the other.
What are applications of XED?
Knowledge of XED can be useful for firms because it can help to predict the effect on the quantity demanded if the price of the complementary good changes.
It can affect a firms pricing strategy depending on whether the XED value is very high or otherwise.
It allows firms to predict the effect on the quantity demanded for their product and hence total revenue if a rival firm changes its price.
It also lets firms know the extent to which customers will switch between competing brands thus informing their pricing and marketing strategies to remain competitive.
What is income elasticity of demand?
Measures the degree of responsiveness of demand following a change in income.
What are normal goods?
Products that customers tend to buy more of as their income level increase. they comprises necessities and luxuries.
What are inferior goods?
Products with a negative YED, the demand for such goods will fall when consumer income levels rise.
What are luxury goods?
Superior goods and services as their demand is highly income elastic, an increase in income leads to a proportionally greater increase in the demand for luxuries.
How is YED calculated?
(percentage change in quantity demanded)/(percentage change in income)
What kind of YED do normal goods have?
Positive YED because people will tend to buy more of these products as income levels increase.
What kind of YED do necessities have?
YED between 0 and 1 demand is income inelastic as customer will continue to buy essential goods even if prices begin to rise.
What kind of YED do luxury goods have?
YED greater than 1 demand is income elastic because customers are relatively responsive to changes in income when buying superior goods.
What kind of YED do inferior goods have?
Negative YED as income levels rise customers will seek alternative superior quality products.
What happens if demand is income inelastic?
A change in income causes a proportionally smaller change in the demand for product.
What are some applications of YED?
Firms and governments can estimate the impact on different markets following changes in national incomes - supermarket may promote more inferior products during a recession.
Luxury goods and services are the most affected products during a recession when national income declines hence firms may wish to diversify their output.
Primary sector products have a relatively low YED value this has potentially beneficial implications for producers and the economy as demand is stable despite fluctuations in the business cycle.
Secondary sector output has a higher YED value this means demand is more sensitive to changes in income levels than for primary sector output.
Tertiary sector output has a relatively high YED value so producers and the economy suffer during an economic recession as customers are highly responsive to the fall in income.
What is price elasticity of supply?
Measure the degree of responsiveness of quantity supplied of a product following a change in its price along a given supply curve.
How is PES calculated?
(percentage change in quantity supplied)/(percentage change in price).
When is supply price elastic?
If firms can easily increase supply without a time delay if there is an increase in the price of the product such firms can gain a competitive advantage if they are able to respond to changes in price.
For what values is PES elastic?
PES > 1
For what values is PES inelastic?
PES < 1
For what values is PES perfectly price inelastic?
PES = 0
For what values is PES perfectly price elastic?
PES = infinity
For what values is price elastic?
PES = 1
What is important about the unit supply curve?
Any supply curve that starts at the origin has PES = 1.
What are the determinants of PES?
Time period - supply tends to be price inelastic in the short run. In the long run firms can adjust their levels of production according to price changes in the market.
Level of stocks - firms with high inventories tend to have relatively price elastic supply as they are more able to respond quickly to a change in market prices.
Degree of spare productive capacity - a firm with plenty of spare capacity can increase supply with relative ease so supply is relatively price elastic, the oppose applies for the long run.
Ease and cost of factor substitution - the easier it is to substitute factors or production the more price elastic supply tends to be. Similarly the more mobile factors of production are the greater the PES will be.