Chapter 5: Elasticity of Demand and Supply Flashcards
What is ‘total revenue / total expenditure’?
Definition:
- Total revenue / Total expenditure refers to the total sum of money received by the sellers or paid by the consumers in the transaction.
Calculation formula:
Total revenue / Total expenditure
- = Price (P) x Quantity (Q)
What is ‘price elasticity of demand’?
Price elasticity of demand (需求彈性) measures the responsiveness of the quantity demanded of a good, due to a change in its own price.
- The law of demand only tells us the direction of the change in Qd in response of a change in the good’s price.
How to determine the ‘price elasticity of demand’?
The % changes should be taken into account. It is inappropriate to look at the absolute changes.
If % change in Qd > % change in Price,
- Demand is elastic
If % change in Qd < % change in Price,
- Demand is inelastic
What is the changing direction of total revenue when demand is elastic?
Diagrams: Refer to notes p.4
If Price ↓ and Quantity ↑, when demand is elastic,
- Then Total Revenue will ↑
If Price ↑ and Quantity ↓, when demand is elastic,
- Then Total Revenue will ↓
Explanation:
- When demand is elastic (% change in Qd > % change in P), the changing direction of total revenue must be the same as the changing direction of Q.
What is the changing direction of total revenue when demand is inelastic?
Diagrams: Refer to notes p.5
If Price ↓ and Quantity ↑, when demand is inelastic,
- Then Total Revenue will ↓
If Price ↑ and Quantity ↓, when demand is inelastic,
- Then Total Revenue will ↑
Explanation:
- When demand is inelastic (% change in Qd < % change in P), the changing direction of total revenue must be the same as the changing direction of P.
What is the formula for calculating ‘price elasticity of demand (Ed)’?
Price elasticity of demand
- = % change in Qd / % change in P
How to interpret the result from the calculation of price elasticity of demand (Ed)?
Ed must be a negative number, however, only the absolute value of Ed will be taken into account.
When demand is elastic,
- % change in Qd > % change in P
- Ed > 1
When demand is inelastic,
- % change in Qd < % change in P
- Ed < 1
What is ‘arc elasticity of demand (Ed)’?
(average price method)
Calculation formula:
Arc elasticity of demand
- = % change in Q / % change in P
- [(New Q - Old Q) / Average Q] / [(New P - Old P) / Average P]
Graphical representation: Refer to notes p.9
The demand elasticities vary along a downward sloping demand curve (elastic - inelastic, i.e. demand elasticity decreases).
- Price elasticity of demand > 1 (elastic demand) along the upper portion of a demand curve (above the mid-point).
- Price elasticity of demand < 1 (inelastic demand) along the lower portion of a demand curve (below the mid-point).
- Price elasticity of demand = 1 at the mid-point of the demand curve.
What are the special types of elasticity of demand?
(other than elastic/inelastic demand)
1. Unitarily elastic demand
Diagram: Refers to notes p.12 (Rectangular hyperbola)
- % change in P = % change in Qd (Ed = 1)
- Total revenue remains unchanged
(size of gain = size of loss)
2. Perfectly inelastic demand
Diagram: Refers to notes p.13 (Verticle line)
- % change in Qd = 0 / Qd remains unchanged (Ed = 0)
- The changing direction of total revenue (TR) must be the same as the changing direction of price (P),
i.e. Price ↓, TR ↓; Price ↑, TR ↑
3. Perfectly elastic demand
Diagram: Refers to notes p.13 (Horizontal line)
- Qd drops to 0 at the slightest increase in price, Qd increases indefinitely at the slighest drop in price (Ed = ∞)
What are the factors affecting the elasticity of demand?
Availability of close substitutes
- More close substitutes → More elastic ∵
Consumers can easily switch to substitutes when the price of a good ↑
Proportion of expenditure to income
- Smaller proportion of expenditure → Less elastic
Degree of necessity
- Higher degree of necessity → Less elastic ∵
People have little ability to reduce consumption of necessities when price ↑
Habit forming good
- Habit forming good → Less elastic ∵
Difficult to change their habits and switch to substitutes
Durability
- Durable good → More elastic ∵
Consumers can postpone their purchase when price increases
What is ‘price elasticity of supply’?
Price elasticity of supply measures the responsiveness of the quantity supplied of a good, due to a change in its own price.
- The law of supply only tells us the direction of the change in Qs in response of a change in the good’s price.
What is the formula for calculating ‘price elasticity of supply (Es)’?
Arc elasticity of supply (average price method)
Price elasticity of supply
- = % change in Qs / % change in P
What are the different types of price elasticity of supply?
Diagrams: Refer to notes p.19
1. Elastic supply
- % change in Qs > % change in P (Es > 1)
2. Inelastic supply
- % change in Qs < % change in P (Es < 1)
3. Unitarily elastic supply
- % change in P = % change in Qs (Es = 1)
4. Perfectly inelastic supply
- % change in Qs = 0 / Qs remains unchanged (Es = 0)
5. Perfectly elastic supply
- Qs drops to 0 at the slightest drop in price, Qs increases indefinitely at the slighest increase in price (Es = ∞)
What are the factors affecting the elasticity of supply?
More flexible = More elastic
Availability of production factors
- More readily available → More elastic
Reserve capacity
- More reserve / stocks available → More elastic
Adjusting time / Production duration
- Longer the adjusting time / production duration → Less elastic
Ease of entry
- Industries with strict entry barriers → Less elastic
