Elasticities

Question 1

Define Price Elasticity of Demand

Answer 1

The responsiveness of quantity demanded to a change in price

Question 2

How is it calculated

Answer 2

PED = % change in quantity demanded / % change in price

Question 3

If PED is between (-1, - infinity) , what does this suggest about price elasticity of demand?

Answer 3

The good is very price elastic - a small change in price dramatically reduces demand

Question 4

If PED is between (-1, 0), what does this indicate about the good?

Answer 4

The good is price inelastic - quantity demanded reduces by disproportionately less than the increase in price, meaning that revenue increases.

Question 5

What are the 6 main determinants of PED

Answer 5

Substitutes, Necessities, Time, Addictiveness, proportion of income spent, definition of the market

Question 6

Explain how substitutes for a good affects its PED

Answer 6

If a good has many close substitutes, then the good will be price elastic. Quantity demanded will be very responsive to changes in price because if the firm decides to raise the price of the good, its demand will decrease dramatically as consumers will quickly switch to cheaper close substitutes.

Question 7

Explain how proportion of one’s income spent affects its PED for a good

Answer 7

The greater the proportion of income spent on the good, the more price elastic the good will be. This is because even if the price of a CHEAP good increases by 30%, people will still be willing and able to buy it. In contrast, if the price of a car went up 30%, people will reconsider.

Question 8

Explain how time affects PED for a good

Answer 8

In the short run, the good you are looking at might be the only available option, therefore PED is more inelastic

In the Long run, you can shop around, so the good will be more price elastic

Question 9

Define YED

Answer 9

Income elasticity of demand - the responsiveness of demand to a change in income.

Question 10

What is the formula for YED?

Answer 10

YED = % change in QD / % change in income

Question 11

If YED is positive, what does this say about income and the type of good

Answer 11

As real incomes rise, quantity demanded for this good will increase

Normal good

Question 12

If YED is negative, what does this say about income and the type of good

Answer 12

As real income rises, the quantity demanded for this good falls

Inferior good

Question 13

If YED is positive and >1, what does this say about income and the type of good

Answer 13

As income rises, quantity demanded increases by more than the rise in real income

Luxury good

Question 14

If YED is positive and <1, what does this say about income and the type of good

Answer 14

As income rises, quantity demanded increases by less than the rise in real income

Necessity

Question 15

Define XED

Answer 15

Cross - Elasticity of Demand - responsiveness in demand for one good to a change in price of another

Question 16

XED formula

Answer 16

XED = %∆ quantity demanded of good x / %∆ in price of good y

Question 17

If the XED coefficient is between -1<x<1, what does this suggest about the two goods

Answer 17

The goods are cross price inelastic

Demand for good X changes by less than the change in price of the good Y

Question 18

If the XED coefficient is between x<-1 and x>1, what does this suggest about the two goods

Answer 18

The goods are cross price elastic

Demand for good x changes by more than the change in price of good Y

Question 19

If the goods are complements, what can we infer about their XED?

Answer 19

• It will be negative
• An increase in price of good Y will lead to decrease in demand for its complement, causing XED to be negative

Question 20

If the goods are substitutes, what can we infer about their XED?

Answer 20

• It will be positive
• An increase in price of good Y will mean that demand for its cheaper substitutes, will increase.

Question 21

Define PES

Answer 21

PES - the responsiveness of supply to a change in price

Question 22

Formula of PES

Answer 22

PES = %∆ quantity supplied / %∆ price

Question 23

What can we infer if a good’s PES is between 0<x<1?

Answer 23

Price inelastic
If the price rises, firms will increase the supply but by less than the increase in price

Question 24

What can we infer if a good’s PES is greater than 1

Answer 24

The good is price elastic
As price rises, firms are willing and able to supply disproportionately more than the change in price

Question 25

What are the key determinants of supply?

Answer 25

• Stocks,
• Spare capacity
• Availability and cost of switching from one resource to another
• Time

Question 26

Explain the determinants of elasticity of supply

Answer 26

Stocks
If stocks of finished goods are available, then supply will be relatively elastic because manufacturers will be able to respond disproportionately to a price change

Spare Capacity
If a firm is operating below its full capacity, it has underutilised machinery and underemployed workers, then supply is likely to be price elastic

Availability and cost of switching from one resource to another
If workers need very specific skills, or if machinery is highly specialised, then supply is likely to be more inelastic because, for a change in price, the firm won’t be able to increase the quantity supplied

Time
In the short run supply is likely to be more inelastic because producers find it difficult to increase production

In the long run, supply will be more price elastic because producers can adjust to changing market conditions by buying more machinery and storing spare stock, predicting future demand etc.

Question 27

Explain, with the aid of a diagram, why price elasticity of demand changes along a
downward sloping straight-line demand curve. [10]
(b) Evaluate the extent to which knowledge of price elasticity of demand is important for
decision making by firms and governments. Use diagrams to illustrate your answer. (20)

Answer 27

10 marker in green book