Topic 2 - Elasticity

Question 1

What is the Price Elasticity of Demand?

Answer 1

Price elasticity of demand (PED) is the responsiveness of quantity demanded to a change in price (when all other influences remain the same).

Question 2

Why is PED vital for firms?

Answer 2

It defines the nature of the relationship between price and quantity.

Question 3

What does total revenue = ?

Answer 3

Total Revenue (TR) = Price (P) x Quantity (Q)

Question 4

How do we work out PED?

Answer 4

The change in quantity demanded divided by the change in price.

If PED = -x, we can say that 10% price cut will generate a x X 10% increase in quantity demanded.

Delta Q/Q ave … / Delta P/P ave

Question 5

What is the general rule with PED along a curve?

Answer 5

As we move down along a linear demand curve, demand becomes more price inelastic.

Question 6

What happens when quantity demanded remains constant when the price changes?

Answer 6

The PED = 0, and it’s perfectly inelastic demand.

Graph = vertical

Question 7

What happens when quantity demanded equals price change?

Answer 7

The PED = 1, and it’s unit elastic demand.

Question 8

What happens when quantity demanded > price change?

Answer 8

It’s perfectly elastic demand, and graph is horizontal.

Question 9

What is elastic and inelastic with PED?

Answer 9

Inelastic = 0 - 1
Elastic = 1 - infinity

Question 10

What happens to PED along a linear demand curve?

Answer 10

At prices above the midpoint, demand = elastic

At prices below the midpoint, demand = inelastic.

Question 11

How is total revenue affected by PED?

Answer 11

If demand = elastic, 1% price cut increases quantity sold by more than 1%, so revenue increases

If demand = unit elastic, 1% price cut increases quantity sold by 1%, so revenue stays constant

If demand = inelastic, 1% price cut increases the quantity sold by less than 1%, so revenue decreases.

Question 12

What happens at unit elasticity?

Answer 12

Total revenue = at its max

Question 13

What is the total revenue test?

Answer 13

A method of estimating the PED, by observing the change in total revenue, that results from a change in price, when all other influences remain the same.

Price cut increases TR = PED is elastic
Price cut decreases TR = PED is inelastic
Price cut doesn’t change TR = PED is unit elastic

Question 14

What are the axis for a TR graph?

Answer 14

x = Q
y = TR

Question 15

How does expenditure change when your ED changes?

Answer 15

Our demand = elastic, 1% price cut increases the Q we buy by >1%, so expenditure increases.

Our demand = inelastic, 1% price cut increases the Q we buy by <1%, so expenditure decreases.

Our demand = unit elastic, 1% price cut increases the Q we buy by 1%, so expenditure is constant.

Question 16

What factors affect our ED?

Answer 16

1 = Closeness of substitutes
2 = Proportion of income spent on the good
3 = Time elapsed since price change

Question 17

How does the closeness of substitutes affect our ED?

Answer 17

The closer the subs for a good, the demand is more elastic.

Question 18

How does the proportion of income spent on the good affect our ED?

Answer 18

The greater the proportion of income spent on a good, the more elastic is the demand for it.

Question 19

How does the time elapsed since price change affect our ED?

Answer 19

The longer the time that has elapsed since a price change, the more elastic is demand.

Question 20

What is the cross elasticity of demand?

Answer 20

A measure of the responsiveness of the demand for a good to a change in price of a sub or complement.

Question 21

How do we work out CED?

Answer 21

% Change in quantity demanded/ % Change in price of sub/complement

Question 22

How does the value of CED affect our results?

Answer 22

\+ve = substitute (demand curve shifts right)
-ve = complement (demand curve shifts left)

Question 23

What is the income of elasticity?

Answer 23

A measure of the responsiveness of the demand for a good to a change in income.

Question 24

How do we work out IOD?

Answer 24

%Change in Q demanded/ % Change in income

Question 25

What do the results of IOD show?

Answer 25

If IOD > 1 = normal elastic good If IOD +ve < 1 = normal inelastic good If IOD -ve < 1 = inferior good

Question 26

What happens when the demand for a good is income elastic?

Answer 26

The % of income spent on that good increases as income increases.

Question 27

What happens when the demand for a good is income inelastic?

Answer 27

The % of income spent on that good decreases as income increases.

Question 28

What is the elasticity of supply?

Answer 28

EOS = The responsiveness of the quantity supplied to a change in price.

Question 29

How do we work out EOS?

Answer 29

% Change in Q supplied / % Change in P

Question 30

How do we know if supply curves are unit elastic?

Answer 30

They all pass through the origin.

Question 31

What happens if EOS = 0 and EOS = infinity?

Answer 31

If EOS = 0, supply curve in vertical | If EOS = infinity, supply curve is horizontal

Question 32

What factors affect EOS?

Answer 32

``` 1 = Resource Substitution Possibilities 2 = Time Frame for the supply decision ```

Question 33

How do resource substitution possibilities affect EOS?

Answer 33

If goods can only be produced using rare resources they have a low EOS, whereas if they can be produced using widely available resources they have a high EOS.

Question 34

How does a momentary supply affect EOS?

Answer 34

When the price of a good changes, the immediate response of the quantity supplied = determined by the momentary supply of the good.

Question 35

How does the time frame for supply decision affect EOS?

Answer 35

Over longer time periods, demand becomes more elastic as there is more time to adjust to potential alternatives.