1.1.4 Elasticity

Price elasticity of demand (PED)

a) Definition of PED: The responsiveness of demand to changes in price.

b) Formula of PED: PED = Percentage Change in Quantity Demanded / Percentage Change in Price

c) Calculate the PED using given percentage changes in quantity demanded and percentage changes in price.

  1. Use the formula above.

  2. Example:

    • If the price increases by 10% and the quantity demanded decreases by 20%, then: PED = -20 / 10 = -2

    • The negative sign indicates the inverse relationship between price and quantity demanded.

d) The use of diagrams to show price elastic and price inelastic demand.

e) Numerical values of PED:

  • Perfect price inelastic (PED = 0)

  • Price inelastic PED (0 < PED < 1)

  • Unitary price elastic (PED = 1)

  • Price elastic (PED > 1)

  • Perfect price elastic (PED = ∞)

f) Factors Influencing PED:

  • Substitutes - More substitutes make demand more elastic as there are more options to purchase from.

  • Necessity - Essential goods are usually more inelastic in demand as they are required despite their price.

  • Percentage of Income Spent - Goods taking up a larger share of income are more elastic as people respond to price changes.

  • Time - Over time, demand becomes more elastic as consumers find alternatives.

g) Total Revenue and PED Relationship:

Formula: Total Revenue = Price ×Quantity Demanded

  • Elastic Demand (PED > 1): Price decrease → TR increases (and vice versa).

  • Inelastic Demand (PED < 1): Price decrease → TR decreases (and vice versa).

  • Unitary Elasticity (PED = 1): Price change has no effect on TR.

Price elasticity of supply (PES)

h) Definition of PES: The responsiveness of supply to changes in price.

i) Formula of PES: PES = Percentage Change in Quantity Supplied / Percentage Change in Price

j) Calculate the PES using given percentage changes in quantity demanded and percentage changes in price.

  1. Use the formula above.

  2. Example:

    • If the price increases by 15%, and the quantity supplied increases by 30%, then: PES = 30 / 15 = 2

    • A PES of 2 means supply is price elastic.

k) The use of diagrams to show price elastic and price inelastic supply.

l) Numerical values of PES:

  • Perfect price inelastic (PES = 0)

  • Price inelastic (0 < PES < 1)

  • Unitary price elastic (PES = 0)

  • Price elastic (PES > 1)

  • Perfect price elastic (PES = ∞)

m) The factors influencing PES:

  • Factors of production - The availability and flexibility of the factors of production determine how quickly producers can adjust supply. More flexibility would mean a higher PES.

  • Availability of stocks - If a firm has a large quantity of a good or product available for sale, it can respond quickly to price changes, increasing PES.

  • Spare capacity - Spare capacity refers to unused production resources. With more spare capacity, firms can increase supply quickly in response to price increases.

  • Time - In the long run, producers have more time to adjust resources, leading to higher PES compared to the short run.

n) Use examples to show the likely PES for manufactured and primary products.

Manufactured Products

Manufactured products are goods produced through industrial processes which involve transforming raw materials into finished goods. PES is generally higher because production can be adjusted more quickly with available resources, spare capacity, and flexibility in production methods.

Example: If demand for cars rises, car makers can quickly adjust production levels by using the existing spare capacity of finished cars or increasing factory working hours.

Primary Products

Primary products are raw materials or agricultural products directly extracted or harvested from natural resources. PES is usually lower because supply is limited by factors like weather, land availability, and extraction methods, which are difficult to adjust quickly.

Example: If the demand for wheat increases, farmers cannot quickly grow more wheat as it depends on the growing season and environmental factors.

Income elasticity of demand (YED)

o) Definition of YED: The responsiveness of demand to changes in income.

p) Formula of YED: YED = Percentage Change in Quantity Demanded / Percentage Change in Income

j) Calculate the YED using given percentage changes in quantity demanded and percentage changes in price.

  1. Use the formula above.

  2. Example:

    • If the quantity demanded of a good increases by 10% and consumer income increases by 5%, then YED would be 10/5 = 2

    • A YED of 2 means that it is a luxury good.

r) Interpret numerical values of YED:

  • Luxury good (YED > 1)

  • Normal good (0 < YED < 1)

  • Inferior good (YED < 1)

s) The significance of price and income elasticities of demand to businesses and the government.

Imposition of Indirect Taxes and Subsidies

  • Businesses: Understanding price and income elasticity helps businesses predict how consumers will react to changes in prices or taxes.

  • Government: Governments can use elasticity information when deciding which goods to tax or subsidize.

Changes in Income

  • Businesses: Understanding YED helps businesses forecast changes in demand based on economic conditions.

  • Government: The government can use YED to predict how changes in national income will affect overall consumption patterns and plan policies such as welfare or tax rates to support economic stability.