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# Elasticity of Demand & Supply

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## Dawn Ang

on 15 April 2014

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#### Transcript of Elasticity of Demand & Supply

Elasticity of
Demand & Supply

Demand, Supply & Price Determination
Definitions
Determinants
Price
Non-Price determinants
Diagram Representations
Market Equilibrium
Equilibrium Price
Equilibrium Quantity
Applications
When there are shifts in Demand and/or Supply,
equilibrium quantity and equilibrium price
changes
But...
How much exactly would equilibrium prices and quantity change by?
PED
PES
Definition
Formula
Magnitude
Determinants
Graphs
Applications
PED for Producers
PED for Government
They use it to evaluate the extent to which a price change would influence
Total Revenue
They use it to discourage/encourage consumption of certain goods
And to evaluate the responsiveness of consumption due to a price change
Pricing
Strategies
Marketing
Strategies
Timing of Decisions on Pricing/Marketing
Raising Revenue through Taxation
Consumption of a Particular Good
Why is a fall in supply of housing likely to trigger a larger percentage increase in price than compared to a fall in supply of Cadbury chocolates?
Definition of Elasticity
Elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of the determinants, ceteris paribus.

The Price Elasticity of Demand (PED) measures the degree of responsiveness of
quantity demanded
of a good to a change in its price, ceteris paribus.
PED is usually
negative

(Recall: Law of Demand)
Usually consider the
absolute values
of PED to compare magnitudes
Units-free measurement
The
larger
the absolute value, the
greater
the sensitivity of quantity demanded to a price change = the
more price elastic

is the demand.
PED =0 : Perfectly price inelastic demand
|PED| < 1 : Price Inelastic demand
|PED| > 1 : Price Elastic demand
|PED| = 1 : Unitary Price Elastic demand
PED = Infinity : Perfectly price inelastic demand
Degree of Availability of Substitutes
Proportion of Income spent on the good
The
higher
the proportion of our income spent on a good, the
more price elastic
is our demand for the good.

This is because small percentage increases in its price will take up more of the consumer's available income & hence have a substantial impact on the quantity that consumers are able to purchase.
The
longer
more responsive
the change in
quantity demanded
to a given
change in price
. WHY?

Consumers require
time
consumption habits
& look for
alternatives
.

Time is required for the development & discovery of new substitutes.
Habit
Whether demand for a particular good will be relatively price elastic or not depends on the following determinants
H.I.T.S

or

T.H.I.S
Number & Closeness of Substitutes
Definition of the good
The number & closeness of substitutes depend on how we
define
the good.

The
more widely defined
the good, the
lesser
the number of substitutes = the
lower
the value of the PED = the
more price inelastic
is the demand of the good
The
greater the number of substitutes
available for the good, the
higher

the price elasticity of demand of the good.

With many close substitutes available, an increase in price of a good will prompt consumers to switch to

Goods with
many
close substitutes : price
elastic
dd
Goods with

no
close substitutes : price
inelastic
dd
Goods that are habit-forming tend to have a price inelastic demand

Goods that are consumed on a regular basis due to customs, cultures...etc. tend to also have a price inelastic demand
Relationship between PED & TR
PED and TR
Price Elastic Demand
When demand is
price elastic
, quantity demanded will change
more than proportionately
to a given change in price.
Price Inelastic Demand
When demand is
price inelastic
, quantity demanded will change
less than proportionately
to a given price change.
Unitary Elastic Demand
Whether demand for a particular good will be relatively price elastic or not depends on the following determinants
H.I.T.S
or
T.H.I.S
If demand is
unitary price elastic
, then P and Q changes by the
same proportion
.
Point Elasticity
PED along a downward sloping linear demand curve
So, how does the knowledge of the responsiveness of quantity demanded to price help us?
Definition
Total revenue refers to the total receipts
or total earnings received by producers
from the sale of goods and services.

Total revenue can be calculated simply
as the price of the good (P) multiplied
by quantity demanded at that price (Q).

TR = P x Q

Note:

Total Revenue

=

Total Expenditure
HOW?
Examples
When price
increases
, the percentage fall in quantity demanded is proportionately more than the rise in price, thus TR will
decrease
overall.
When price
falls
, the percentage increase in quantity demanded more than offsets the percentage decrease in price, so TR will
rise
.
When price
rises
, the percentage fall in quantity demanded is proportionately less than the percentage rise in price, so TR will
increase
overall.
When price
falls
, the percentage increase in quantity demanded is less than the percentage decrease in price, so TR will
fall
.
E.g. when P falls by 10%, Q rises by 10%
and so, TR remains
unchanged
.
All these means that when price changes along
different portions
of a linear demand curve, total revenue will vary depending on whether the portion is
price elastic
,
inelastic
or
unitary elastic
.
Self
Assessment
1
Definition
Magnitude
Graphs
The Price Elasticity of Supply (PES) measures the degree of responsiveness of
quantity supplied
of a good to a change in its price, ceteris paribus.
PES is usually
positive

(Recall: Law of Supply)
Units-free measurement
The
larger
the value, the
greater
the sensitivity of quantity supplied to a price change = the
more price elastic
is the supply.
PES =0 : Perfectly price inelastic supply
PES < 1 : Price Inelastic supply
PES > 1 : Price Elastic supply
PES = 1 : Unitary Price Elastic supply
PES = Infinity : Perfectly price inelastic supply
Formula
Importance
of PES
Determinants
Whether supply for a particular good will be relatively price elastic or not depends on the following determinants
C.P.F

or

F.T.C
Cost of Production
The
more firms will be encouraged to produce
for a given price rise.
Time Period
Immediate Time Period
:
Highly

Price Inelastic
-Depending on availability of
stocks
Factor Mobility
Ease
at which variable factors can move from
one industry use to another
.

If factors of production can
easily move into or move out
of an industry, then the supply of the product of the industry will be
more price elastic
.
Short run
:
Relatively

Price Inelastic
-Depending on availability on
raw materials
Long Run
:
Relatively
Price Elastic
-Depending on how fast
machinery
& other
fixed factors
can be increased.
Unstable Prices of Agricultural Products
Prices of farm products tend to fluctuate widely.
Why?
Demand for farm products tend to be price inelastic
- Lack of substitutes
Supply of farm products tends to be price inelastic
- Cultivation takes time and agricultural products cannot be stored.
Incidence of Tax
The

incidence of tax
identifies who ultimately
bears the burden
of paying the tax.
Whether the consumers or producers bear more tax will depend on the PED and PES.
Effect of PED
Effect of PES
What is a subsidy?
The benefit of the subsidy is shared between consumers and producers depending on the PED and PES.
Consumers benefit by paying a lower market price while producers benefit by receiving a higher market price.
Effect of PED
Limitations with the use of elasticity figures
Concepts only look at the responsiveness of quantity demanded and quantity supplied to changes in price of the good itself
Ceteris paribus assumption
In reality, there are many factors affecting demand/supply simultaneously
Figures are often historical estimates and thus may apply at a certain point in time or for a given group of people.
Note: ab > bc
Producers receive a greater share of the subsidy when demand is relatively more price elastic than supply

Note: ab  bc
Consumers receive a greater share of the subsidy when demand is relatively less price elastic than supply

Self Assessment 5
How do you think the share of the benefit of the subsidy will be shared between producers and consumers in the case of:
Supply will be
price elastic
if the firms
have
existing spare capacity
of variable inputs which allow
greater flexibility in supply
for firms to respond to increases in price
can easily
store goods at low cost
, keeping costs low &