Chapter 4: Elasticity
Price elasticity of demand
Elasticity: Looks at how one variable changes in response to another variable changing
Price elasticity of demand = %change in quantity demanded ÷ %change in price
•0<PED<1, it is inelastic (%decrease in Qd is less than %increase in price)
•PED > 1, it is elastic (%decrease in Qd is greater than % increase in price)
•PED = 1, it is unit elastic (the %decrease in Qd equals %change in price)
•PED = 0, perfectly inelastic (Qd is the same at all prices)
^same for price elasticity of supply
When supply increases, the equilibrium price falls and equilibrium quantity increases
-the amount at which the variables change is dependent on the responsiveness of the quantity demanded to a change in price
(I.e the price elasticity of demand)
-average price and average quantity is used because it gives the most precise measurement of elasticity
-elasticity is a ratio of two percentage changes and has no unit
-due to law of demand, PED is a negative number, but only the magnitude is used
Factors that influence the elasticity of demand
closeness of substitutes
-the closer the substitutes, the more elastic the demand
proportion of income spent on the good
-the greater the proportion spent on the good, the more elastic the demand
time elapsed since price change
-the longer the time that has passed since the last price change, the more elastic the demand
Cross elasticity of demand
CED can be:
negative (complements)
positive (substitutes)
zero (they are unrelated)
CED = %change in quantity demanded ÷ %change in price of a substitute or complement
-magnitude of the CED value determines how far the demand curve shifts (the larger the value, the greater the change and vice versa
Income elasticity of demand
IED = %change in quantity demanded ÷ %change in income
IED can be positive or negative and falls into 3 ranges:
• > 1 (normal, good, income elastic)
• positive but < 1 (normal good, income inelastic) the good is a necessity
- < 0 (inferior good)
Elasticity of supply
Factors that influence EOS:
-resource substitution possibilities
-time frame for the supply decision
Elasticity of supply = %change in quantity demanded ÷ %change in price
A units free measure of the responsiveness of the Qd of a good to a change in price, when all other influences on buying power remain the same
Total revenue test
-method of estimating the PED by observing the change in total revenue from a change in price
-if a price cut increases total revenue, demand is elastic
-if a price cut decreases total revenue, demand is inelastic
-if a price cut leaves total revenue unchanged, demand is unit elastic
A measure of the responsiveness of demand for a good to a change in the price of a substitute or complement
When the price of a complement increases, the demand for the main good decreases ∴ negative CED
A measure of the responsiveness of the demand for a good or service to a change in income
-when demand for a good is income elastic, the percentage of income spent on a good increases as income increases
when income inelastic, percentage of income spent on that good decreases as income increases (% change in income is +ve but less than % increase in income)
when IED is negative, the Qd and the percentage of income spent on that good decreases as income increases
a measure of the responsiveness of quantity supplied to a change in price of a good all other factors remaining the same
When elasticity is unit elastic, the percentage decrease/increase in Qd/Qs equals the change in price for that good
Total revenue is maximised when PED is 1 (unit elastic)