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CHAPTER 2B RESOURCE ALLOCATION: ELASTICITIES OF DEMAND AND SUPPLY -…
CHAPTER 2B
RESOURCE ALLOCATION: ELASTICITIES OF DEMAND AND SUPPLY
ELASTICITY
measure used to show the
degree of responsiveness
of
quantity demanded or quantity supplied
of a good or service to a change in one of the determinants of demand and supply
Price elasticity of demand (PED)
Price elasticity of supply (PES)
Price Elasticity of demand (PED)
the
degree of responsiveness
of the
quantity demanded
of a good to a change in its price, ceteris paribus
1 < | PED | < infinity:
Demand for a good is
price elastic
when
change in price of a
good
leads to
proportionately larger
change in
quantity demanded
0 < | PED | < infinity:
Demand for a good is
price inelastic
when a
change in price of a good
leads to a
proportionately smaller
change in
quantity demanded
Factors
affecting PED
a. Availability and closeness of Substitutes:
Greater availability
, consumers can switch to substitutes more easily when price increase,
greater PED
-->
more price elastic
b. Degree of necessity
Greater necessity
,
lower PED
-->
price inelastic
c. Proportion of income spent on product
Greater proportion of income spent
,
greater PED
-->
price elastic
d. Time period
Longer time, greater PED
-->
price elastic
Reasons:
(a)
habits
of consumers
change
(b) longer term,
more substitutes
developed
PED
=
Percentage change
in
Quantity demand
/
Percentage change
in
price of the good
Application of PED
TOTAL REVENUE
ii. Demand for the product is price inelastic
Loss of revenue
due to
fall in price
is
greater than
the gain in revenue due to the
increase in quantity demanded
-->
TR decreases
i. Demand of Product is relatively
price elastic
:
Loss of revenue
due to
fall in price
is
smaller
than the
gain the revenue
due to the
increase in quantity demanded
-->
TR increases
Price Elasticity of Supply (PES)
the
degree of responsiveness
of the
quantity supplied
of a good to changes in its price, ceteris paribus
Factors
Affecting PES
a. Time
i. Momentary period (very short run)
producers
unable to respond to change in price
-->
PES = 0
ii. Short Run
production is restricted by at least
one fixed factor of production
-->
quantity supplied < proportionate
-->
price inelastic
iii. Long Run
more factors
available -->
quantity supplied > proportionate
-->
price elastic
b. Existence of spare capacity
more spare capacity
available,
quantity supplied > proportionate
-->
price elastic
c. Availability and durability of stocks
greater no. of goods durable
,
quantity supplied > proportionate
-->
price elastic
d. Length of production period
Longer time --> quantity supplied < proportionate --> price inelastic
Shorter time --> quantity supplied > proportionate --> price elastic
e. Factor mobility (labour)
higher the factor mobility, more price elastic
PES =
Percentage change
in
quantity supplied
/
Percentage change
in
price of the good
1. PES > 1:
price of a good
leads to a
proportionately larger
change in quantity supplied
-->
price elastic
2. PES < 1:
price of a good
leads to a
proportionately smaller
change in quantity supplied
-->
price inelastic
3. PES =1:
price of a good
leads to an
equal proportionate change
in
quantity supplied
-->
unitary price elasticity
Limitations of elasticity concepts
a. Assumptions of ceteris paribus
all other factors remain unchanged
i. Costs held constant
ii. Other non-price determinants are not constant in the real world
b. Reliability and Accuracy of Elasticity data
data may not be reliable/accurate. If PED wrong, pricing strategy wrong, total revenue may decrease
c. Interactions between demand and supply
In reality, there could be other changes in supply that would result in changes to the price of the product.