Elasticities of Demand & Supply

Unitary Elastic Demand

A demand curve that has unitary elasticity at every point takes the shape of a rectangular hyperbola. When PED=1, dd is UED.

Factors affecting PED

(i) Availability of close substitutes The greater the amount of substitutes and the closer the substitutes, the more price elasticity the demand for good or service. Coke vs Pepsi (ii) Proportion of income spent on the good or service When proportion of income spent in the good or service is small, demand for the good or service becomes price inelastic. (iii) Time period Since it takes time finding substitutes or changing spending habits and preferences, PED is higher when time period is longer (iv) Nature of good or service -Basic goods(necessities) PED<1 inelastic -Luxurious goods PED>1 elastic -Addictive goods PED<1 inelastic

Elasticity Concept

A way of quantifying cause and effect relationships. A numerical measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants(price), ceteris paribus. When relationships are elastic, a small change in the independent variable(cause) has big effect on the dependent variable. Where the relationships are inelastic(less responsive), a large change in the cause has limited effect on the dependent variable.

Non pricing strategy

As PED is affected by availability of close substitutes, producer can reduce substitutability of production through product differentiation. Perceived: -Advertising using mass media -Celebrity endorsements -Branding to establish identity that is easily recognized and relatable to consumers or Real differences: -Research and developments Product that is uniquely different would make its demand price inelastic.

XED<0

Complements

Inferior Good

Goods or services which consumers will demand less of when their income increases and demand more when income falls.

Normal goods

Goods or services which consumers will demand more of when their income increases.

How does PED affect demand curve?

PED refers to movement on the demand curve not shift of demand curve. When moving down along a straight-line demand curve, the values of PED vary from infinity to zero.

Perfectly Price Inelastic

PED=0, any change in price will not bring any change in quantity demanded. Happens when same amount of goods is demanded at all prices. Represented by vertical demand curve. When price increases from 0p0 to 0P1, there will be no change in quantity demanded.

PED values

PED>1: Price elastic Increase in price would lead to a more than proportionate decrease in quantity demanded, ceteris paribus. PED<1: Price inelastic increase in the price would lead to a less than proportionate decrease in quantity demanded

PED definition

Price elasticity if demand measures the degree of responsiveness of the quantity demanded for a good or service to a given change in its price, ceteris paribus. PED=%change in quantity demanded for good/% change in price for good

PED application by producers

Price strategies, If producer/firm knows that demand for his good is price elastic, he can increase his total revenue by lowering the price of his good through discounts. When he lowers the price of good, it would lead to a more than proportionate increase in quantity demanded , assuming ceteris paribus. Conversely, if the demand is price inelastic, raising prices of good would increase total revenue. Producer should consider the PED value of good to different groups of consumers and adjust price accordingly.

market equilibrium

Refers to situation where no further tendency for the transacted price or quantity of a good in the market to change, unless external forces disturb the situation. Point where amount consumers are willing to purchase is the same as amount producers are willing to produce. Quantity demanded equals quantity supplied.

XED Definition

The cross elasticity of demand measures the degree of responsiveness of the demand for a good to a given change in the price of a related food or service, ceteris paribus. %change in quantity demanded for Good X/% change in price of Good Y

Consumer surplus

The difference between the price consumers are willing and able to pay for a good or service and the price they actually pay. Below demand curve.

Producer surplus

The difference between the price producers are willing and able to supply a good or service for and the price they actually receive.

Perfectly price elastic

Value of PED is equal to infinity. Represented by a horizontal demand curve.

Are PED values always negative?

Yes. But negative sign is ignored and absolute value is considered for interpretation since the negative sign simply reflects the inverse relationship between price and quantity demanded.