Economics Microeconomics Chapter 2.5 Elasticities of demand
YED
(YED) is the percentage change in the quantity demanded of a good, divided by the percentage change in income.
Change in price elasticity of demand (PED) along a linear demand curve
*For any linear downward-sloping demand curve, demand is price elastic for high prices and low quantities, and price inelastic for low prices and high quantities. *The price elasticity of demand is equal to the slope of the curve multiplied by the original price divided by the original quantity. *At lower prices, consumers are less concerned and impacted by changes in the price due to the lower proportion of income spent on the good
Do governments have an ulterior motive when imposing taxes on goods with inelastic demand?
Governments will often use increased taxes to claim that their goal is to reduce consumption of harmful products, when in reality it is to increase government revenues.
Terminology
For every 1 per cent increase in price, the quantity demanded a good decreases by X%
PED and influencing production/consumption
Governments can use taxes and subsidies to influence the quantity of products produced and consumed in society.
Why is demand for manufactured goods usually more elastic?
Higher number of (close) substitutes, manufactured goods take up a larger proportion of income.
What does the positive YED mean ?
Normal goods -A positive sign means that as incomes increase, quantity demanded of a good increases; and as incomes decrease, quantity demanded decreases.
PED = ∞
Perfectly elastic demand -Any change in price would lead to an infinite change in the quantity demanded. -If the price is raised, even by a minimal amount, the quantity demanded will fall to zero, therefore the change in quantity is infinite
PED = 0
Perfectly inelastic demand -A change in price leads to no change in the quantity demanded.
PED > 1
Price elastic demand -A change in price leads to a proportionately greater change in the quantity demanded.
Price elasticity of demand (PED)
Price elasticity of demand (PED) is a measure of how much the quantity demanded of a good changes when there is a change in its own price.
0 < PED < 1
Price inelastic demand -A change in price leads to a proportionately smaller change in the quantity demanded
PED = 1
Unitary elastic demand -A change in price leads to a proportionately equal change in the quantity demanded.
YED = 0 (extremly low, close to zero but not negative!)
Very inelastic demand - Necessity goods The quantity demanded is not very responsive to price changes or to other non-price determinants of demand, such as income changes. Higher incomes generally do not cause people to consume measurably more of these goods
In times of economic recession, the avergae income
decreases
△% PED
change in the quantity demanded of good %/ change in the price of the good%
Be aware: It is not correct to refer to goods as price elastic or inelastic. Demand for goods has elasticity, not the goods themselves.
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Be aware: For income elasticity of demand, we must pay attention to the sign (positive or negative) of the result. The sign helps us classify the type of good.
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Terminology
-When the demand is price inelastic, as consumers' demand is relatively unresponsive to price changes
Industries in an economy are typically divided into three sectors:
1.The primary sector. This includes all primary commodities and products (eg: Raw materials) 2.The secondary sector. This includes industries producing goods manufactured from primary commodities or intermediate goods 3.The tertiary sector. This includes all economic goods that are not tangible and yet improve people's quality of life or standards of living (services)
How can we use law of demand to explain Price elasticity of demand?
According to the law of demand, when the price of a good increases, quantity demanded declines, ceteris paribus. The extent to which the quantity demanded changes depends on how 'elastic' its demand is with respect to its price.
Commodities
Commodities, also calledprimary commodities or primary goods, are goods that come from the land,
Determinants of price elasticity of demand (PED)
Elastic *The more substitutes there are for a product, the more elastic the demand for it will be. *The closer (more similar) the existing substitutes for a product are, the more elastic the demand for it will be. *The higher the proportion of income spent on a good, the more elastic the demand. Inelastic *The greater the level of necessity for the consumer, the more inelastic the demand of the good will be. *The more widely a good is defined, the more inelastic is its demand. *The demand for a good will be more inelastic in a short period of time than in a longer period of time.
Elasticity of demand
Elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to changes in one of the factors that determines it.
What happens to the revenue of firms who produce normal goods during economic growth and economic recession?
Firms who sell normal goods or superior goods should see demand and quantity demanded of their goods increase during periods of economic growth. Their sales and revenues should improve in these periods. However, they will likely see sales and revenues decline during recessions.
Should a firm raise its prices to increase the TR generated by the production of an inelastic good or a service?
If a firm wishes to increase its total revenue and demand for its product is inelastic, it should raise the price of the good.
Should a firm raise its prices to increase the TR generated by the production of an elastic good or a serivce?
If a firm wishes to increase its total revenue, but has a product for which demand is elastic, it should not raise the price. Depending on how elastic the demand is, it may be beneficial to decrease the price of the good instead.
How can governments affect the consumption of products with inelastic demand?
If a government wants to have a significant impact on the quantity demanded and supplied, it msut impose a very large tax or subsidy. This would move the price into the elastic portion of the demand curve, hence the dmemand for the product is no longer inelastic and this will cause a much larger reduction in the quantity demanded and supplied.
Should a firm raise its prices to increase the TR generated by the production of unitary price elastic of a good or a service?
If demand is unitary elastic (also referred to as unit elastic), a firm is unable to increase its revenue by changing its price.
How effective are taxes and subsidies on inelastic demand ?
If the product is one where demand is inelastic, taxes and subsidies will not have much of an impact on production and consumption. This is because consumers are not very responsive to price changes -Subsidising a product with inelastic demand will be very costly for the government and will not result in increased consumption of the good -Taxation of a product with inelastic demand will not result in decreased consumption of the good, however, it will generate high government revenue
Relationship between PED along a demand curve and total revenue
If their goal is to increase revenues, firms need to be aware of the elasticity of demand for their products in order to decide whether to increase or decrease their prices. Even if demand for their product is inelastic, raising prices too high can bring demand into elasticity and cause decreases in revenues.
What happens to the revenue of firms who produce inferior goods during economic growth and economic recession?
In an economic recession, incomes and employment are decreasing. We would expect an increase in the demand and quantity demanded of inferior goods. Firms that sell inferior goods should experience an increase in sales and revenues. However, these firms may also experience a decrease in sales and revenues when economic growth resumes.
Total revenue of an unitary price elastic demand
In the case of a unitary price elasticity, the percentage change in the quantity demanded is equal to the percentage change in the price, as PED = 1. Therefore, when the price of the product is increased, the quantity demanded will fall by the same proportion (percentage) and the total revenue of the firm will not change, no matter what the change in price is.
The time period considered
In the immediate term, Consumers do not have any time to react to find alternatives for those goods whose prices have increased.
YED < -1, YED > 1 (absolute value greater than 1)
Income elastic demand Goods wtih YED > 1 tend to be superior goods
Income elasticity of demand (YED)
Income elasticity of demand (YED) is a measure of how much the quantity demanded of a good will change in response to a change in consumers' incomes.
-1 < YED < 1
Income inelastic demand
In times of economic growth, the average income
Increases
What does the negative YED mean ?
Inferioir goods -A negative sign for a YED value means that as incomes increase, quantity demanded of a good decreases; and conversely, as incomes decrease, quantity demanded increases.
Tax incidence
It refers to the percentage of an indirect tax paid for by consumers and producers, respectively. Elasticity of demand has an impact on the tax burden faced by consumers
The number and closeness of substitutes
The demand for goods with many (close) substitutes will be more responsive to price changes and therefore demand will be MORE elastic.
Why is the demand for most primary commodieites inelastic?
The demand for most primary commodities is inelastic, so consumers are not very responsive to price changes. Primary commodities are often necessities to those who consume them and have few or no substitutes. In addition, many primary commodities take up a small proportion of income and are used immediately.
Volatile prices for commodity producers
The demand for primary commodities is relatively inelastic because of their nature as necessity goods, often with few or no replacements. Additionally, the supply of agricultural commodities can be quite unstable, as agricultural production depends on many factors beyond the producer's control. Farmers are subject to weather conditions such as drought, floods and frosts, and other natural influences such as pests, which cause large and frequent supply changes.
Important
The terms elastic or inelastic should be used to refer to a portion of a demand curve or a price range along the demand curve.
The degree of necessity and how widely a product is defined
When a good is a necessity good, consumers will be less responsive to changes in its price because they have to consume it regardless of price. -This is the case for basic necessities like food and water, addictive goods such as drugs and cigarettes, and also for medical services or products, like insulin.
The proportion of income spent on the good
When the price of a good is very low and/or people spend a very small proportion of their income on a good or service, a change in its price will not have a very big impact on the quantity demanded. The change in price will be insignificant for consumers' disposable income and demand will be more inelastic.
Revenue consequences for primary producers
When the prices of primary commodities fluctuate in the short term, producers' revenues also fluctuate.
How do changes in the price of a good affect the total revenue of firms?
When there is a change in the price of a good or service, the impact on the firm's total revenue will depend on the price elasticity of demand of the good. Note
%△P=
[(P2−P1)/P1]×100
%△Qd=
[(Q2−Q1)/Q1]×100 Q1=Original value Q2=New quantity