Microeconomics AS Part 3

Price Elasticity of Demand (PED) is defined as a numerical measure of the responsiveness of demand to a change in the price of a product, ceteris paribus. It is calculated by dividng the % change in demand by the % change in price.

PED usually has a negative value, since demand usually decreases as price increases.

Should PED have a magnitude of less than 1, demand is said to be relatively inelastic. This means it is relatively unresponsive to price change. Propotionately, demand will change less than price.

Should PED have a magnitude of greater than 1, demand is said to be relatively elastic. This means it is relatively responsive to price change. Propotionately, demand will change more than price.

PED can also have a value of exactly 1, this means that demand is unitary elastic - demand changes at the same rate, proportionate to price.

Income Elasticity of Demand (YED) is defined as a numerical measure of the responsiveness of demand to a chnage in income, ceteris paribus.

It is calculated by dividing the % change in demand by the % change in income.

The value of the YED value is important, as this determines what type of good the product is:

• A positive value shows a normal good (consumption increases with income)
• A negative value shows an inferior good (consumption decreases as income increases)

A YED value of >1 shows demand for the product is relatively income elastic, i.e. demand will change proportionately more than income. These products are called luxury products.

A YED value of <1 shows demand for the product is relatively income inelastic, i.e. demand will change proportionately less than income. These products are called normal necessities.

YED is drawn on a graph using an Engel curve - with income on the y axis and quantity demanded on the x axis.

Cross (sometimes 'Cross-Price-') Elasticity of Demand (XED or CPED) is defined as a numerical measure of the responsiveness of the demand for one product, A, to a change in the price of a related product, B. It is calculated by dividing the % change in demand for product A by the % change in price of product B.

The value of XED is very important, as it determines both the nature (if any) and the strength of the relationship between two products.

If XED is positive, this shows the two products are substitutes in consumption, whilst if it is negative the two products are complements.

The magnitude of the figure shows the stength of the relationship:

• A value of greater than 1 shows a relatively close/strong relationship (the demand for A changes by proportionately more than the price of B)
• A value of less than 1 shows a relatively weak relationship (the demand for A changes by proportionately less than the price of B)

Price Elasticity of Supply (PES) is a numerical measure of the responsiveness of supply to a chnage in price, ceteris paribus. It is calculated by dividing the % change in quantity supplied by the % change in price. Since supply almost exclusively increases with price, the value of PES is neraly always positive.

If PES is greater than 1, supply is relatively price elastic. This means that supply is relatively responsive to a change in price. When price changes, supply will change by proportionately more. This could be the case when there is spare capacity in production, or when factor inputs can easily and cheaply be trasferred into production as they have a high factor mobility.

If PES is less than 1, supply is relatively price inelastic. This means that supply is relatively unresponsive to a change in price. When price changes, supply will change by proportionately less. This could happen in the opposite situations to the above, with no spare capacity and factor inputs with low factor mobility.

When PES is exactly 1, we say it is unitary elastic, i.e. a change in price will lead to a change in supply of the same proportion. PES of 0 means supply is perfectly inelastic, for example a cinema or plane where there are a limited number of seats are the closest we can get to this. PES of an infinite value means supply is perfectly elastic, such as streaming over the internet.

Factors affecting price elasticity of demand

• The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch
• The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic.
• The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.
• The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will have a more elastic demand

Elasticity of demand and total revenue for a producer / supplier

When demand is inelastic, a rise in price leads to a rise in total revenue, but when demand is elastic a fall in price leads to a rise in total revenue.

The usefulness of price elasticity for producers

Firms can use PED estimates to predict:

• The effect of a change in price on the total revenue & expenditure on a product.
• The price volatility in a market following changes in supply – this is important for commodity producers who suffer big price and revenue shifts from one time period to another.
• The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
• Information on the PED can be used by a business as part of a policy of price discrimination. This is where a supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines.
• Usually a business will charge a higher price to consumers whose demand for the product is price inelastic

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales. Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services. The income elasticity of demand will also affect the pattern of demand over time.

• For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumer’s income spent on that product will go up.
• For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall
• For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales. Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services. The income elasticity of demand will also affect the pattern of demand over time.

• For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumer’s income spent on that product will go up.
• For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall
• For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.

The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

The price mechanism plays three important functions in a market:

Signalling function

• Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
• Prices rise and fall to reflect scarcities and surpluses
• If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
• If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

Transmission of preferences

• Through their choices consumers send information to producers about the changing nature of needs and wants
• Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
• When demand is weaker in a recession then supply contracts as producers cut back on output.

Rationing function

• Prices serve to ration scarce resources when demand in a market outstrips supply.
• When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product.

• The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending.
• Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).
• Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.
• The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.