Mrs. Pinke
IB Economics I HL
8 June 2012
1. The Price Elasticity of Demand (PED) and Its Determinants, P.62-63
● PED measures the responsiveness of the quantity demanded of a good to changes in price
● Mathematically:
● Different products will have different values for PED
● Values of PED:
○ if PED = , demand is considered to be perfectly elastic
○ if PED > 1, demand is considered to be relatively elastic
○ if PED = 1, demand is considered to be unit elastic
○ if PED < 1, demand is considered to be relatively inelastic
○ if PED = 0, demand is considered to be perfectly inelastic
● Determinants of PED:
○ The number and closeness of substitutes
■Most important determinant of PED
■The greater number of substitutes available, the more elastic the product will
be
● e.g. household products like butter, meat, and fruit
■Products that have few substitutes have relatively inelastic demand
● e.g. crude oil
○ The necessity of the product and how widely the produce is defined
■Goods and services that are necessities are usually very inelastic
● e.g. food, drinks (the general categories, not specific food and
drinks)
■Chicken would be relatively elastic, but specific brand-name chicken like
KFC, Popeyes, etc. would be even more elastic
○ The time period considered
■In the short-run, goods are more inelastic
■In the long-run, goods are more elastic
○ Luxury versus necessity
■Luxury goods are more elastic than necessities
■Necessities are more inelastic than luxuries
○ Addictive products
■Addiction makes a good a necessity, makes demand more inelastic
○ Percentage of income spent on the product
■Higher percentage, more elastic
■Lower percentage, less elastic
2. Applications of PED
● Because PED is a measure of the responsiveness of quantity demanded to changes in
price, a PED value for a given good or service can be used to predict how future price
changes would affect quantity demanded.
● PED used in Business Decisions - Total Revenue
○ PED can be used to determine the optimal quantity at which to produce in order to
maximize profit
○ In a sector of inelastic demand (PED<1), the magnitudes of increases in price are
larger than the corresponding decreases in quantity demanded. Thus, overall, total
revenue (PxQ) increases when prices are raised under relatively inelastic
conditions.
○ In a sector of more elastic demand (PED>1), the magnitudes of increases in price
are smaller than the corresponding decreases in quantity demanded. Thus, overall,
total revenue (PxQ) decreases when prices are raised under relatively elastic
conditions.
○ Total revenue is thus maximized where PED = 1.
● PED and
Taxation Incidence of Tax
○ Taxes are meant to either a) bring in revenue for a government or b) reduce
demand for a good or service to correct an externality
○ Governments can use PED to determine how a tax will affect quantity demanded
and tax revenue
○ Incidence of tax is divided into two sections - the extra price paid by consumers,
and the lower price received by producers.
○ The group with the lower price elasticity bears the brunt of the tax
■if PED > PES, producers pay most of the tax, because quantity demanded
drops more than quantity supplied.
■if PES > PED, consumers pay most of the tax, because quantity supplied
drops more than quantity demanded.
○ If governments wish to maximize their revenue, they should tax goods for which
PES > PED
○ If governments wish to maximize the decrease demand for a good or service, they
should tax it if PED > PES
● PED and Primary vs. Secondary Sectors - Luxury Goods
○ PED can be used to determine whether goods are considered part of the primary
sector (basic necessities) or the secondary or tertiary sector (luxury goods and
technologies)
○ Primary sector goods, such as agricultural products, tend to have relatively low
PEDs because consumers view them as necessities and are more willing to
purchase them at any price. Primary sector goods also have fewer close subsitutes.
○ Tertiary sector goods, however, are often unnecessary luxuries such as
automobiles or computers - while they do make life easier, it is much easier to go
without them if price becomes an issue.
3. Cross Price Elasticity of Demand (XED)
● Definition and formula for the cross-elasticity of demand
○ A measure of the responsiveness of the demand for on good to a change in the
price of another good.
● XED = percentage change in demand for good X / percentage change in price of good Y
○ XED =
● XED is either positive or negative (this is crucially important to its interpretation)
○ the magnitude of the XED: how small or large is its numerical value
● Interpreting the cross-elasticity of demand
○ Positive XED: Substitutes
○ Negative XED: Compliments
○ Zero XED: Unrelated Products
● Applications of XED
○ There are a number of situations where knowing the XED is beneficial for firms
and the government alike.
○ It would be of interest of them to know whether two or more goods are substitutes
or compliments as well as the degree of substitutability or complementarity
○ Substitute goods
■when the change in the demand for the one good is in the same direction as
the change in the price of the other good
■in other words, when the price of Y increases the demand for X also increases;
and when the price of Y falls, the demand for X also falls
○ Substitute produced by a single business
■When a business produces a line of goods that are substitutes (ex: Coca Cola
and Sprite), they must consider XED when making decisions about prices
■Therefore in this example they consider:
● the PED for Coca Cola, so that it can determine whether a price cut
will lower or raise total revenue from Coca Cola
● the XED for Coca Cola and Sprite. Also, the degree of
substitutability between them.
○ Substitutes produced by rival businesses
■A business in interested in knowing the XED of substitutes in the event that
they are produced by rival business since it could mean a drop in sales (if
Coca Cola dropped its price and the XED was large then Pepsi would
suffer a serious drop in sales).
■They would also want to know it in order to be able to predict the effect on
Coca Cola sales of any change in the price of Pepsi
○ Substitutes and mergers between firms
■A merger takes place when two firms unite to form a single firm. Business
that produce close substitutes, i.e. goods with a high XED, might be
interested in merging in order to eliminate competition between them
■Governments generally try to prevent firm mergers that are likely to result in a
major reduction of competition
■One of the main roles of the government is to try to promote competition
○ Complementary goods
■the XED is negative when the demand for one good and the price of another
good change in opposite directions; this occurs when the two goods are
complements.
■the larger the numerical value of the negative XED, the greater is the
complementary between two goods, and the larger will be the demand
curve shift
○ Unrelated Products
■if the XED is 0 or close to 0, this means that the two products are unrelated or
independent of each other
4. Income Elasticity of Demand (YED)
● Definition
○ Measure of the responsiveness of demand to changes in income
● Examples
○ Income elasticity for fine wines: High
○ Income elasticity for baked beans: Low but positive as beans are a staple food
○ Income elasticity for private executive air travel: High
● Values of YED
○ A negative income elasticity of demand is associated with inferior goods; an
increase in income will lead to a fall in the demand and may lead to changes to
more luxurious substitutes.
○ A positive income elasticity of demand is associated with normal goods; an
increase in income will lead to a rise in demand. If income elasticity of demand of
a commodity is less than 1, it is a necessity good. If the elasticity of demand is
greater than 1, it is a luxury good or a superior good.
○ A zero income elasticity (or inelastic) demand occurs when an increase in income
is not associated with a change in the demand of a good. These would be sticky
goods.
● Determinants: how different goods are impacted by YED
○ Normal necessities have an income elasticity of demand of between 0 and +1 for
example, if income increases by 10% and the demand for fresh fruit increases by
4% then the income elasticity is +0.4. Demand is rising less than proportionately
to income.
○ Luxuries have an income elasticity of demand > +1 i.e. the demand rises more
than proportionate to a change in income – for example a 8% increase in income
might lead to a 16% rise in the demand for restaurant meals. The income elasticity
of demand in this example is +2.0. Demand is highly sensitive to (increases or
decreases in) income.
● Inferior Goods
○ Inferior goods have a negative income elasticity of demand
○ Demand falls as income rises
○ Typically inferior goods or services tend to be products where there are superior
goods available if the consumer has the money to be able to buy it.
○ Examples include the demand for cigarettes, low-priced own label foods in
supermarkets and the demand for council-owned properties.
● Detailed examples
○ The income elasticity of demand is usually strongly positive for:
■Fine wines and spirits, high quality chocolates (e.g. Lindt) and luxury holidays
overseas.
■Consumer durables - audio visual equipment, 3G mobile phones and designer
kitchens.
■Sports and leisure facilities (including gym membership and sports clubs).
○ In contrast, income elasticity of demand is lower for
■Staple food products such as bread, vegetables and frozen foods.
■Mass transport (bus and rail).
■Beer and takeaway pizza!
○ Income elasticity of demand is negative (inferior) for cigarettes and urban bus
services.
● Product ranges:
○ However the income elasticity of demand varies within a product range.
○ For example the YED for own-label foods in supermarkets is probably less for the
high-value “finest” food ranges that most major supermarkets now offer.
○ You would also expect income elasticity of demand to vary across the vast range
of vehicles for sale in the car industry and also in the holiday industry.
● Long-term changes:
○ There is a general downward trend in the income elasticity of demand for many
products, particularly foodstuffs.
○ One reason for this is that as a society becomes richer, there are changes in
consumer perceptions about different goods and services together with changes in
consumer tastes and preferences.
○ What might have been considered a luxury good several years ago might now be
regarded as a necessity (with a lower income elasticity of demand).
○ Consider the market for foreign travel. A few decades ago, long-distance foreign
travel was regarded as a luxury. Now as real price levels have come down and
incomes have grown, so millions of consumers are able to fly overseas on short
and longer breaks. For many an annual holiday overseas has become a necessity
and not a discretionary item of spending
5. PES and its Determinants
● Price Elasticity of Supply (PES) = a measure of the respoinsiveness of the quantity of a
good supplied to changes in its price. [large responsiveness to price - elastic; small
responsiveness to price -ine lastic]
● PES =
● Mathematical Derivation
Value of PED
Classification
Interpretation
0<PED<1
Inelastic supply
Quantity supplied is relatively unresponsive to
price
1<PED<infinity
Elastic supply
Quantity supplied is relatively unresponsive to
price
PED=1
Unit elastic supply
Percentage change in quantity supply equals
percentage change in price
PED=0
Perfectly inelastic
supply
Quantity supplied is completely unresponsive
to price
PED=infinity
Perfectly elastic
supply
Quantity supplied is infinitely responsive to
price
Frequently Encountered
Cases
● Values for PES
○ PES ranges in value from 0 to infinity.
○ The direct relationship between price and quantity supplied makes the curve
positive.
○ PES<1: Supply is price inelastic
■% change in quantity supplied is smaller than the percent change in price, thus
PES<1. Quantity supplied is relatively unresponsive to changes in price.
■Example: Water--you need it to survive, therefore you will pay almost any
price to get it.
○ PES>1: Supply is price elastic
■% change in quantity supplied is larger than % change in price, thus PES>1.
Quantity supplied is relatively responsive to price changes.
■Example: Diamond--they are a luxury good, therefore if it gets too expensive
you will not buy it.
○ PES=1: Supply is unit elastic
○ % change in quantity supplied is equal to the %change in price, thus PES=1.
When the supply curve passes through the origin, PES=1.
○ PES=0: Supply is perfectly inelastic
■% change in quantity supplied is 0 therefore there is no change in quantity
supplied regardless of what happens to price.
● Examples:
○ the supply of Kandinksy’s paintings
○ the number of seats in a stadium
○ you cannot change any of these quantities...but the price of
each can change.
○ PES = infinity: Supply is perfectly elastic
■% change in quantity supplied is infinite therefore a very small change in
price means a very large change in quantity supplied.
■In relation to the graph: at the price where the supply curve is situated, firms
can supply any quantity of the good.
■Example: there is no real life example...it basically means that there is
unlimited supply of a product...it will never run out.
● Determinants of PES:
○ Length of Time:
■Immediate Time Period -- firm is unable to change any of its inputs in order to
change the quantity that firm produces. In this case, supply is highly
inelastic or even perfectly inelastic (PES = 0).
■Short Run -- a period of time where the firm is able to vary at least one input,
but not all of its inputs in order to change its quantity produced. Thus, the
firm is able to increase or decrease its quantity produced by varying some
of its inputs, but not by varying all of the inputs. In the short run, supply is
inelastic (PES < 1).
■Long Run -- a period of time where the firm is able to vary all of its inputs in
order to change the quantity supplied. In the long run, supply is elastic
(PES > 1).
○ Ease of Entry into the market:
■If there are low barriers of entry into the market, and firms can come into and
go from the market as they please, supply is elastic.
■If there are high barriers of entry into the market, and it is more difficult for
firms to enter and exit the market, supply is inelastic.
○ Spare Capacity of Firms
■If firms in a market have spare capacity to produce (i.e. factories or equipment
running idle for some hours of the day) it is easier for the firm to respond
to a change in price and increase its quantity supplied, thus supply is
elastic.
■If firms in a market are already running at full capacity, it is much harder for
the firms to respond to changes in price and supply is inelastic.
○ Number of Supplier Substitutes
■If a market for a good or service has many supplier substitutes (i.e. a firm can
easily switch from producing basketballs to producing volleyballs), the
firms would be more able to respond to changes in price in either market
and supply is elastic.
■If a market for a good or service has few or no supplier substitutes (i.e. a farm
cannot easily switch from growing corn to growing wheat), the firms
would not be able to respond to changes in price easily and supply is
inelastic.
6. Applications of PES
● Explain why the PES for primary commodities is relatively low and the PES for
manufactured products is relatively high.
● PES and shorter term price instability of agricultural products
○ Agricultural produces are more inelastic PES over short periods of time
because of the time needed to respond to price changes and because
agriculture is constrained by growing seasons for particular product’s demand
fluctuates because:
■changes in foreign demand
■crop failures
■increased protection of farmers (price supports)
■quotas/tariffs
■changes in consumer tastes
○ Thus, in short term, agriculture has lower PES than manufactured goods
because length of time but in long term, opposite occurs (PES decreases)
● Prices of agriculture tends to be volatile over short term and decline over long term.
Explain this using PED, PES, and YED.
● Agricultural goods and others produced in the primary sector of the economy is
subject to determinants of supply which affect the prices of the products. Beneficial
or adverse environmental conditions/weather can increase or decrease the supply
curve, a determinant that is not in the control of the farmers. The fluctuating supply is
a major factor to which PED, PES, and YED are elastic or inelastic. In the short term,
produces have no time to produce substitutes and thus have a t least one of its inputs
in a fixed quantity. The PES is inelastic in the short term, supply is relatively
unresponsive to price. In the long term, produces have more time to search for
substitutes so PES is more elastic. So when PES is low, inelastic, it has greater price
fluctuations in changes in demand. The PED is highly inelastic due to the lack of
substitutes and that food is a necessity. Price fluctuations are great for inelastic
demand than for elastic demand. The combination of fluctuating supply, changing
prices, PES, and PED in the short term leads to a YED that is less than 1 but greater
than 0. So, YED is inelastic, meaning the farmers’ income grows at a rate greater
than the demand for the good. Therefore, in the short term, the PED and PES are low
(inelastic) and the farmers’ income will be greater in adverse weather conditions (S2)
than in increased supply (S3). As world income increases, primary products would
get a less increase in demand relative to those in secondary/tertiary sectors. Farmer
income decreases relative to world income
○ inelastic b/c <0
○ low PED
○ low PES
○ strong changes in supply
○ determinants of demand (i.e. change in taste