Price elasticity of Demand (PED)
PED = Measures the responsiveness of quantity demanded to a change in the price of the good/service.
Calculation
Formula = (percentage change in quantity demanded/percentage change in price) * 100.
If the PED is below one, the product is price inelastic. Essentially a rise in prices won’t force customers a way, demand will remain roughly constant (the demand curve is steep). In this case raising prices will lead to an increase in revenue. This can be seen in the diagram below on the left. As the price rises from P1 to P2 quantity demand falls from Q1 to Q2. The dark grey area identifies the fall in revenue, while the grey revenure represents the increase in revenue.
If the PED is above one the product is price elastic. A rise in price will force customer to stop buying the product, they will switch to close substitutes (the demand curve is relativley flat). In this case raising your prices will cause revenue too fall, where as reducing prices will cause revenue too rise. This can be seen in the diagram above on the right. As the price falls from P1 to P2 quantity demand rises from Q1 to Q2. The dark grey area identifies the fall in revenue, while the grey revenure represents the increase in revenue.
If the PED = 1, the good is termed unitary, any rise in price will cause an identical fall in demand. For example a 1% rise in the price level will lead to a 1% fall in demand.
Determinants:
- Substitutes: The more substitutes there are, the more price elastic the good will be. The reason being that, people can easily switch from one product to another should there be a change in the price level.
- Percentage of income: The greater the percentage of income required to purchase the good, the higher the elasticity. The reason being that people will be careful when purchasing this good because of its cost.
- Necessity: The more necessary a good is, the lower the price elasticity. Quite simply people will buy the product irrespective of its price - its a necessity (milk and bread).
- Time: As the time span increases consumers can adjust there expenditure switching to cheaper alternatives. And so the longer a price change holds, the higher the elasticity.
- Habit goods – Goods that are addictive such as cigarettes tend to have a low price elasticity. The reason being that people are addicted to them and so will buy them no matter the price.
Price elasticity of supply (PES)
PES = Measures the responsiveness of quantity supplied to a change in price.
Formula = (Percentage change in quantity supplied/Percentage change in price ) * 100.
The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa.
If the PES is below one, supply is inelastic and the supply curve is relativley steep. Essentially a rise in demand won’t lead to a change in supply, output will remain constant, while prices increase. In the diagram below the supply curve on the left is vertical, this represents a PES of 0. The good is perfectly price inelastic and a change in price will have no affect on quantity supplied. The only change will be in the price level.
If the figure is above one, supply is elastic i.e. responsive to changes in the price level. In this case a rise in prices will lead to a larger rise in quantity supplied. In the diagram above on the right, the supply curve is horizontal. This illustrates a perfect elastic supply, the value for PES is infinite. In this case supply will adjust perfectly to a change in demand while prices remain unchanged.
Determinants:
- Spare capacity - How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output without a rise in costs and therefore supply will be elastic.
- Stocks - The level of stocks - if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly - supply will be elastic
- Ease of factor substitution - If capital and labour resources are substitutable then the production process will be flexible to changes in demand leading to an elastic supply.
- Time - Supply is more elastic, the longer the time a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs, if this is the case supply will be inelastic and unable to alter. Where as in the long run new inputs can be added to the production process enabling supply to adjust to new demands/prices.
Income elasticity of Demand (YED)
YED = Measures the responsiveness of the quantity demanded to a change in income.
A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the quantity demanded. As income rises consumers may change to more luxurious substitutes. An example of an inferior good is frozen vegetables, or own brand bread.
A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in the quantity demanded.
If the YED for a commodity is less than 1, it is a necessity good (income elasticity is inelastic – demand doesn’t change as income rises). Examples of necessities include utilities and fresh vegetables.
If the YED is greater than 1, it is a luxury good, as income alters demand for this good will alter too. Examples of luxury goods include private education and designer clothes. As income rises, demand for these goods will rise, where as a fall in income will lead to a fall in demand.
Formula = (percentage change in quantity demanded/percentage change in income) * 100.
Cross elasticity of Demand
Measures the responsiveness of the quantity demanded of a good to a change in the price of another good.
Formula = (percentage change in quantity demanded of good A / percentage change in price of good B) * 100.
If the two goods are substitutes the cross elasticity of demand will be positive. As the price of one goes up the quantity demanded of the other will increase. For example, in response to an increase in the price of coffee, the demand for tea will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to infinity.
If the two goods are complements the cross elasticity of demand will be negative. As the price of one goes up the quantity demanded of the other will decrease. For example, as the price of fuel increases, the demand for new cars will decrease.
If the two goods are independent (not related), the cross elasticity demand will be zero. As the price of one good changes, there will be no change in quantity demanded of the other good.
Below is a diagram illustrating what the curves will look like depending on whether the goods are substitutes or complements.
Economic surpluses
There are two forms of economic surplus 1) consumer surplus 2) producer surplus.
Consumer surplus: The difference between what a consumer is willing to pay for a good and what he actually pays. In other words the consumer surplus is the amount that consumers benefit by being able to purchase a product for a price that is less than they would be willing to pay. It is measured by the area between the price and the demand curve. This is highlighted as the red area in the diagram below.
Why does this occur?
Consider the market for mars bars.
Two people, John and Mark are both on the same income. However they have different tastes, John absolutley loves Mars bars where as Mark thinks they are ok. Mark is only willing to pay the going rate £0.40, but due to Johns admiration he would willingly pay £1. Clearly John is benefiting from the market price being lower than his valuation and this benefit is measured by the consumer suplus.
Mark and his brother Phil value Mars bars equally in terms of taste. However Phil is very rich, he earns twice as much as Mark. Due to his large disposable income he is willing to pay £0.50 for a Mars bar. As with John, Phil benefits from the relativley low market price.
Producer surplus: The difference between what a producer is willing to sell a good for and what the good is actually sold for. In other words the producer surplus is the amount that producers benefit by selling at a market price that is higher than they would be willing to sell for. It is measured by the area between the price and the supply curve. This is highlighted as the blue area in the diagram below.
Why does this occur?
Two businesses Paint Direct and Paint Splatter both sell black paint. Paint Direct uses very basic technology and so costs are relativley high. Due to these high costs Paint Direct is only willing to supply paint at the market price £12. But Paint Splatter utilises state of the art technology, produtivity is very high and so cost per unit is extremely low. Due to these low costs Paint Splatter is willing to sell the paint for £10, it will still earn a healthy profit margin. Clearly Paint Splatter is benefting from the high market price, its profit margins are very high. The benefit is represented by the producer surplus.
Want to find out more...about any economic topics...or anything in general?
Follow the link below to Amazon and search for many economics books covering every economic topic. The books can be bought new or second hand (excellent condition) for very cheap.