# LEARNING UNIT 6 LEARNING UNIT 6

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1 DATE: March 2014 MODULE: PMIC6111 TEXTBOOK REFERENCE: pg THEME: ELASTICITY OBJECTIVES: BY END OF YOU SHOULD KNOW THE FOLLOWING: DEFINE ELASTICITY EXPLAIN MEANING AND SIGNIFICANCE OF PRICE ELASTICITY OF DEMAND EXPLAIN MEANING OF SPECIFIC ELASTICITY COEFFICIENT ep = 1,8 IDENTIFY VALUE OF ep VARIOUS POINTS ON A LINEAR DEMAND CURVE CLACULATE PRICE ELASTICITY OF DEMAND USING ARC ELASTICITY FORMULA EXPLAIN LINK BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE FROM SALES DISTINGUISH BETWEEN 5 DIFFERENT CATEGORIES OF PRICE ELASTICITY OF DEMAND EXPLAIN EFFECT ON TOTAL REVENUE OF A CHANGE IN SUPPLY WHEN DEMAND CURVES HAVE DIFFERENT ELASTICITIES EXPLAIN DETERMINANTS OF PRICE ELASTICITY OF DEMAND DEFINE AND CALCULATE CROSS ELASTICITY OF DEMAND AND CLASIFY GOODS ON BASIS OF CROSS ELASTICITY EXPLAIN MEANING AND SIGNIFICANCE OF PRICE ELASTICITY OF SUPPLY DEFINITION FORMAL DEFINITION: THE PERCENTAGE CHANGE IN A DEPENDENT VARIABLE IF THE RELEVANT INDEPENDENT VARIABLE CHANGES BY ONE (1) PERCENT SUPPLY AND CURVE ANALYSIS USED TO EXPLAIN: HOW PRICE OF A PRODUCT IS DETERMINED PREDICT WHAT WILL HAPPEN IF A PRICE OF A COMPLEMENT GOOD CHANGES ANALYSE EFFECTS OF A SUBSIDY OR TAX ON PRICES AND QUANTITIES WE HAVE ANALYSED DIRECTION (RIGHTWARD; LEFTWARD; UP;DOWN) OF CHANGES IN SUPPLY AND DEMAND NOW WE WILL ANALYSE THE MAGNITUDE OF THE CHANGE IEBY HOW MUCH WILL PRICE AND QUANTITY CHANGE WHEN DEMAND AND SUPPLY CHANGES 1

2 INFORMAL DEFINITION ELASTICITY IS A MEASURE OF RESPONSIVENESS OR SENSITIVITY TWO VARIABLES ARE RELATED HOW RESPONSIVE IS THE DEPENDENT VARIABLE TO CHANGES IN THE INDEPENDENT VARIABLE FORMULA ELASTICITY = PERCENTAGE CHANGE IN DEPENDENT VARIABLE PERCENTAGE CHANGE IN INDEPENDENT VARIABLE 4 TYPES OF ELASTICITY PRICE ELASTICITY OF DEMAND INCOME ELASTICITY OF DEMAND CROSS ELASTICITY OF DEMAND PRICE ELASTICITY OF SUPPLY 2

3 PRICE ELASTICITY OF DEMAND LOOKING AT DEMAND CURVE DEPENDENT VARIABLE = QUANTITY DEMANDED INDEPENDENT VARIABLE = PRICE OF PRODUCT IN OTHER WORDS: THE QUANTITY DEMANDED DEPENDS ON THE PRICE IMPORTANT: PERCENTAGE CHANGES ARE USED (RELATIVE CHANGES NOT ABSOLUTE CHANGES) PRICE ELASTICITY OF DEMAND IS RATIO OF % CHANGE IN QUANTITY DEMANDED TO PERCENTAGE CHANGE IN PRICE ANSWER TO ELASTICITY CALCULATION IS A NUMBER CALLED ELASTICITY COEFFICIENT ELASTICITY COEFFICIENTS HELP US COMPARE (REACTIONS OF DIFFERENT PRODUCTS TO CHANGES IN PRICES) ANSWERS WILL BE NEGATIVE PRICE AND DEMAND MOVE IN OPPOSITE DIRECTIONS CALCULATING PRICE ELASTICITY OF DEMAND 1. NEED TO CALCULATE % CHANGE IN QUANTITY DEMANDED Q x 100 Q 2. NEED TO CALCULATE % CHANGE IN PRICE OF PRODUCT P x 100 P 3. EQUATION (9.1) 3

4 ep= % change in quantity demanded % change in price of product SLOPE OF LINEAR CURVE: GIVEN BY CHANGE IN PRICE DIVIDED BY CHANGE IN QUANTITY FIGURE 9.1 (TEXTBOOK PG 156) POINTS A; B; C; D; E ELASTICITY VARIES FROM INFINITY ( ) TO ZERO (0) ARC ELASTICITY CALCULATES THE ELASTICITY COEFFICIENT BY COMPARING TWO POINTS ON A DEMAND CURVE THE FORMULA FOR ARC ELASTICITY IS MUCH EASIER TO USE: PG159 TEXTBOOK / / BECAUSE WE IGNORE THE NEGATIVE SIGN, ARC ELASTICITY SHOULD GIVE YOU THE SAME ANSWER FROM BOTH POINTS ON THE CURVE 4

5 PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE/EXPENDITURE PRICE ELASTICITY CAN BE USED TO DETERMINE HOW MUCH THE TOTAL EXPENDITURE (OR TOTAL REVENUE (TR) OF PRODUCERS) BY CONSUMERS ON A PRODUCT CHANGES WHEN THE PRICE OF A PRODUCT CHANGES IF CHANGE IN PRICE GREATER CHANGE IN QUANTITY DEMANDED TRWILL CHANGE IN OPPOSITE DIRECTION TO PRICE CHANGE IF CHANGE IN PRICE EQUALCHANGE IN QUANTITY DEMANDED TRWILL REMAIN UNCHANGED IF CHANGE IN PRICE SMALLERCHANGE IN QUANTITY DEMANDED TRWILL CHANGE IN SAME DIRECTION AS PRICE CHANGE 5

6 If price elasticity of demand is greater than 1, TR increases as the quantity sold (Q) increases TR reaches a maximum when the price elasticity of demand is equal to 1 If the price elasticity of demand is smaller than 1, TR decreases as Q increases 6

7 PERFECTLY INELASTIC DEMAND REFERS TO A SITUATION WHERE THE PRICE ELASTICITY OF DEMAND IS ZERO REPRESENTED BY A VERTICAL LINE PARALLEL TO THE PRICE AXIS CONSUMERS PLAN TO PURCHASE A FIXED AMOUNT OF THE PRODUCT IRRESPECTIVE OF ITS PRICE PRODUCERS CAN THUS RAISE THEIR REVENUE BY INCREASING THE PRICE WHEN P INCREASES AND Q REMAINS CONSTANT, TR INCREASES IF JERRY S CARS HAVE A PERFECTLY INELASTIC DEMAND, HE CAN SELL HIS CARS AT ANY PRICE AND CONSUMERS WILL STILL BUY THEM 7

8 2.INELASTIC DEMAND WHEN A CHANGE IN PRICE LEADS TO A CHANGE IN QUANTITY, BUT THE CHANGE IN PRICE IS GREATERTHAN THE PERCENTAGE CHANGE IN QUANTITY THE ELASTICITY COEFFICIENT IS GREATER THAN ZERO, BUT LESSTHAN 1 PRODUCERS WILL HAVE AN INCENTIVE TO RAISETHE PRICE SINCE THE PERCENTAGE CHANGE IN PRICE WILL BE GREATER THAN THE PERCENTAGE CHANGE IN THE QUANTITY SOLD IF THE PRICE OF THE PRODUCT INCREASES, THE PRODUCERS TR WILL INCREASE P IF JERRY INCREASES HIS PRICES, A GREAT INCREASE IN PRICE WILL NOT LEAD TO A GREAT DECREASE IN THE QUANTITY DEMANDED FOR HIS CARS 8

9 3. UNIT ELASTIC DEMAND OCCURS WHEN THE PERCENTAGE CHANGE IN THE QUANTITY DEMANDED IS EXACTLY EQUAL TO THE PERCENTAGE CHANGE IN PRICE 1 UNIT ELASTICITY IS THE DIVIDING LINE BETWEEN ELASTIC AND INELASTIC DEMAND PRODUCERS CANNOT RAISE REVENUE BY INCREASING OR DECREASING THE PRICE TR WILL REMAIN UNCHANGED 4. ELASTIC DEMAND 1 WHEN A CHANGE IN PRICE LEADS TO A GREATERCHANGE IN THE QUANTITY DEMANDED PRODUCERS CAN INCREASE THEIR REVENUE BY LOWERINGTHE PRICE OF THE PRODUCT THERE IS NO INCENTIVE TO RAISE THE PRICE 9

10 1 IN THIS CASE JERRY CAN INCREASE SALES BY LOWERING HIS PRICES 5. PERFECTLY ELASTIC DEMAND HAS AN ELASTICITY COEFFICIENT OF INFINITY CONSUMERS ARE WILLING TO PURCHASE ANY QUANTITY AT A CERTAIN PRICE, BUT IF THE PRICE INCREASES, THE QUANTITY DEMANDED FOR THE PRODUCT WILL FALL TO ZERO 10

11 IF JERRY INCREASES HIS PRICES HE WILL SELL NO CARS Determinants of the Price Elasticity of Demand What makes some goods elastic and others inelastic? 1) SUBSTITUTION POSSIBILITIES The more substitutes available the more price elastic is demand Eg beef/mutton; butter/margarine 2) DEGREE OF COMPLEMENTARITY OF THE PRODUCT The more complementary the more inelastic is demand Eg sugar (tea/coffee) 3) TYPE OF WANT SATISFIED BY THE PRODUCT Whether a good is a necessity or luxury Eg basic foodstuffs vsluxury motor vehicles 11

12 4) Time period More elastic in the long run Eg airfares 5) Proportion of income spent on product Greater the % of income spent on a product the greater the price elasticity Lower the % of income spent on a product the lower the price elasticity EgMatches vsmeat Matches low % of income is spent low price elasticity Meat large % of income spent high price elasticity INCOME ELASTICITY OF DEMAND As income rises quantity demanded usually increases ey= % change in quantity demanded of a product % change in consumers income Positive income elasticity = normal good Ie as income increases quantity demanded increases Normal goods essential goods ( eyless than 1) -luxury goods ( eymore than 1) Negative income elasticity = inferior good Ie as income increases quantity demanded decreases 12

13 CROSS ELASTICITY OF DEMAND ec = % change in quantity demanded of product A % change in price of product B Negative coefficient: complementary good Positive coefficient: substitute good The price elasticity of supply Price elasticity of supply the ratio between the percentage change in the quantity supplied of a product and the percentage change in the price of the product By how much will the quantity supplied change if the price changes by one per cent? 13

14 Different categories of price elasticity of supply: Perfectly inelastic supply (e s = 0) Inelastic supply (0 < e s < 1) Unitary elastic supply (e s = 1) Elastic supply (1 < e s < ) Perfectly elastic supply (e s = ) The different categories of price elasticity of supply 14

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17 Determinants of the price elasticity of supply: Time Expectations Stockpiling Excess capacity Availability of inputs 17

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