CHAPTER 6 PRICE ELASTICITIES OF DEMAND & SUPPLY
Previously, we cover the theory of DD and SS. We now move on to elasticity concepts. Think of such concepts as an extension to the basic demand and supply theories. More illustrations in our Econs tutorial lessons.
Elasticity of demand for a good measures the responsiveness of quantity demanded to a change in one of its determinants. We focus on the price factor, the non-price factor of incomes and prices of related goods. For H1 Econs students, you are only required to learn price elasticity of demand (PED) and price elasticity of supply (PES) . As for H2 Economics pupils, you have to 2 more elasticity concepts of income elasticity of demand (YED) and cross elasticity of demand (XED or CED).
6.1 Definition of Price Elasticity of Demand (PED)
Price elasticity of demand (PED) measures the degree of responsiveness of quantity demanded of a good to changes in its own price.
1. Formula for calculation,
2. Sign of PED
The negative sign indicates that % change of price and quantity are inversely related. Since PED is always negative because of the Law of Demand, the sign is for convenience, ignored.
3. Magnitude of PED
Ignoring the negative sign, PED can vary from zero to infinity. Most goods have demand being either price elastic or inelastic.
6.2 Interpretation of PED Values
1. Demand is Price Elastic (1 < PED < ∞)
Demand is said to be price elastic when a change in price brings about a more than proportionate change in quantity demanded. Normally, written as PED > 1.
2. Demand is Price Inelastic (0 < PED < 1)
Demand is said to be price inelastic when a change in price brings about a less
than proportionate change in quantity demanded. Normally, written as PED < 1.
When PED >1, the demand curve is relatively flat. When PED < 1, it is relatively steep. See diagrams 1 and 2.
Note: Less common/theoretical values: PED =0, 1, ∞. E.g.: When PED = 1, demand is unitary price elastic, i.e. a change in price leads to a proportionate change in the quantity demanded.
6.3 Determinants of PED
Individual Demand refers to the quantity of a good a consumer would purchase at given prices over a period of time.
Market Demand refers to the quantity of a good that all the consumers in the market would be willing to purchase at given prices over a period of time. It can be derived by the horizontal summation of all the individual consumers’ demand curves.
6.3.1 Availability of Substitutes
The greater the number of substitutes and the closer they are, the more price elastic is the demand for a good.
The number and closeness of substitute goods also depend on the definition of the good. The broader the definition, the more prices inelastic is the demand. For example, footwear versus Reebok trainers.
6.3.2 Proportion of Income Spent on the Good
The higher the proportion of income spent on the good, the more price elastic is the demand for it. For example, demand for bus transport is likely to be price inelastic while demand for luxury cars is likely to be price elastic.
6.3.3 Nature of Good or Service
Generally, goods that are considered as necessities are more price inelastic than luxuries. For example demand for rice will be more price inelastic than that of crabs.
6.3.4 Time Period
Since it takes time to find substitutes or change spending habits and preferences, the price elasticity of demand for a good may be greater when the time period under consideration is longer.
In other words, demand tends to be more price elastic in the long run than in the short run. E.g.: Your demand pattern is different when you buy an air ticket 6 months in advance versus 3 days before you fly. (PED > 1 vs PED < 1). Similarly for products that are in fashion currently. DD is price inelastic. Then, when it goes out of fashion, DD becomes price elastic.
6.3.5 Habit / Addiction of Consumption
The demand for tobacco / cigarettes is price inelastic. Smokers tend to disregard changes in the price of these goods because they consume them either out of habit or because of addiction. Smokers will smoke no matter how expensive cigarettes are.
6.4 Application: PED and Total Revenue
6.4.1 Usefulness of PED to Governments
Under the Theory of Supply, we see that in the case of taxes and subsidies, taxes raise prices while subsidies lower it.
If the government wants to increase tax revenue, PED concept can suggest which type of goods should be taxed. E.g.: She should tax goods with inelastic demand (PED < 1), goods consumed out of habit like liquor.
If instead the government wants to discourage excessive consumption of certain goods such as cigarettes, PED concept will allow government to determine if taxation policy is effective or not.
6.4.2 Usefulness of PED to Firms
Business owners are concerned with the total revenue (TR) they earn from the goods sold. (TR = P x Q). Will a rise or fall in price leads to an increase in TR? This depends on the PED value of the good.
|PED > 1
|PED < 1
|Price is set lower
|Price is set higher
|Rise by more than
|Quantity Falls by less than
Example: How airlines price tickets
6.5 Definition of Price Elasticity of Supply (PES)
PES is a measure of the responsiveness or sensitivity of quantity supplied of a commodity to a change in its own price.
The formula is identical to that of PED, except that in this case it is quantity supplied. PES is always positive as the price and quantity supplied change in the same direction.
6.6 Interpretation of PES Values
We are concerned with goods with value of PES > 1 (supply is price elastic) and PES < 1 (price inelastic.)
When PES >1, we say that the supply is price elastic. A given change in price leads to a more than proportionate change in quantity supplied. The SS curve is relatively flat.
When PES <1, we say that the supply is price inelastic. A given change in price leads to a less than proportionate change in quantity supplied. The SS curve is relatively steep.
6.7 Determinants of PES
6.7.1 Length of the Production Period
If production converts inputs into outputs in the space of a few hours, supply will be more price-elastic than when several months are involved. Agricultural products have long harvest / gestation period, so PES < 1.
6.7.2 Ease of Accumulation of Stocks
If it is easy to store unsold stocks at low cost, firms will be able to meet a sudden increase in demand. Certain goods can be stored while others are perishable. The easier to store inventories, the greater the PES value.
6.7.3 Existence of Spare Capacity
If spare capacity exists and if variable inputs such as labour and raw materials are available, it is possible to raise production quickly in the short run, so PES > 1.
6.7.4 Number of Firms in the Industry
Generally, the greater the number of firms in an industry means the more price elastic the industry supply.
3.5.5 Ease of Factor Substitution
Many firms produce a range of products and are able to switch machines and labour from one type of production to another. If inputs can be switched in this way, then the supply of one particular product will tend to be price elastic.
For eg, during COVID-19, hotel rooms care easily converted to quarantine rooms. Thus, the supply of quarantine room is price elastic.
6.8 PES and Total Revenue
6.8.1 Usefulness of PES to Governments
The supply of primary products is relatively more inelastic than the supply of manufactured goods. Producers of manufactured goods can respond faster to changes in demand by changing output, but impossible for primary producers to respond to increases in market demand in the short run.
Prices of primary products therefore experience greater fluctuations compared to that of manufactured goods. The income of primary producers would likewise fluctuate greatly. Governments may use to help stabilise prices by price controls, offering subsidies, or implement stockpile schemes.
6.8.2 Usefulness of PES to Firms
Certain goods have fixed supply E.g. stadium seats. During the soccer season, the club might want to raise the capacity of the stadium to meet the increase in demand. However, building seats in the stadium takes time and therefore, the supply of seats in the stadium is perfectly inelastic in the short run.
The soccer club would need to consider alternative ways to allocate their resources. Say lease out for alternative events, say concerts, charity events, etc.
Also, PES also helps a firm to cater to a rise in demand, without incurring huge rise in costs. E.g.: instead of opening a new food outlet, a firm may wish to lengthen the opening hours, for instance.
More application examples taught in lesson. 🙂
6.9 Sample Short Answer Questions
- Explain why the PED values for Adidas running shoes differ from that of footwear.
- Explain why the low ability to store primary products suggest that it may face large changes in prices.
- Discuss whether consumer or producers bear more of the tax burden when a government imposes a tax on private car sharing services.
The above questions require your knowledge of the content of basic SS and DD theories, the concepts of PED and / or PED, plus the higher order thinking skills (HOT) examination techniques,. More of such HOT assessment skills in our Econs tuition class.