A-Level Economics Notes on Elasticities of Supply and Demand

Definitions

1. Elasticity: A measure of how much one economic variable responds to a change in another economic variable.
2. Price Elasticity of Demand (PED): Measures how sensitive the quantity demanded of a good is to a change in its price.
3. Price Elasticity of Supply (PES): Measures how sensitive the quantity supplied of a good is to a change in its price.
4. Income Elasticity of Demand (IED): Measures how sensitive the quantity demanded of a good is to a change in income.
5. Cross-Price Elasticity of Demand: Measures how the quantity demanded of one good changes in response to a change in the price of another good.
6. Unitary Elastic: A situation where a 1% change in price leads to a 1% change in quantity demanded or supplied.
7. Elastic Demand or Supply: When the elasticity is greater than 1, indicating a high responsiveness to price changes.
8. Inelastic Demand or Supply: When the elasticity is less than 1, indicating low responsiveness to price changes.
9. Perfectly Elastic: When the quantity demanded or supplied changes by an infinite amount in response to any price change.
10. Perfectly Inelastic: When the quantity demanded or supplied does not change regardless of changes in price.
11. Normal Goods: Goods for which demand increases as income increases. They have a positive IED.
12. Inferior Goods: Goods for which demand decreases as income increases. They have a negative IED.
13. Substitute Goods: Goods that can replace each other; they have a positive cross-price elasticity.
14. Complementary Goods: Goods that are often used together; they have a negative cross-price elasticity.
15. Price Ceiling: A government-imposed limit on how high a price can be charged for a product.
16. Price Floor: A government-imposed limit on how low a price can be charged for a product.
17. Tax Incidence: The division of the burden of a tax between buyers and sellers.
18. Consumer Surplus: The difference between what consumers are willing to pay and what they actually pay.
19. Producer Surplus: The difference between the price at which producers are willing to sell a good and the actual selling price.
20. Total Welfare: The sum of consumer and producer surplus in a market.

Price Elasticity of Supply

Definition and Formula: Price Elasticity of Supply (PES) quantifies how the quantity of a good supplied changes in response to a change in its price. The formula for calculating PES is the percentage change in quantity supplied divided by the percentage change in price. This gives us a numerical value that helps us understand supply responsiveness.

1. Types of PES:
   • Elastic Supply (>1): When the PES value is greater than 1, it means that suppliers are highly responsive to price changes. A small change in price leads to a proportionally larger change in the quantity supplied.
   • Inelastic Supply (<1): Here, the PES value is less than 1, indicating that suppliers are less responsive to price changes.
   • Unitary Elastic Supply (=1): In this case, a change in price leads to a proportional change in quantity supplies.
2. Factors Affecting PES:
   • Production Time: The quicker a good can be produced, the more elastic its supply tends to be.
   • Availability of Resources: If resources are readily available, suppliers can easily adjust production, making the supply more elastic.
3. Representation in Supply and Demand Diagrams:
   • Elastic Supply: Represented by a steeper curve on the graph.
   • Inelastic Supply: Represented by a flatter curve.
4. Real-world Examples: The supply of agricultural products like wheat can be inelastic due to factors like weather and growing seasons.
5. Influence on Economic Phenomena:
   • Price Floors: When supply is inelastic, price floors can lead to large surpluses.
   • Tax Incidence: The more inelastic the supply, the more the tax burden shifts to consumers rather than producers.

Price Elasticity of Demand

Price Elasticity of Demand (PED) is a concept in economics that measures how much the quantity of a product that consumers want to buy changes when the price of that product changes. In simpler terms, it tells us how sensitive consumers are to a change in price. If the price of a candy bar goes up, do people buy a lot fewer or just a little fewer? That’s what PED helps us understand.

2. Types of PED

• Elastic Demand (>1): When demand is “elastic,” it means that consumers are very sensitive to price changes. If the price goes up a little, demand drops a lot.
• Inelastic Demand (<1): Here, consumers are not very sensitive to price changes. Even if the price goes up, they’ll still buy nearly the same amount.
• Unit Elastic Demand (=1): In this case, the percentage change in quantity demanded is exactly the same as the percentage change in price.

3. Factors Affecting PED

• Availability of Substitutes: If there are many other products similar to the one in question, demand is likely to be elastic.
• Necessity vs. Luxury: Products considered necessities (like medicine) often have inelastic demand, while luxuries (like vacations) usually have elastic demand.
• Time Horizon: Over a longer time period, demand tends to become more elastic because people have more time to adjust their behavior.

4. PED in Supply and Demand Diagrams

In a graph where the vertical axis represents price and the horizontal axis represents quantity, the demand curve shows how much of a product consumers want at different prices. A flatter curve indicates elastic demand, while a steeper curve indicates inelastic demand.

5. Real-world Examples

• Gasoline: Generally has inelastic demand because people need it for transportation regardless of minor price changes.
• Luxury Cars: These usually have elastic demand because people can easily choose a different brand if prices rise.

6. PED’s Influence on Economic Phenomena

• Price Floors: These are minimum prices set by the government. If demand is inelastic, such floors can lead to surplus because people won’t buy as much at the higher price.
• Tax Incidence: This refers to who bears the burden of a tax. If demand is inelastic, consumers will bear more of the tax burden because they’ll still buy the product even if it’s more expensive due to the tax.

Income Elasticity of Demand

Income Elasticity of Demand (IED) measures how the quantity demanded of a good or service changes in response to a change in consumers’ income. In simple terms, it tells us whether people will buy more or less of something if their income changes.

2. Types of IED

• Positive IED: When IED is positive, it means the good is a “normal good.” As income increases, people buy more of it.
• Negative IED: A negative IED indicates the good is an “inferior good.” As income rises, people buy less of it.
• Zero IED: A zero IED means the good is a “necessity.” Changes in income don’t affect its demand.

3. Factors Affecting IED

• Nature of the Good: Whether the good is a luxury or a necessity affects its IED. Luxuries usually have a high positive IED, while necessities often have a low or zero IED.
• Consumer Preferences: Cultural and personal preferences can influence IED. For example, a health-conscious society may have a higher IED for organic foods.

4. IED in Supply and Demand Diagrams

In a supply and demand diagram, a shift in the demand curve to the right indicates an increase in demand due to higher income, assuming a positive IED. A shift to the left would indicate a decrease in demand due to lower income or a negative IED.

5. Real-world Examples

• Organic Foods: Generally have a high positive IED because people buy more when their income increases.
• Fast Food: May have a negative IED as people might opt for healthier options when they have more money.

6. IED’s Influence on Economic Phenomena

• Price Floors: These are minimum prices set by the government. If a good with a price floor has a high positive IED, an increase in income could lead to a surplus.
• Tax Incidence: The burden of a tax may shift depending on the IED of the taxed good. For example, a tax on luxury cars (high positive IED) might be more easily passed on to consumers than a tax on basic groceries (low or zero IED).

Cross Price Elasticity of Demand

Cross-Price Elasticity of Demand (CPED) measures how the quantity demanded of one good changes when the price of another good changes. In simpler terms, it tells us if people buy more of one item when the price of a different item goes up or down.

Factors Affecting CPED

1. Substitute Goods: If two goods are substitutes, like tea and coffee, an increase in the price of one will lead to an increase in the demand for the other. CPED will be positive.
2. Complementary Goods: If two goods are complements, like printers and ink cartridges, an increase in the price of one will lead to a decrease in the demand for the other. CPED will be negative.
3. Unrelated Goods: If the goods are unrelated, like pencils and televisions, changes in the price of one won’t affect the demand for the other. CPED will be close to zero.

Representation in Supply and Demand Diagram

In a supply and demand diagram, CPED isn’t directly represented. However, you can infer it by looking at shifts in the demand curve. If Good A becomes more expensive and its demand curve shifts left (decreases), check if the demand curve for Good B shifts right (increases) or left (decreases). A right shift indicates they are substitutes, and a left shift indicates they are complements.

Real-World Examples

1. Fuel and Cars: If fuel prices rise, the demand for fuel-efficient cars may increase, indicating they are substitute goods.
2. Smartphones and Apps: If the price of smartphones decreases, the demand for mobile apps may increase, showing they are complementary goods.

Influence on Economic Phenomena

1. Price Floors: Governments may set minimum prices for essential goods. If a price floor is set for milk, the demand for its substitute, say, almond milk, might increase.
2. Tax Incidence: If a tax is imposed on cigarettes, the demand for nicotine gum may rise. The tax burden shifts to the substitute good.
3. Market Strategies: Companies often bundle complementary goods, like razors and blades, to increase overall demand.