Elasticities. The range of values of price elasticity of demand. Price elasticity of demand [PED] Formula and definition

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1 46 4 Easticities By the end of this chapter, you shoud be abe to: expain the concept of easticity define easticity of demand define and cacuate price easticity of demand iustrate different vaues of price easticity of demand using demand curves expain the determinants of price easticity of demand define and cacuate cross easticity of demand expain the possibe range of vaues for cross easticity of demand define and cacuate income easticity of demand expain the possibe range of vaues for income easticity of demand define easticity of suppy define and cacuate price easticity of suppy iustrate different vaues of price easticity of suppy using suppy curves expain the determinants of price easticity of suppy understand some impications of easticity information for businesses and governments expain a probem for producers of primary commodities due to the ow price easticities of demand and suppy. Easticity is a measure of responsiveness. It measures how much something changes when there is a change in one of the factors that determines it. We now ook at easticity in terms of demand and suppy. Easticity of demand Easticity of demand is a measure of how much the demand for a product changes when there is a change in one of the factors that determine demand. There are three easticities of demand to consider: 1 price easticity of demand [PE] 2 cross easticity of demand [XE] 3 income easticity of demand [YE]. Price easticity of demand [PE] Formua and definition Price easticity of demand is a measure of how much the quantity demanded of a product changes when there is a change in the price of the product. It is usuay cacuated by using the foowing equation: PE 5 Percentage change in quantity demanded of the product Percentage change in price of the product Take an exampe. A pubishing firm discovers that when they ower the price of one of their monthy magazines from $5 to $4.5, the number of magazines that are bought by customers each month rises from 2, to 23,. With this information, we can cacuate the price easticity of demand for the magazine in question: 1 The price has faen by 5 from an origina price of $5, which is a change of 21%. This is cacuated by the equation %. 1 2 The quantity demanded has increased by 3 from an origina demand of 2, which is a change of 15%. This is cacuated by the equation %. 2 3 If we put the two vaues above into the equation for PE, we get PE 5 15%, which gives a vaue of % 4 The negative vaue indicates that there is an inverse reationship between price and the quantity demanded. However, in order to simpify matters, economists usuay ignore the negative vaue that comes from the equation and simpy give the answer as a positive figure. Thus, in this case, the PE for the monthy magazine woud be 1.5. The range of vaues of price easticity of demand The possibe range of vaues for price easticity of demand usuay goes from zero to infinity. The two extreme vaues are theoretica and the rea vaues ie in between. If PE is equa to zero, then a change in the price of a product wi have no effect on the quantity demanded at a. The percentage change in quantity demanded woud therefore be zero and so woud the vaue on the top of the PE equation. Since zero divided by anything is zero, no matter what the percentage change in price, the PE vaue wi be zero. A demand curve with a PE vaue of zero is shown in Figure 4.1 and, in this case, demand is said to be perfecty ineastic it is competey unresponsive to price changes. Whether price is P 1, P 2, or any other price, the quantity demanded wi be Q. A PE vaue of infinity is best expained by using a diagram and the situation is shown in Figure 4.2. In this case, demand is said to be perfecty eastic. At the price P 1, the demand curve goes on for ever and so the quantity demanded is infinite. However, if price is raised above P 1, even by the smaest amount, demand wi fa to zero, an infinite change. Because of this, the vaue on the top of the PE equation woud be infinity. Since infinity divided by anything is infinity, no matter what the percentage change in price, the PE vaue wi be infinity. As stated before, it must be remembered that the extreme vaues of PE are simpy theoretica and there are no singe products that woud possess a PE vaue of zero or infinity. Norma products have vaues of PE between the two and we wi now ook at 4 Easticities Figure 4.1 A perfecty ineastic demand curve P2 P1 Q P1 Quantity demanded of product Quantity demanded of product Figure 4.2 A perfecty eastic demand curve 47

2 4 Easticities 4 Easticities those vaues. The range of vaues of PE is normay spit into three categories. 1 Ineastic demand: The vaue of PE is ess than one and greater than zero. If a product has ineastic demand, then a change in the price of the product eads to a proportionay smaer change in the quantity demanded of it. This means that if the price is raised, the quantity demanded wi not fa by much in comparison, and so the tota revenue gained by the firm (the number of units sod 3 the price of the product) wi increase. This may be shown by an exampe. When the price of a carton of strawberry yoghurt is raised from $1 to $1.2, the firm finds that quantity demanded per week fas from 12 cartons to 1 8 cartons. Thus a 2% increase in price is causing a 1% fa in the quantity demanded. We can work out the PE by using the equation: PE 5 % in Quantity emanded 5 1% % in Price 2% 5.5 As we can see, the PE is.5, ess than one, so the demand for the yoghurt is ineastic. Before the price increase, the tota revenue gained by the firm was 12 3 $1 5 $12. After the increase, the tota revenue becomes $1.2 5 $ The firm has increased revenue by raising the price. This is shown in Figure 4.3. The revenue boxes in the diagram ceary show why a price increase causes an increase in tota revenue, when the demand for a product is ineastic. In this case, before the price rise, the firm was getting revenue equa to revenue box b 1 revenue box c. After the price increase, the firm oses revenue box c, because quantity demanded fas to 1 8 cartons, but gains revenue box a, because the remaining cartons are now sod at $1.2 each. Since revenue box a ( $2,16) is ceary arger than revenue box c (1,2 3 $1 5 $1,2), the firm s tota revenue rises by $96. Price of cartons ($) a b Figure 4.3 The demand for strawberry yoghurt c Quantity of cartons (s) 2 Eastic demand: The vaue of PE is greater than one and ess than infinity. If a product has eastic demand, then a change in the price of the product eads to a greater than proportionate change in the quantity demanded of it. This means that if price is raised, the quantity demanded wi fa by more in comparison, and so the tota revenue gained by the firm (the number of units sod 3 the price of the product) wi fa. This may be shown by an exampe. When the price of a hot dog is raised from $2 to $2.1, a hot dog seer finds that quantity demanded per week fas from 2 hot dogs to 18 hot dogs. Thus a 5% increase in price is causing a 1% fa in the quantity demanded. We can work out the PE by using the equation: PE 5 % in Quantity emanded 5 1% % in Price 5% 5 2 As we can see, the PE is 2, greater than 1, so the demand for the hot dog is eastic. Before the price rise, the tota revenue gained by the hot dog seer was 2 3 $2 5 $4. After the increase, the tota revenue becomes 18 3 $2.1 5 $378. The seer has caused a fa in revenue by raising the price. This is shown in Figure 4.4. The revenue boxes in the diagram ceary show why a price increase causes a decrease in tota revenue, when the demand for a product is eastic. In this case, before the price rise, the hot dog seer was earning revenue equa to revenue box b 1 revenue box c. After the price increase, the hot dog seer oses revenue box c, because quantity demanded fas to 18 hot dogs, but gains revenue box a, because the remaining hot dogs are now sod at $2.1 each. Since revenue box a (18 3 $.1 5 $18) is ceary smaer than revenue box c (2 3 $2 5 $4), the hot dog seer s tota revenue fas by $22. Thus, if a firm has eastic demand for its product and wishes to increase tota revenue, it shoud not raise the price of the product. Price of hot dogs ($) a b Figure 4.4 The demand for hot dogs c 18 2 Quantity of hot dogs 48 Thus, if a firm has ineastic demand for its product and wishes to increase tota revenue, it shoud raise the price of the product. Student workpoint 4.1 Be a thinker cacuate, iustrate, and expain A firm producing decorative candes owers the price of one of its scented candes from $4 to $3.6 and finds that the weeky quantity demanded of the candes goes up from 6 per week to Cacuate the percentage changes in price and quantity demanded. 2 Cacuate the price easticity of demand for the scented candes. 3 Cacuate the change in tota revenue that the firm wi experience foowing the fa in price. 4 raw a revenue box diagram to iustrate the effect on quantity demanded and tota revenue foowing the price change for the scented cande. 5 Was the firm sensibe to ower the price of the scented candes? Expain your answer. Student workpoint 4.2 Be a thinker cacuate, iustrate, and expain A pizzeria owers the price of its most popuar takeaway pizza, the Margherita, from $5 to $4.5 and finds that the weeky quantity demanded of the pizzas goes up from 6 per week to Cacuate the percentage changes in price and quantity demanded. 2 Cacuate the price easticity of demand for the pizzas. 3 Unit eastic demand: The vaue of PE is equa to one. If a product has unit eastic demand, then a change in the price of the product eads to a proportionate, opposite, change in the quantity demanded of it. This means that if price is raised by a certain 3 Cacuate the change in tota revenue that the pizzeria wi experience foowing the fa in price. 4 raw a revenue box diagram to iustrate the effect on quantity demanded and tota revenue foowing the price change for the Margherita. 5 Was the firm sensibe to ower the price of the Margherita? Expain your answer. 49

3 4 Easticities 4 Easticities percentage, then the quantity demanded wi fa by the same percentage, and so PE is equa to 1 and the tota revenue gained by the firm (the number of units sod 3 the price of the product) wi not change. A curve that has unit easticity at every point is shown in Figure 4.5. It is known as a rectanguar hyperboa. The rectanguar hyperboa is drawn in such a way that price times quantity at any point is constant. This means that the tota of the revenue boxes aways have the same area and if the revenue does not change when price changes, then PE must be unity. Thus, in Figure 4.5, the two rectanges a1b have the same area, and as the two rectanges a1b is equa to b1c. A mathematica note about easticity It is a common mistake for students to assume that easticity is a measure of the sope of the demand curve and that the vaue is aways the same at any point on the curve. This is not the case. For a straight-ine, downward-soping demand curve, the vaue of PE fas as price fas. This is shown in Figure 4.6. When price fas from $2 to $18, quantity demanded increases from 6 to 8 units. Thus the PE vaue is: PE 5 % Q % P % 1% The vaue of PE is 3.3, eastic, when we move from point a to point b. When price fas from $1 to $8, quantity demanded increases from 16 to 18 units. Thus the PE vaue is: PE 5 % Q % P % 2% Price of meas ($) Figure 4.5 A rectanguar hyperboa, where PE 5 1 at every point Price ($) a b c a b emand becomes ess eastic Quantity of meas PE = 3.3 (eastic) Quantity (units) Figure 4.6 PE vaues for a norma demand curve c d PE =.625 (ineastic) For exampe, there are many different brands of butter avaiabe on the market and so an increase in the price of one brand wi ead to a arge number of customers changing their demands to another brand. Thus the demand for products with ots of substitutes, such as brands of househod products, types of meat, and types of fruit, wi tend to have eastic demand. Products with few substitutes, such as oi, wi tend to have reativey ineastic demand, with the demand faing reativey itte as the price goes up. 2 The necessity of the product and how widey the product is defined: Food is a necessary product. Indeed, if we do not have food, then we wi die, so it is very necessary. Thus we woud expect the demand for food to be very ineastic, which it is. However, if we define food more narrowy and consider meat, we woud expect the demand to be ess ineastic, since there are many aternatives, such as vegetabes. Once again, if we then define meat more narrowy and consider chicken, beef, amb, and pork, we coud once again reasonaby assume that the demand for each woud be reativey eastic, since the consumer can easiy change from one type of meat to another, if the price of one rises. As the product is defined even more narrowy, into chicken products and then identica, but branded, chicken products, demand becomes even more eastic. This is shown in Figure 4.7. The vaue of PE is.625, ineastic, when we move from point c to point d. Thus we can see that the vaue of PE fas as we move down a demand curve. It is ogica that this shoud happen. Low-priced products have a more ineastic demand than high-priced products, because consumers are ess concerned when the price of an inexpensive product rises than they are when the price of an expensive product rises. eterminants of price easticity of demand ifferent products wi have different vaues for PE. For exampe, the demand for a restaurant mea may have a PE vaue of 3, i.e. it is eastic, whereas the demand for petro may have a PE vaue of.4, which is ineastic. What actuay determines the vaue of PE for a product? There are a number of determinants: 5 1 The number and coseness of substitutes: The number and coseness of substitutes that are avaiabe is certainy the most important determinant of PE. It is fair to say that the more substitutes there are for a product, the more eastic wi be the demand for it. Aso, the coser the substitutes avaiabe, the more eastic wi be the demand. Figure 4.7 Leve of definition 51

4 4 Easticities 4 Easticities It is worth remembering that for many goods, necessity wi change from consumer to consumer, since different peope have different tastes and necessity is often a subjective view. For exampe, in Maaysia, chicken is very popuar among the popuation and so the demand for it is ess eastic than it woud be in Itay, where it is not vaued as highy. Necessity may go to extremes when individuas consider products to be very necessary, such as habit-forming goods, ike cigarettes, acoho, or hard drugs. Such products tend to have ineastic demand. 3 The time period considered: As the price of a product changes, it often takes time for consumers to change their buying and consumption habits. PE thus tends to be more ineastic in the short term and then becomes more eastic, the onger the time period it is measured over. For exampe, when heating oi prices rose sharpy in Austria, the demand for oi that winter changed by a proportionatey smaer amount than the change in price. emand was reativey very ineastic, since peope did not reay have many aternative products that they coud switch to. They sti needed heating oi for their centra heating. However, over the next few years, the demand for heating oi began to fa as peope started to change their heating systems to ones that used gas, coa, or wood. The PE, when measured over a onger time period, was certainy more eastic. Price easticity of demand and taxation Governments need to be aware of the possibe consequences when they impose indirect taxes, such as saes taxes, on products. If a government puts a tax on a product, then its price wi usuay rise. (This is deat with in more detai in Chapter 5.) This means that the quantity demanded of the product in question is ikey to fa and this wi have consequences for empoyment in the industry concerned. If the demand for the product is very eastic, then a price increase as a resut of the imposition of a tax on the product wi ead to a reativey arge fa in the demand for the product. This means that the demand for production workers in the industry is ikey to fa significanty, increasing unempoyment in the economy. Student workpoint 4.3 Be a thinker identify and expain For each of the foowing pairs of goods, identify the one that you woud expect to have the higher price easticity of demand and expain your choice by referring to at east one of the determinants of easticity. 1 Heineken beer 2 A prescription tabet to reduce bood pressure Beer A tabet to reduce headache pain 3 Mik Orange juice Since governments are not usuay keen to increase unempoyment, they normay pace taxes on products where demand is reativey ineastic, so that the demand for the product wi not fa by a significant amount, and wi thus not ead to high unempoyment. Cross easticity of demand (XE) Formua and definition Cross easticity of demand is a measure of how much the demand for a product changes when there is a change in the price of another product. It is usuay cacuated by using the equation beow: XE 5 Percentage change in quantity demanded of product X Percentage change in price of product Y For exampe, the owners of a pizza stand find that when their competitor, a hamburger stand, owers the price of a burger from $2 to $1.8, the number of pizza sices that they se each week fas from 4 to 38, because of the ower priced burger. With this information, we can cacuate the cross easticity of demand for the pizza sices from the stand. 1 The price of the competitor s burgers has faen by 2 from an origina price of $2, which is a change of 21%. This is cacuated by the equation %. 2 2 The quantity demanded of the pizza sices has faen by 2 from an origina demand of 4, which is a change of 25%. This is cacuated by the equation %. 4 3 If we put the two vaues above into the equation for XE, we get 25%, which gives a vaue of % The range of vaues for cross easticity of demand XE expains the reationship between products. Unike price easticity of demand, where the vast majority of products have a positive vaue for PE, the vaue of XE may be positive or negative and the sign is important, since it tes us what the reationship between the two goods in question is. 52 Student Workpoint 4.4 Be a thinker cacuate, consider, and expain Estimates based on studies of the US popuation suggest that a 1% increase in the price of cigarettes woud reduce overa consumption by aduts by 3% to 5%. The same 1% increase woud reduce the consumption by youths by 13%. 1 Cacuate the price easticity of demand for cigarettes among US aduts and among US youths. 2 Suggest possibe reasons for the different magnitude of easticity between the two groups. 3 Expain two possibe reasons why a government woud pace a tax on cigarettes. If the vaue of XE is positive, then the two goods in question may be said to be substitutes for each other. Products that are very cose substitutes wi have a higher positive vaue than products that are not so cose. Two types of margarine may be very cose substitutes in the view of consumers and so a rise in the price of one wi ead to a significant fa in the demand for it and a arge increase in the demand for the competitor s margarine. Thus there woud be a high positive vaue for XE. 53

5 4 Easticities 4 Easticities If the vaue of XE is negative, then the two goods in question may be said to be compements for each other. Products that are very cose compements wi have a ower negative vaue than products that are not so cose. A computer gaming machine and the games that are payed on it may be very cose compements for consumers. A rise in the price of the gaming machine may ead to a significant fa in the quantity demanded of it and so a arge fa in the demand for the games. Thus there woud be a strong negative vaue for XE. Some products, such as matchsticks and houses, are not connected. Thus an increase in the price of matchsticks woud have no effect on the demand for housing and so the vaue of XE for the two products woud be zero. We say that the two goods are unreated. Income easticity of demand (YE) Formua and definition Income easticity of demand is a measure of how much the demand for a product changes when there is a change in the consumer s income. It is usuay cacuated by using the equation beow: YE 5 Percentage change in quantity demanded of the product Percentage change in income of the consumer Take an exampe. A person has an increase in annua income from $6, per year to $66. She then increases her annua spending on hoidays from $2,5 to $3,. With this information, we can cacuate her income easticity of demand for hoidays. Firms need to be aware of the XE for the products that they produce. It is essentia that firms are aware of the possibe impact on the demand for their products that may arise if there is a change in the price of a cose riva s products. In the same way, they need to be aware of the impact of any change in price that they make on the demand for their cose riva s products. In addition, firms that produce compementary products, such as power toos and accessories, need to be aware of the effect that any price change they make on one product might have on the demand for compementary products that they aso produce. 1 Her income has risen by $6, from an origina income of $6,, which is a change of 11%. This is cacuated by the equation 16, %. 6 2 The quantity demanded of hoidays has increased by $5 from an origina demand of $2,5, which is a change of 12%. This is cacuated by the equation 2, %. 54 XE Vaue Reationship Negative Cose Compements Remote Compements Figure 4.8 XE vaues and the strength of the reationship between products Student workpoint 4.5 Zero Unreated Products Be a thinker cacuate and expain Light-Bites, a sandwich shop, finds that when its riva, Super-Snack, reduces the price of its chicken wraps from $5 to $4.6, the demand for Light-Bites sandwiches fas from 4 sandwiches a week to 34 sandwiches a week. In addition, Super-Snack finds that foowing the fa in price of their chicken wraps, the demand for soft drinks rises from 6 cans to 63 cans per week. 1 Cacuate the cross easticity of demand between Light-Bite sandwiches and Super-Snack chicken wraps. 2 Expain the reationship above in terms of cross easticity of demand. 3 Cacuate the cross easticity of demand between Super-Snack sandwiches and the Super-Snack soft drinks. 4 Expain the reationship above in terms of cross easticity of demand. Remote Substitutes Positive Cose Substitutes 3 If we put the two vaues above into the equation for PE, we get 12%, which gives a vaue of % The range of vaues for income easticity of demand Like XE, the sign obtained from the equation is important. In this case, the sign of YE tes us whether the product we are ooking at is a norma good or an inferior good. Remember that the demand for a norma good rises as income rises and the demand for an inferior good fas as income rises. For norma goods, the vaue of YE is positive, i.e. the demand increases as income increases. If the percentage increase in quantity demanded is ess than the percentage increase in income, then a YE vaue between zero and one is obtained and the demand is said to be income-ineastic. If the percentage increase in quantity demanded is greater than the percentage increase in income, then a YE vaue greater than one is obtained and the demand is said to be income-eastic. Necessity goods are products that have ow income easticity. The demand for them wi change very itte if income rises. For exampe, the demand for bread does not increase significanty as income rises, because peope fee that they aready have enough bread and so wi not increase consumption. Superior goods are products that have high income easticity. The demand for them changes significanty if income rises. As peope have more income and have satisfied their needs, they begin to purchase products that are wants, i.e. non-essentia, in greater number. For exampe, the demand for hoidays in foreign countries is ikey to be income-eastic. 55

6 4 Easticities 4 Easticities For inferior goods, the vaue of YE is negative, because the demand decreases as income increases. Peope start to switch their expenditure from the inferior goods that they had been buying to superior goods, which they can now afford. For exampe, the demand for inexpensive jeans fas as income rises because peope switch to buying branded jeans. An Enge Curve shows the reationship between income and the demand for a product over time. It is named after Ernst Enge, a nineteenth-century German economist. Such a curve is shown in Figure 4.9. We can see that as the income in a country rises over time, the demand for potatoes may increase, then become constant, and then begin to fa as peope begin to buy superior products instead, such as pasta. Quantity of potatoes demanded Income 1 The price has risen by 5 from an origina price of $5, which is a change of 11%. This is cacuated by the equation %. 2 The quantity suppied has increased by 3, from an origina suppy of 2,, which is a change of 15%. This is cacuated by the equation %. 2 3 If we put the two vaues above into the equation for PES, we get 15%, which gives a vaue of % 4 The vaue of PES wi amost aways be positive. Student workpoint 4.6 Be a thinker cacuate and expain A consumer had an increase in income, foowing a saary rise, from $8, per year to $1 per year. In the foowing year, her expenditure on hoidays increased from $8, to $1, her expenditure on gym membership remained the same, and her expenditure on ocay produced cothes fe from $2, to $1,5. 1 Cacuate her income easticity of demand for hoidays. 2 Expain what the vaue of her income easticity of demand for hoidays means. 3 Cacuate her income easticity of demand for gym membership. 4 Expain what the vaue of her income easticity of demand for gym membership means. 5 Cacuate her income easticity of demand for ocay produced cothes. 6 Expain what the vaue of her income easticity of demand for ocay produced cothes means. Figure 4.9 An Enge Curve showing the reationship between income and the demand for potatoes The range of vaues of price easticity of suppy The possibe range of vaues for price easticity of suppy usuay goes from zero to infinity. Unike PE, we wi come across exampes of both extreme vaues as we continue our study of economics. If PES is equa to zero, then a change in the price of a product wi have no effect on the quantity suppied at a. Thus the percentage change in quantity suppied woud be zero and so woud the vaue on the top of the PES equation. Since zero divided by anything is zero, no matter what the percentage change in price, the PES vaue wi be zero. A suppy curve with a vaue of zero is shown in Figure 4.1 and, in this case, suppy is said to be perfecty ineastic it is competey unresponsive to price changes. Whether price is P 1, P 2, or any other price, the quantity suppied wi be Q. In the very short run, sometimes known as the immediate time period, it is impossibe for firms to increase their suppy straight away, no matter what happens to price, and so the suppy curve woud ook ike the one in Figure 4.1, unti new factors of production coud be empoyed. Thus a perfecty ineastic suppy curve is a possibiity. P2 P1 Q Quantity suppied of product Figure 4.1 A perfecty ineastic suppy curve S Easticity of suppy Price easticity of suppy (PES) Formua and definition Price easticity of suppy is a measure of how much the suppy of a product changes when there is a change in the price of the product. It is usuay cacuated by using the equation beow. PES 5 Percentage change in quantity suppied of the product Percentage change in price of the product For exampe, a pubishing firm reaises that they can now se their monthy magazine for $5.5 instead of $5.. In ight of this, they increase their suppy from 2 to 23 magazines per month. With this information, we can cacuate the price easticity of suppy for the magazine in question. A PES vaue of infinity is best expained by using a diagram and the situation is shown in Figure In this case, suppy is said to be perfecty eastic. At the price P 1, the suppy curve goes on forever and so the quantity suppied is infinite. However, if price fas beow P 1, even by the smaest amount, suppy wi fa to zero, an infinite change. Because of this, the vaue on the top of the PES equation woud be infinity. Since infinity divided by anything is infinity, no matter what the percentage change in price, the PES vaue wi be infinity. In internationa trade, it is often assumed that the suppy of commodities, such as wheat, avaiabe to a country for import is infinite. The consumers in the country can have a that they want as ong as they are prepared to pay the current word market price. Thus the market in the country wi have a word suppy curve that is perfecty eastic at the current word market price. (We wi dea with this in more detai in Chapter 22.) P1 Quantity suppied of product Figure 4.11 A perfecty eastic suppy curve S 56 57

7 4 Easticities 4 Easticities 58 Norma products have vaues between zero and infinity and we wi now ook at those vaues. The range of vaues of PES is normay spit into three categories: 1 Ineastic suppy: The vaue of PES is ess than one and greater than zero. If a product has ineastic suppy, then a change in the price of the product eads to a ess than proportionate change in the quantity suppied of it, and so the vaue of PES is greater than zero and ess than one. 2 Eastic suppy: The vaue of PES is greater than one and ess than infinity. If a product has eastic suppy, then a change in the price of the product eads to a greater than proportionate change in the quantity suppied of it, and so the vaue of PES is greater than one and ess than infinity. 3 Unit eastic suppy: The vaue of PES is equa to one. If a product has unit eastic suppy, then a change in the price of the product eads to a proportionate change in the quantity suppied of it and so the vaue of PES is equa to one. Exampes of suppy curves with different vaues of PES are shown in Figure In Figure 4.12, curves S 1 and S 2 have a PES vaue of one aong their entire ength. This is because the percentage change in price is aways equa to the percentage change in quantity suppied. For mathematica reasons, it is correct to say that any straight-ine suppy curve, passing through the origin, has an easticity of suppy of one. Curve S 3 has a PES vaue of ess than one aong its entire ength. This is because the percentage change in price is aways greater than the percentage change in quantity suppied. For mathematica reasons, it is correct to say that any straight-ine suppy curve starting from the x-axis has a PES vaue ess than one. Curve S 4 has a PES vaue of greater than one aong its entire ength. This is because the percentage change in quantity suppied is aways greater than the percentage change in price. For mathematica reasons, it is correct to say that any straight-ine suppy curve starting from the y-axis has a PES vaue greater than one. eterminants of price easticity of suppy ifferent products wi have different vaues for PES. For exampe, the suppy of cans of a soft drink may have a PES vaue of 2, i.e. the suppy is eastic, whereas the suppy of eectricity may have a PES vaue of.5, which is ineastic. What actuay determines the vaue of PES for a product? There are a number of determinants: 1 How much costs rise as output is increased: If tota costs rise significanty as a producer attempts to increase suppy then it is ikey that the producer wi not raise the suppy and so the easticity of suppy for the product wi be reativey ineastic. It woud take arge price rises to make increasing the suppy worthwhie. If, however, tota costs do not rise significanty then the producer wi raise the quantity suppied and take advantage of the ow increase in costs to benefit from the higher prices, thus making Figure 4.12 Suppy curves with different vaues of PES Student workpoint 4.7 Be a thinker iustrate, expain, and cacuate A firm producing stuffed toys experiences an increase in the demand for its main product, a cuddy dog, because of an increase in its popuarity. The price of the toy rises from $15 to $18. In response, the firm increases its output of the toy from 5, per week to 5,5 per week. 1 Using a demand and suppy diagram, expain why the price of the toy dog has increased. 2 Cacuate the easticity of suppy for the toy dog. S1 S3 S2 S4 Quantity suppied more profits. Tota costs wi not rise significanty if the costs of factor inputs do not increase quicky as the firm uses more of them. There are a number of factors that assist in preventing a significant rise in costs, such as: a) The existence of unused capacity If a firm has a ot of unused capacity, i.e. if it has significant productive resources that are not being fuy used, then it wi be abe to increase output easiy and without great cost increases. In this case the easticity of suppy for the product wi be reativey high. If a firm is producing at capacity then it is difficut to increase suppy without a significant increase in productive resources, which wi be expensive. It is therefore unikey that the firm wi increase suppy. PES wi be reativey ineastic. b) The mobiity of factors of production If factors of production are easiy moved from one productive use to another then PES wi be reativey eastic. For exampe, if it is easy to shift production from manufacturing one itre pastic bottes to manufacturing two itre pastic bottes, when the price of two itre bottes goes up, then the extra cost of switching to the arger bottes wi not be great and the change wi take pace. 2 The time period considered: The amount of time over which PES is measured wi affect its vaue. In genera terms the onger the time period considered the more eastic the suppy wi be. In the immediate time period firms are not reay abe to increase their suppy very much, if at a, if price increases, since they cannot immediatey increase the number of factors of production that they empoy. The vaue of PES wi be very ineastic. In the short run firms may be abe to increase the quantity of some of the factors that they empoy, such as raw materias and abour, but they may not be abe to increase a of their factors, such as the number of machines that they use or the size of their factory. The vaue of PES wi be more eastic than the immediate time period. In the ong run firms may be abe to increase the quantity of a of the factors that they empoy and so the vaue of PES wi be much more eastic. We wi ook at time periods and production in much more detai in Chapter 6. 3 The abiity to store stock: If a firm is abe to store high eves of stock (inventories) of their product, then they wi be abe to react to price increases with swift suppy increases and so the PES for the product wi be reativey eastic. Primary commodities Price easticity of demand for commodities Commodities (or primary commodities) is another word for raw materias, such as cotton or coffee. Such products tend to have ineastic demand as they are necessities to the consumers who buy 59

8 4 Easticities 4 Easticities them and they have few or no substitutes. We must remember that the consumers of primary commodities tend to be manufacturing industries which process the raw materia into finished products. For exampe, if there is an increase in the price of green coffee (raw coffee beans), then the coffee processing companies who buy the green coffee to make instant coffee for consumers have itte choice but to continue buying the coffee, and thus the quantity demanded wi fa by a proportionatey smaer amount. Simiary, if there were to be a decrease in the price of green coffee the processing companies woud not want proportionatey more coffee as their production targets woud aready have been set and they have no use for further inputs, regardess of the price. Assessment advice: using the anguage of economics Whenever you are discussing any type of easticity in an examination question, you must try to be very precise with anguage. Easticity measures the responsiveness of change, and it is the percentage change or proportionate change that is significant. Never say that a sma change in price (or income) causes a arge change in the quantity. Be specific say that a given price change causes a proportionatey smaer (or proportionatey arger) change in quantity. Or say that a given percentage change in price eads to a smaer (or arger) percentage change in quantity. Or you coud give vaues. For exampe, say that a 1% increase in price eads to a change in quantity that is greater (or ess) than 1%. The adjectives sma and big are just too imprecise. On the other hand, demand for manufactured goods tends to be more eastic as there are many more substitutes avaiabe to consumers. Price easticity of suppy for commodities Commodities tend to have ineastic suppy as a change in price cannot ead to a proportionatey arge increase in quantity suppied. For exampe, if there were to be an increase in the demand for cocoa, and therefore an increase in the price of cocoa, producers woud be unabe to respond with a proportionate increase in the quantity as it takes time to grow the cocoa and/or it takes time to re-aocate resources to the production of cocoa. Simiary, if there were to be a fa in the price of cocoa then the quantity suppied woud not adjust accordingy as the cocoa crop might aready have been harvested. On the other hand, the suppy of manufactured goods tends to be more eastic as it is easier to increase or decrease quantity suppied in response to a change in price. Price of copper ($ per tonne) Suppy Quantity of copper (thousands of tonnes) Figure 4.13 The market for copper Examination questions Paper 1, part (a) questions 1 With the hep of exampes, expain the determinants of price easticity of demand. 2 A businessperson wants to increase her revenues. Using appropriate diagrams, expain why knowedge of price easticity of demand woud be usefu. 3 With the hep of exampes, expain the concept of cross easticity of demand. 4 With the hep of exampes, expain the determinants of price easticity of suppy. 5 Using income easticity of demand, expain the difference between norma, necessity, and inferior goods. Paper 1, essay question [1 marks] [1 marks] [1 marks] [1 marks] [1 marks] 1 a Expain the concept of easticity of demand. [1 marks] b iscuss why it may be important for a firm to have a knowedge of price easticity of demand. [15 marks] 6 The combination of reativey ineastic demand and ineastic suppy for commodities means that any changes in the demand or suppy of a commodity wi resut in arge swings in prices. Take a ook at the artice on copper prices in Chapter 3. According to the text the price of copper in Apri 21 was around $8, per tonne, which was the highest price since August 28. The previous year the price had reached a ow of $3, per tonne. Thus, within two years, there were fuctuations in price (up or down) of more than 15%. Part of the reason for the arge fuctuations ies in the ow easticities of suppy and demand. In the case of an industria commodity such as copper the suppy is ineastic due to the high costs and time invoved in changing suppy when price changes. As you can see in Figure 4.13, a change in demand wi resut in changing prices for copper. In the case of copper and the artice in Chapter 3 the increase in demand, argey due to demand from China, resuted in a shift in demand from 1 to 2. The resuting change in price of $5, per tonne in one year is very arge. But, as the artice impies, what goes up aso comes down! For copper producers the upswings in price might be very good in terms of generating arge revenue gains but the same producers are very vunerabe to the inevitabe downswings in prices. The voatiity of commodity prices and the vunerabiity of commodity producers is a topic that we sha return to ater in the companion. You be the journaist Headine: Pharmaceutica giant Paado misjudges its market by raising the price on its best-seing headache reief tabet. Economics concept: PE, substitute goods, XE. iagram: Revenue box diagram. Hint: What do you think Paado was assuming about the easticity of demand for its tabet? Who might gain from this decision? Assessment advice: essay questions The first examination paper you wi write in your fina IB ipoma Programme economics exam wi be the essay paper, Paper 1. You wi find more information about this paper in Chapter 34, but we introduce you to the topic here. Paper 1 consists of two sections and you wi write two essays in tota. Section A wi be based predominanty on microeconomic theory and section B wi be based predominanty on macroeconomic theory. Each question has a part (a), worth 61

9 4 Easticities 1 marks, and a part (b) worth 15 marks. You wi have 9 minutes for this paper so the assumption is that you wi take 45 minutes for your microeconomics essay and 45 minutes for your macroeconomics essay. In part (a) you wi be expected to define key terms, provide exampes and iustrate the theory with an appropriate diagram. Remember to use the diagram in your answer. on t just stick it on at the end! Part (b) invites you to use the ski of evauation, which essentiay means making reasoned evauation incuding evauate, discuss, to what extent, compare, contrast, compare and contrast, examine and justify. Evauation is a higher order ski and one that you wi practice a great dea. It is a process that invoves the carefu consideration of a topic or issue with a view to forming a baanced concusion. It is important to note that whie an essay question might be based on microeconomic theory it wi inevitaby bring in other sections of the syabus. For exampe, consider the essay question Evauate the significance of ow easticities of demand and suppy of primary commodities for producers of such goods. Whie this question used the core theory of easticities, which is a microeconomics concept, it is aso concerned with the effect on primary commodity producers. For the question given above, where you are asked to discuss why it may be important for a firm to have a knowedge of price easticity of demand, you woud have to justify your expanation with the deveopment of appropriate theory. An expression such as The most important reason why a firm woud wish to have knowedge of price easticity of demand is... because... woud be appropriate. This woud show that you have come to a reasoned decision and then offered an expanation using economic theory. 62