Your Comprehensive Guide to Price Elasticity!
Hey everyone! Welcome to your study notes for "Price Elasticity of Demand and Supply". Don't worry if this topic sounds a bit technical. We're going to break it down with simple language and everyday examples.
So, what will you learn? We'll explore how much buyers and sellers react to price changes. Think of it like a rubber band – some are super stretchy, others aren't. Understanding this "stretchiness" is super important because it helps businesses decide on prices and helps us understand how government policies, like taxes, affect us. Let's get started!
Part 1: Price Elasticity of Demand (PED)
What on earth is PED?
Imagine the price of your favourite bubble tea suddenly doubles. Would you buy less of it? Probably! Now, what if the price of life-saving medicine doubles? People would still have to buy it.
Price Elasticity of Demand (PED) measures how much the quantity demanded of a good changes when its price changes. In simple terms, it tells us how "sensitive" or "responsive" consumers are to a price change.
- If consumers are very sensitive to price changes, demand is elastic.
- If consumers are not very sensitive to price changes, demand is inelastic.
How to Calculate PED (Arc Elasticity)
To get a precise measure, we use a formula. The syllabus requires us to use the arc elasticity method, which is just a fancy way of saying we use the average of the prices and quantities. This gives us a more accurate result.
Here is the formula. It looks scarier than it is!
$$E_d = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}} = \frac{\frac{(Q_2 - Q_1)}{(Q_1 + Q_2)/2}}{\frac{(P_2 - P_1)}{(P_1 + P_2)/2}}$$Where:
- P₁ and Q₁ are the initial price and quantity.
- P₂ and Q₂ are the new price and quantity.
Step-by-step Calculation Example:
The price of a concert ticket increases from $500 to $600. As a result, the quantity demanded falls from 2,000 tickets to 1,500 tickets. Let's calculate the PED.
- Identify the values:
P₁ = $500, P₂ = $600
Q₁ = 2,000, Q₂ = 1,500 - Calculate the change in quantity and average quantity:
Change (Q₂ - Q₁) = 1,500 - 2,000 = -500
Average (Q₁ + Q₂)/2 = (2,000 + 1,500)/2 = 1,750 - Calculate the change in price and average price:
Change (P₂ - P₁) = $600 - $500 = $100
Average (P₁ + P₂)/2 = ($500 + $600)/2 = $550 - Plug into the formula:
$$E_d = \frac{-500 / 1750}{100 / 550} = \frac{-0.2857}{0.1818} \approx -1.57$$
Important Note: Because of the Law of Demand (when price goes up, quantity demanded goes down), the PED value will always be negative. For simplicity, economists often ignore the minus sign and look at the absolute value. So, we'd say the PED is 1.57.
Interpreting the PED Value: The 5 Types of Elasticity
The number we calculate tells us a story. Here's what the different values mean:
1. Elastic Demand (|E_d| > 1)
- Meaning: Quantity demanded is very responsive to price changes. A small percentage change in price leads to a larger percentage change in quantity demanded.
- Example: Luxury goods like designer watches or restaurant meals. If the price goes up a bit, many people will just stop buying them.
2. Inelastic Demand (0 < |E_d| < 1)
- Meaning: Quantity demanded is not very responsive to price changes. A large percentage change in price leads to a smaller percentage change in quantity demanded.
- Example: Necessities like rice, electricity, or petrol. Even if the price goes up a lot, people still need to buy them, so demand doesn't fall much.
3. Unitary Elastic Demand (|E_d| = 1)
- Meaning: The percentage change in quantity demanded is exactly the same as the percentage change in price. This is the middle ground.
- Example: This is more of a theoretical concept, but some goods might fall into this category over a specific price range.
4. Perfectly Inelastic Demand (|E_d| = 0)
- Meaning: Quantity demanded does NOT change at all, no matter what happens to the price. (This is very rare!).
- Example: Life-saving drugs. A patient needs a specific dose, and they will pay any price to get it.
5. Perfectly Elastic Demand (|E_d| = ∞)
- Meaning: Consumers will buy an infinite amount at one specific price, but if the price increases even a tiny bit, quantity demanded drops to zero. (Also very rare in the real world).
- Example: Imagine a farmer selling carrots at a large market where all carrots are identical. If they try to charge even one cent more than the market price, nobody will buy from them.
Quick Review: PED Summary
Elastic (|E_d| > 1): Sensitive Consumers (e.g., luxuries)
Inelastic (0 < |E_d| < 1): Insensitive Consumers (e.g., necessities)
Unitary (|E_d| = 1): Proportional Response
The Big Question: PED and Total Revenue
Why do businesses care so much about PED? Because it helps them predict what will happen to their total revenue (TR) if they change their prices. Remember, Total Revenue = Price × Quantity.
When a firm changes its price, there are two opposing effects:
- Price Effect: Each unit is sold at a higher (or lower) price.
- Quantity Effect: Fewer (or more) units are sold.
Which effect is stronger? PED tells us!
If Demand is ELASTIC (|E_d| > 1)...
...the Quantity Effect is stronger. Consumers are sensitive!
- If you increase the price, the drop in quantity sold will be so large that your total revenue will fall.
- If you decrease the price, the increase in quantity sold will be so large that your total revenue will rise.
Example: A cinema with elastic demand should consider a price cut to fill more seats and increase revenue.
If Demand is INELASTIC (|E_d| < 1)...
...the Price Effect is stronger. Consumers are not sensitive!
- If you increase the price, people will mostly keep buying, so your total revenue will rise.
- If you decrease the price, you won't attract many new customers, so your total revenue will fall.
Example: An MTR fare increase might lead to higher total revenue because most people have few alternatives for their daily commute (inelastic demand).
If Demand is UNITARY ELASTIC (|E_d| = 1)...
...the Price Effect and Quantity Effect are equal. They cancel each other out, and total revenue does not change when the price changes.
Common Mistake to Avoid!
Don't assume that raising the price always leads to more revenue. It completely depends on the price elasticity of demand! Smart businesses will try to estimate their PED before making pricing decisions.
What Determines PED? Factors Affecting Price Elasticity of Demand
Why are some goods elastic and others inelastic? Several factors are at play. A good way to remember them is the mnemonic SPLAT.
- S – Substitutes: The more close substitutes a good has, the more elastic its demand. If the price of Coca-Cola goes up, it's easy to switch to Pepsi.
- P – Proportion of Income: Goods that take up a large percentage of a person's income tend to have more elastic demand. A 10% price increase on a new car is a big deal; a 10% price increase on a box of matches is not.
- L – Luxury or Necessity: Luxuries are goods we can live without, so their demand is more elastic. Necessities are things we must have, so their demand is more inelastic.
- A – Addictive Nature: Addictive goods, like cigarettes, tend to have very inelastic demand.
- T – Time: Demand becomes more elastic over time. In the short term, if petrol prices soar, you still have to drive your car. In the long term, you might buy a more fuel-efficient car or move closer to work.
Key Takeaway for Section 1
Price Elasticity of Demand (PED) is a crucial concept that measures consumer sensitivity to price changes. It helps businesses make smart pricing decisions by showing the link between price changes and total revenue. Remember that factors like substitutes, necessity, and time all influence how elastic demand for a good is.
Part 2: Price Elasticity of Supply (PES)
What is PES?
Now let's switch over to the producers' side. Price Elasticity of Supply (PES) measures how much the quantity supplied of a good changes when its price changes.
Basically, it tells us how "responsive" or "flexible" producers are to a price change. Can they quickly make more if the price goes up?
- If producers can easily change production levels, supply is elastic.
- If producers find it difficult to change production levels, supply is inelastic.
Calculating PES (Arc Elasticity)
Good news! The formula is almost identical to the one for PED. We just use quantity supplied (Qs) instead of quantity demanded (Qd).
$$E_s = \frac{\text{Percentage Change in Quantity Supplied}}{\text{Percentage Change in Price}} = \frac{\frac{(Q_2 - Q_1)}{(Q_1 + Q_2)/2}}{\frac{(P_2 - P_1)}{(P_1 + P_2)/2}}$$Important Note: Because of the Law of Supply (when price goes up, quantity supplied goes up), the PES value will always be positive. No need to worry about minus signs here!
Interpreting the PES Value
The interpretation is similar to PED, but now we're thinking about production.
1. Elastic Supply (E_s > 1)
- Meaning: Producers are very responsive. A small percentage price increase leads to a larger percentage increase in the quantity they supply.
- Example: Manufacturers of simple goods like t-shirts. If the price rises, they can easily hire more workers, run an extra shift, and quickly produce more.
2. Inelastic Supply (0 < E_s < 1)
- Meaning: Producers are not very responsive. A large percentage price increase leads to only a small percentage increase in quantity supplied.
- Example: Agricultural products like avocados. If the price of avocados shoots up today, farmers can't instantly grow more trees. It takes years. Supply is fixed in the short term.
3. And the others...
Unitary Elastic (Es = 1), Perfectly Inelastic (Es = 0), and Perfectly Elastic (Es = ∞) supply follow the same logic as with demand. For example, perfectly inelastic supply would be the number of seats in a concert hall for a show tonight – you can't add more seats, no matter how high the ticket price goes!
What Determines PES? Factors Affecting Price Elasticity of Supply
What makes it easy or hard for firms to change their output?
- Factor Mobility: How easily can a firm get the resources (labour, raw materials, machines) needed to increase production? If skilled labour and materials are readily available, supply will be more elastic.
- Flexibility of Production / Spare Capacity: Does the firm have unused machines or factory space? Can workers easily do overtime? If a factory is already running 24/7, it has no spare capacity, and its supply will be inelastic. A firm with a lot of spare capacity has elastic supply.
- Time: This is the most important factor! Supply is almost always more elastic in the long run than in the short run.
- Short Run: It's hard to change production. A farmer can't grow more wheat overnight.
- Long Run: With enough time, the farmer can buy more land, invest in new machinery, and significantly increase production.
Did you know?
The supply of original paintings by a deceased artist like Van Gogh is perfectly inelastic (PES = 0). No matter how high the price goes, the quantity of original paintings can never be increased.
Key Takeaway for Section 2
Price Elasticity of Supply (PES) measures producer responsiveness to price changes. The main factors affecting it are the flexibility of production and, most importantly, the time frame. In the short run, supply is often inelastic, but it becomes much more elastic in the long run.
Part 3: Applications of Elasticity - Who Pays the Tax?
Elasticity and Tax Incidence
So why did we learn all this? One of the most important applications is understanding who really pays a tax. When the government puts a tax on a good (like a tax on sugary drinks), who bears the burden? The consumer (through higher prices) or the producer (through lower revenue)? This is called tax incidence.
The answer depends on the relative elasticities of demand and supply!
The Golden Rule of Tax Incidence
The burden of a tax falls more heavily on the side of the market that is less elastic (more inelastic).
Memory Aid: Think of being "inelastic" as being "stuck". If you're stuck, you can't escape the tax!
Scenario 1: Demand is Inelastic, Supply is Elastic
Think of a tax on cigarettes.
- Demand: Demand for cigarettes is inelastic because they are addictive. Smokers are "stuck" buying them.
- Supply: Supply is relatively elastic. Cigarette companies can adjust production.
- Result: Because consumers are less responsive (more inelastic), they can't easily reduce their consumption. They will end up paying most of the tax in the form of a much higher price. The consumers bear a larger tax burden.
Scenario 2: Demand is Elastic, Supply is Inelastic
Think of a tax on luxury yachts made in a specific small town with specialised workers.
- Demand: Demand for luxury yachts is very elastic. If the price goes up, rich people will just spend their money on something else (e.g., a private jet).
- Supply: Supply is inelastic. The specialised workers and facilities can't easily be used to produce something else. The producers are "stuck" making yachts.
- Result: If producers try to pass the tax on to consumers by raising the price, their sales will plummet. So, they have to absorb most of the tax themselves, receiving a lower price for their yachts. The producers bear a larger tax burden.
And What About Subsidies?
A subsidy is the opposite of a tax (the government gives money to encourage production or consumption). The rule is simply the reverse:
The benefit of a subsidy goes more to the side of the market that is less elastic (more inelastic).
So, if the government subsidises a good with inelastic demand (like education), the consumers will get most of the benefit through lower prices.
Key Takeaway for Section 3
Elasticity is a powerful tool for real-world analysis. It determines who really bears the burden of a tax or receives the benefit of a subsidy. Just remember the golden rule: the more inelastic ("stuck") side of the market pays more of the tax and gets more of the subsidy. You've got this!