IB Economics SL 3 - Elasticities

ECONOMICS SL chapter three - elasticities

3.1 Price elasticity of demand (PED) PED • The PED measures the responsiveness of quantity demanded of a good to price changes. • PED when calculated results in a negative number, but it is dropped and the absolute value is taken instead.

%ΔQx PED = %ΔPx

CASES • Price inelastic when 0 < PED < 1 • Qd % change is less than the % price change, and so Qd is relatively unresponsive. • Price elastic when 1 < PED < ∞ • Qd % change greater than % change in price. Qd is relatively responsive. • Unit elastic when PED = 1 • Qd % change is equal to % price change. • Perfectly inelastic when PED = 0 • Qd % does not change even if price changes. Demand curve is vertical. • Perfectly elastic when PED = ∞ • The demand curve is horizontal. An increase in price will decrease Qd to 0, and a decrease will raise Qd infinitely.

VARYING CURVES • On a straight-line demand curve, the PED changes down the curve. At high prices and low quantities, the Q change is large while the P change is small, so the PED is usually elastic. At lower regions, the PED is usually low (inelastic). • However, the special cases (unit elastic, perfectly in/elastic) remain constant. DETERMINANTS • If a good has many substitutes, the demand for the good tends to be more elastic because people can switch to a substitute. • If a good does not have many substitutes, the demand for the good is usually inelastic. • Substitutability is how close two substitutes are. The closer they are the greater the PED because it’s easier for people to change to the other good. • The more specific something is defined, the more close substitutes it has. (fruit/food) • Necessities are goods that we need in our lives, and luxuries are not necessary. • Necessity PED is usually inelastic because we need it, but luxuries are more elastic. A good someone is addicted to would be more inelastic. 1 ELASTICITIES

• The demand for a good becomes more elastic the longer the time period it takes for the consumer to make a decision. They are able to decide whether they really need it or not. • Demand is more elastic if the good takes a larger proportion of one’s income. STEEPNESS OF CURVE (SUPPLEMENT) • One does not simply conclude whether the demand is more/less elastic in different curves. • Two curves may not be drawn to scale. • PED is not constant along demand curves. • PED can only be compared if the demand curves intersect at some point. APPLICATIONS (REVENUE) • Total revenue - amount of money received by firms when a good or service is sold. Equal to P x Q. • If demand is elastic, and increase in price will cause a fall in total revenue. This is because the price change will cause a greater Qd decrease. • If demand is inelastic, a price increase will cause an increase in total revenue. • If demand is unit elastic, TR does not change because the change is fixed. • Total revenue is maximized at the point where demand is unit elastic. APPLICATIONS (COMMODITIES) • Primary commodities • goods that come from natural resources. • usually have lower PED than manufactured goods • Fishing, agricultural, forestry, etc. • Have low PED and is inelastic because it’s a necessity and has no substitutes. • This, with supply issues can cause problems, as the price fluctuations will be greater. • Exceptions: medication, as it’s manufactured but is inelastic. • Indirect taxes • The lower the PED for a taxed good, the greater the gov’t tax revenues.

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3.2 Cross-price elasticity of demand (XED) XED • The XED measures the responsiveness of demand for one good to a change in the price of another good. • The value and the sign of the XED are both important.

%ΔQx XED = %ΔPy

SUBSTITUTE GOODS • If the XED of two goods is positive, these two goods are substitutes. An increase in price of a good will result in the increase of demand of the other good. • EXAMPLE: Tea and coffee. If the price of coffee rises, people may switch to tea. • In two pairs of substitute goods, the pair with a larger XED are stronger substitutes. • EXAMPLE: 0.7 > 0.3 COMPLEMENTARY GOODS • If the XED of two goods is negative, these two goods are complements. an increase in price of a good will result in the fall of demand of the other good. • EXAMPLE: If the price of tennis balls increase, people might not buy tennis rackets as much. • In two pairs of complementary goods, the pair with the larger absolute value XED are stronger complements. • EXAMPLE: |-1.2| > |-1.0| UNRELATED GOODS • If the XED of two goods is zero or close to zero, the two products are unrelated. • EXAMPLE: potatoes and energy drinks APPLICATIONS • Substitutes in a single business - If a company produces two goods that are substitutes, they may want to consider the impacts if the price of one of them dropped. • Substitutes by rival businesses - A company can lower prices of a good if it will impact the demand of a rival substitute. • Substitutes and mergers - A merger is when two firms join to become one firm. Those producing goods with a high +XED may want to eliminate competition. Can be illegal. • Complementary goods - Companies work together if they produce complementary goods. Lowering of the price of plane tickets can increase the demand for hotel bookings. 3 ELASTICITIES

3.3 Income elasticity of demand (YED) YED • The YED measures the responsiveness of demand to a change in income. • Income is abbreviated as Y. • The sign and the value of YED provide the necessary info.

%ΔQx YED = %ΔY

NORMAL OR INFERIOR GOODS (SIGN OF YED) • If YED > 0, the good is a normal good. An increase in income results in a demand increase. • If YED < 0, the good is inferior. An increase in income results in a demand decreases.

NECESSITIES AND LUXURIES (VALUE OF YED) • If 0 < YED < 1, the good has income inelastic demand, and are necessities. An increase in income causes a smaller Qd increase. • If YED > 1, the good is a luxury. A percentage increase in income causes a larger Qd increase. APPLICATIONS • YED and producers • The income of a society increases as countries experience economic growth. • A higher YED may result in more expansion of the market of the good because income increases. A lower YED may result in slower expansion; • YED and economy • There are 3 sectors in the economy: • Primary sector: agriculture, fishing, extractive industries… • Manufacturing sector • Services sector • Agriculture is income inelastic. Most primary products have low income elasticity. • Manufactured goods are usually income elastic. • Causes agricultural output to shrink, and manufacturing output to increase. • Services sector increases but lowers both the primary and the manufacturing sector • In less developed countries, there is usually an increased primary sector because agriculture is more important than services and manufacturing. • Economic growth usually causes the importance of the primary sector to decrease. • YED and long term impacts (HL) • HL only. This is an SL guide. 4 ELASTICITIES

3.4 Price elasticity of supply (PES) PES • The PES measures the responsiveness of the quantity supplied of a good to price changes. • PES is positive because of the relationship between price and Qs. INTERPRETATION • Price inelastic when PES < 1. • Small percentage change in Qs compared to percentage change in P. • The end point of the supply curve cuts the horizontal axis. • Price elastic when PED > 1. • Percentage change in Qs greater than change in price. • The end point of the supply curve cuts the vertical axis. • Unit elastic when PES = 1 • Percentage change in Qs equal to change in P • End point pass through the origin. • Perfectly inelastic when PES = 0 • No change in Qs even if price changes. • Vertical line. Completely unresponsive to price. • Perfectly elastic when PES = ∞ • Percentage change in Qs is infinite. • Horizontal line. Infinitely responsive to price. • We can compare supply curves when they intersect, and the flatter curve is more elastic. They should be done only at a specific price range. DETERMINANTS • Length of time • Firms have to adjust resources and Qs in response in price changes. • Inelastic over short period but becomes more elastic as they have more time. • Mobility of factors of production • The PES is greater if firms are able to shift resource use to a good with a rising price. • Spare capacity of firms • The PES is greater if a firm has more spare capacity so it can respond easily. • Ability to store stocks • Some firms can store output that they do not sell yet. As a result, they have a higher PES. Firms that cannot store stocks usually have a lower PES. 5 ELASTICITIES

APPLICATIONS • Primary commodities have lower PES compared to manufactured products. • Farmers need a season to respond to prices, land destruction, new tech needed • Other primary commodities like oil require time to start production. • Consequences of low PES • If supply is inelastic, there are greater price fluctuations. This makes revenue unstable for producers. A small demand increase will greatly shift the equilibrium price upward. • Short-run and long-run • PES is larger for agricultural goods over a longer period of time.

Summary PED XED % change Qd / % change P % change Qdx / % change Py 0