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Slide 2 The relationship between Demand/Supply and how sensitive the good is to changes in Price, Income, or Other Goods Price Elasticity of Demand (PED) Income Elasticity of Demand (YED) Cross-Price Elasticity of Demand Price Elasticity of Supply Elasticities Slide 3 Possible test questions: What factors determine the price and income elasticities of demand for a product? Why might firms be interested to know the price and income elasticities of demand for various products? What are the various factors that determine the value of (i) price elasticity of demand and (ii) income elasticity of demand? Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material. Slide 4 Elasticity of Demand Price Elasticity of Demand A measure of how much the quantity demanded changes in response to a change in the price of the product. Simple formula: % in Quantity Demanded of the product % in price of the product Slide 5 In theory, the range in value is from 0 to infinity in actuality neither of these values will occur Value under 1 the product has price inelastic demand Value over 1 the product has price elastic demand Value equal to one the product has unit (unitary) price elastic demand unitary elastic inelastic -----------elastic-------------------------- 0123456 Slide 6 When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2. When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is -2.6. Slide 7 Disregard the negative sign The own price elasticity of demand is always negative. Economists usually refer to the own price elasticity of demand by its absolute value (ignore the negative sign). So, even though the formula says that the own price elasticity of demand is negative, we would say the elasticity of demand is.2 in the first example and 2.6 in the second. Slide 8 Perfectly Elastic Demand Price Quantity Perfectly Elastic Demand (elasticity = ) We say that demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded. (theoretical) Slide 9 Perfectly Inelastic Demand Price Quantity Perfectly Inelastic Demand (elasticity = 0) We say that demand is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded. (theoretical) Slide 10 Determinants of Price Elasticity 1. The Availability/Closeness of Substitutes 2. Time Span i.e. oil, inelastic short-run, slightly less long run 3. Proportion of Income Spent 4. Necessity of the product (vs. luxury goods) i.e. habit-forming products have inelastic D Slide 11 Warning:Elasticity and Slope of line A straight line will have a slope that is constant, the value of PED over the same line will vary. upper portions- more elastic lower portions more inelastic Slide 12 Significance of Price Elasticity When demand is price elastic: Price and revenue (income) move in opposite directions (indirect relationship) A rise in price will cause a fall in revenue A decrease in price will cause an increase in revenue. When demand is price inelastic: Price and revenue (income) move in the same direction (direct relationship) A rise in price will cause an increase revenue and vice versa Slide 13 Elasticity and Taxation If the government increases a tax on a product there will be a greater affect on their revenue when the product has price__________ demand. Slide 14 PED and commodities Oil, minerals, food (tangible raw materials) Tend to have inelastic demand Tend to have price volatility and the elasticity of demand has a huge effect on revenue for producers and for governments than depend on the export of commodities Price volatility due to supply shifts (short-run supply shifts) Slide 15 PED and price discrimination The same good may have different elasticities of demand for different consumers; such as airline tickets and hotel rooms. Slide 16 Income Elasticity of Demand Measures the extent to which demand for a product changes in response to a change in income Formula: % change in Quantity Demanded % change in Income Slide 17 Determinants of Income Elasticity Necessities or luxuries: Necessities have positive, but less than 1 elasticity Luxuries have positive and more than 1 Income level of consumers Slide 18 Positive Income Elasticity of Demand A rise in income will cause a rise in demand and a fall in income will cause a fall in demand for a product (a normal good) Positive value = normal goods if the value is 0-1 = income inelastic demand Necessities: bread, milk, petrol If the value is 1+ = income elastic demand Very elastic: Fine wines and spirits, high quality chocolates, luxury holidays overseas, Consumer durables - audio visual equipment, 3G mobile phones and gym memberships. These are called Superior or Luxury goods Slide 19 -+ Negative Income Elasticity of Demand A rise in income will cause a decrease in demand and a fall in income will cause an increase in demand for a product, an inferior good less than 0 (negative value) = inferior good Examples include the demand for potatoes, white- bread and low-priced own label foods in supermarkets, bikes in China, but not in developed country.. (surprisingly: cigarettes, why?) Slide 20 Uses of Income Elasticity: If a product is income elastic and the economy is getting better the company needs to plan investment. How? Government needs to know what percentage of jobs are income elastic/inelastic to plan for unemployment. Why? Slide 21 Positive Income Elastic and inelastic Demand Inelastic Income elastic Quantity Demanded Slide 22 Cross-Price Elasticity of Demand (CPed) Measures the extent to which demand for one product changes in response to a change in the price of another product % in Quantity Demanded of the product A % in price of the product B Note: Positive/Negative sign does matter Slide 23 Formula CPED (XED)= %QDa % Pb Positive Cross Elasticity (greater than 0) Substitute goods: a rise in the price of one product is likely to cause an increase in demand for its substitute(s) Slightly more than 0 = remote substitutes Greater positive number = close substitutes Apples vs. Oranges: Price of oranges increases 10% the demand for apples increases by 12% Slide 24 Positive cross elasticity (substitutes) Price of oranges quantity of apples Slide 25 Negative Cross Elasticity (Less than 0) Complementary Goods: A rise in price of one product is likely to cause a decrease in demand for its complementary good)s) Slightly less than 0 = remote complements Greater negative number = close complements Slide 26 Price Elasticity of Supply Is a measure of the responsiveness of supply to a change in price. Formula: PES = %QS %P Elastic Supply: A percentage change in price results in a greater percentage change in Supply ( 1< PES ) Inelastic Supply: When the supply is not very responsive to changes in price ( 0