IB Economics Course Companion Chapter 5: Elasticities

Elasticity of Demand PED: Price elasticity of demand XED: Cross elasticity of demand YED: Income elasticity of demand

PED Measures the responsiveness of demand to a change in price Formula –% change in QD / % change in P Example –If a 5% increase in price leads to a 7% decrease in QD –-7/5 = -1.4 What do the value mean?

What do the values of PED mean? PED <1 = price inelastic PED >1 = price elastic PED =0 = perfectly price inelastic PED =  = perfectly price elastic PED =1 = unitry PED is positive = giffen or veblen good PED is negative = law of demand holds true  BUT  BUT what do these actually mean for my business and how does it affect the demand curve?

How does PED affect the slope of the demand curve? P Q P Q P Q P Q TASK: draw and label the curves

Interesting mathematical views of PED PED along a linear D curve We are measuring the movements between points and not the slope of the entire curve Demand curves in reality are unlikely to be linear A note on UNITRY If PED=1 then as price rises demand falls but revenue remains constant In reality this is very unlikely Right angled hyperbola P Q P Q P1 P2 Q1Q2 More price elastic Less price elastic DD

Determinants of PED The number and closeness of substitutes The necessity of the price and width of definition The time period considered Questions to consider 1)What is the PED for cigarettes to a smoker this week? 2)How will your answer change in the longer term? 3)What is the PED for tennis rackets in the summertime in the UK?

PED and taxes We need to consider PED when we impose an indirect tax – this is covered in Ch 6

YED Measures the responsiveness of demand to a change in income Formula –% change in QD / % change in Y Example –If a 5% increase in income leads to a 10% increase in QD –10/5 = 2 What do the value mean?

What do the values of YED mean? The sign (+/-) is now important Positive: YED <1 = Normal but income inelastic YED >1 = Normal but income elastic Negative YED <1 = Inferior but income inelastic YED >1 = Inferior but income elastic  BUT  BUT what do these actually mean for my business and how does it affect the demand curve?

Engel Curve Shows the relationship between income and the demand for a product Named after 19 th Century German economist ERNST ENGEL As income rises demand may initially increase As incomes rise further consumers substitute out into other more appealing (more expensive) products e.g. pasta Quantity of potatoes demanded Income CLASS TASK : complete the diagram

What is XED? Measures the responsiveness of QD x to changes in P y Formula –%age ∆ QP x / %age ∆ P y Example –Say the price of chicken falls by 12% what happens to the QD of fish? What do the sign and value of the calculations tell us? –Substitutes or complements –Close, distant or non-related

What is PES? Measures the responsiveness of supply to changes in price Formula –%∆QS/ %∆P Example –Suppose a 16% fall in price led to a 6% fall in QS (6/16=0.375) PES will almost always be +ve What do the values tell us?

How does PES affect the slope of the supply curve? P Q P Q P Q P Q TASK: draw and label the curves Perfectly inelastic supplyPerfectly elastic supply Inelastic supplyElastic supply

Mathematical considerations of PES Any Supply curve that passes through the origin mathematically has a PES=1 Even though S1 and S4 have different steepness mathematically they both produce a PES=1 S3: PES > 1 S2; PES <1 HL THINK about tax QS per month P S1 S2 S3 S4

Determinants of PES How are costs affected by increases in Q? Time period considered –SR –LR –Very short run (immediate) –Very long run Example: –What is the PES of grain in the US in winter?

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