Elasticity and Consumer/Producer Behaviour
Elasticity converts 'demand falls' into 'demand falls by how much', which is what businesses and governments actually need. This domain tests the four elasticities, the link between elasticity and total revenue, tax incidence, and the marginal-utility foundations of consumer choice. Numerical questions are common, so be prepared to compute and then interpret.
Price elasticity of demand
- PED = percentage change in quantity demanded ÷ percentage change in price. The value is negative; use the absolute value for classification. |PED| > 1 elastic, < 1 inelastic, = 1 unit elastic, 0 perfectly inelastic, infinite perfectly elastic.
- Determinants: availability of substitutes, proportion of income spent, necessity versus luxury, time horizon, habit or addiction, and how broadly the good is defined.
- Revenue rule: if demand is elastic, a price cut raises total revenue; if inelastic, a price rise raises total revenue. Revenue is maximised at unit elasticity.
- Tax incidence: the burden falls more heavily on the side of the market that is more inelastic.
Income, cross and supply elasticities
- YED positive = normal good; above 1 = luxury; negative = inferior good.
- XED positive = substitutes; negative = complements; near zero = unrelated.
- PES depends on spare capacity, time period, factor mobility and storability. Supply is more elastic in the long run.
Consumer and producer behaviour
- Marginal utility diminishes as consumption rises; the consumer is in equilibrium when MUx/Px = MUy/Py.
- A price fall pivots the budget line outward, producing an income effect and a substitution effect.
- Consumer surplus is the area between the demand curve and the price paid; producer surplus the area between price and the supply curve. Together they measure welfare, which is why market-failure questions use them.
Worked example
A bakery sells 500 loaves a day at €2.00, giving revenue of €1,000. It raises the price to €2.20 and sales fall to 450. The price change is +10 per cent and the quantity change is −10 per cent, so PED = −1: unit elastic and total revenue is unchanged at €990, which is close enough to confirm the rule. Had the good been a luxury with PED = −2, the same 10 per cent rise would have cut sales by 20 per cent to 400 loaves, leaving revenue of €880 - a fall, so the price rise destroys revenue when demand is elastic.
Traps that cost marks
- Reporting elasticity as a percentage; it is a ratio of percentages and has no units.
- Confusing steepness of a straight-line demand curve with elasticity: elasticity changes along a linear curve even though slope does not.
- Applying the revenue rule in reverse, claiming a price rise raises revenue when demand is elastic.
- Assuming the tax is fully passed on to consumers regardless of elasticities.