Elasticity and Its Applications
Domain 3 tests numerical calculation of elasticity and, more importantly, your ability to use elasticity to predict revenue, tax incidence and policy outcomes.
The four measures
- Price elasticity of demand (PED) = percentage change in quantity demanded divided by percentage change in price. Demand is elastic when |PED| > 1, inelastic when < 1, unit elastic when = 1.
- Price elasticity of supply (PES) measures responsiveness of quantity supplied; it is higher when firms have spare capacity and time to adjust.
- Income elasticity (YED): positive for normal goods, above 1 for luxuries, negative for inferior goods.
- Cross elasticity (XED): positive for substitutes, negative for complements.
Determinants
PED is higher when close substitutes exist, the good takes a large share of income, it is a luxury, and buyers have time to adjust.
Worked example
Price falls from N$10 to N$8 and quantity rises from 100 to 140 units. Percentage change in quantity = 40/100 = 40%. Percentage change in price = -2/10 = -20%. PED = 40 / -20 = -2, so demand is elastic. Revenue before = N$1,000; after = N$1,120. A price cut raised revenue because demand was elastic.
Applications
- Tax burden falls mainly on the side of the market that is more inelastic.
- Farmers with inelastic demand can lose income from a good harvest.
- Firms with inelastic demand can raise price and increase revenue.
Traps that cost marks
- Ignoring the negative sign when asked whether demand is elastic.
- Assuming elasticity is constant along a straight-line demand curve; it falls from elastic to inelastic as price drops.
- Confusing a steep curve with inelasticity without checking the axes and scale.