SAJC 2023 JC1 H2 Price Mechanism and its Applications Part 2 Lecture Notes Uploaded

Price Mechanism and its Applications Part 2: Elasticities of Demand and Supply 1 1 INTRODUCTION 3 2 PRICE ELASTICITY OF DEMAND (PED) 4 2.1 Definition and formula 4 2.2 Characteristics of Price Elasticity of Demand 5 2.3 Determinants of Price Elasticity of Demand 10 2.4 Applications of Price Elasticity of Demand 13 3 INCOME ELASTICITY OF DEMAND (YED) 19 3.1 Definition and formula 19 3.2 Characteristics of Income Elasticity of Demand 19 3.3 Factors affecting Income Elasticity of Demand 21 3.4 Applications of Income Elasticity of Demand 22 4 CROSS ELASTICITY OF DEMAND (XED) 23 4.1 Definition and formula 23 4.2 Characteristics of Cross Elasticity of Demand 23 4.3 Factors influencing Cross Elasticity of Demand 25 4.4 Applications of Cross Elasticity of Demand 27 5 PRICE ELASTICITY OF SUPPLY (PES) 29 5.1 Definition and formula 29 5.2 Characteristics of Price Elasticity of Supply 29 5.3 Factors affecting Price Elasticity of Supply 30 5.4 Application of Price Elasticity of Supply 33 6 LIMITATIONS OF ELASTICITY CONCEPTS 35 7 ANNEX A: VARYING PRICE ELASTICITY OF DEMAND ALONG A STRAIGHT- LINE/ LINEAR DEMAND CURVE 39 PRICE MECHANISM AND ITS APPLICATIONS PART 2 ELASTICITIES OF DEMAND AND SUPPLY ST ANDREW’S JUNIOR COLLEGE JC1 H2 ECONOMICS 2023 The theme on Price Mechanism and its Applications provides an understanding of the various elasticity concepts and how they can be applied in the real-world context to explain the implications of differing degrees of elasticity on price and non-price decisions. For example, you will learn how changes in p rices of a product affect a firm’s sales and revenue.

Price Mechanism and its Applications Part 2: Elasticities of Demand and Supply 2 Recommended Reading List and Reference 1. Colander, David. C (2006) “Describing Supply and Demand: Elasticities” in Economics. 6th Edition, New York: McGraw Hill p 140-160 2. Maunder, Peter et al (2000) “Demand and Supply Elasticity” in Economics Explained. Revised 3rd Edition. UK: Harper Collins. p75-93 3. Parkin, Michael (2000), 5th Edition Economics, Addison-Wesley, USA. P87-100 4. Sloman, John, Wride, Alison and Garratt, Dean (2012) 8 th Edition, Economics, Prentice Hall, UK, p57-95 5. Sloman, John (2007), 4th Edition, Essentials of Economics. Prentice Hall, UK, p 54-67 6. Stanlake, GF and Grant, SJ (2000), 7 th Edition, Introductory Economics, Longman. UK, p. 76-87, 94-98 7. Arnold, Roger (2001) Economics, 5 th edition, South Western Publishing, Chapter 18, p 401 – 424. Learning Objectives By the end of this series of lectures and tutorials, you should be able to: ▪ Define price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply. ▪ Interpret the sign(s) and magnitude of coefficient(s) of the various elasticity concepts. ▪ State the formulas of the various elasticity concepts. ▪ Explain the relationship between price elasticity of demand and total revenue/total expenditure. ▪ Explain the main determinants of the various elasticity concepts in the short-run and long-run. ▪ Explain how the various elasticity concepts influence decision -making by different economic agents (consume rs, producers and governments) Concepts and Tools of Analysis ▪ Price elasticity of demand ▪ Income elasticity of demand – normal and inferior goods ▪ Cross elasticity of demand – complements and substitutes ▪ Price elasticity of supply ▪ Consumer expenditure and producer revenue ▪ Consumer surplus and producer surplus

Price Mechanism and its Applications Part 2: Elasticities of Demand and Supply 3 1. INTRODUCTION In the previous topic , we have seen that the demand for and the supply of a good or service depends on changes in price and non -price determinants. Changes in price can affect the quantity demanded for or quantity supplied of a good or service. Changes in the non-price determinants (factors other than the price of the good or service ) can affect the demand for or the supply of a good or service. From these relationships examined in the earlier topic, we know the direction of change in the quantity demanded and quantity supplied of a good or service when its price changes. These relationships , however, do not reveal the extent of the change in quantity demanded/supplied of a good or service when its price changes. For example, if the price of oil changes by 1 per cent, wha t will the extent of the change in quantity of oil demanded/supplied be? Similarly, we would also want to add more depth to our understanding by looking at the extent of the changes in demand and whether there is likely to be a large or small impact on equilibrium. For example, in some cases, a small increase in income may have big impact on demand and this in turn may have a significant impact on the equilibrium price. In other cases, the same increase in income may have little impact on demand and market equilibrium. Elasticity concepts help us understand the changes more precisely. Elasticity is a way of quantifying cause and effect relationships. It is generally a numerical measure of the responsiveness of one dependent economic variable (effect) following a change in another independent variable (cause), ceteris paribus. Where relationships are elastic (responsive), a small change in the cause or independent variable has a large effect on the dependent economic variable . Where the relationships are inelastic (less responsive), a large change in the cause has a limited effect on the dependent variable. RECALL A decrease ( increase) in the price of a good or service will lead to a n increase (decrease) in quantity demanded for a good or service , ceteris paribus. In contrast, a decrease (increase) in the price of a good or service will lead to a decrease ( increase) in quantity supplied of a good or service , ceteris paribus.

Price Mechanism and its Applications Part 2: Elasticities of Demand and Supply 4 2. PRICE ELASTICITY OF DEMAND (PED) 2.1 Definition and Formula It can be computed using the following formula. Price elasticity of demand = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑓𝑜𝑟 𝐺𝑜𝑜𝑑 𝑋 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝐺𝑜𝑜𝑑 𝑋 = ∆𝑄𝑑 𝑄𝑑0 × 100% ∆𝑃 𝑃0 × 100% where Qd = (Qd1 – Qd0) Qd1 = new Qd, Qd0 = original Qd P = (P1 – P0) P1 = new P, P0 = original P For illustration only. Students do not need to know how to calculate and derive the answer. When the price of wheat increases from $4 to $5, the quantity of wheat demanded falls from 100kg to 60kg, ceteris paribus. In this case, the price elasticity of demand for wheat = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑓𝑜𝑟 𝐺𝑜𝑜𝑑 𝑋 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑋 = ∆𝑄𝑑 𝑄𝑑0 × 100% ∆𝑃 𝑃0 × 100% = 60−100 100 × 100% 5−4 4 × 100% = − 40% 25% = −1.6 Price elasticity of demand measures the degree of responsiveness of the quantity demanded for a good or service to a given change in its price, ceteris paribus.

Price Mechanism and its Applications Part 2: Elasticities of Demand and Supply 5 This means for every 1% increase in the price of wheat, there is a 1.6% decrease in the quantity demanded, ceteris paribus. In other words, an increase in the price of wheat brings about a more than proportionate fall in quantity demanded, ceteris paribus. 2.2 Characteristics of Price Elasticity of Demand 2.2.1 Values of Price Elasticity of Demand Price elasticity of demand is usually a negative number. However, the negative sign is usually ignored as we only consider the absolute value since the negative sign simply reflects the inverse relationship betwe en price and quantity demanded. 2.2.2 Graphical representation of price elasticity of demand In exa