The Price Of Elasticity Of Supply Economics Essay

The price of elasticity of supply assesses the sensitiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain constant. It can be calculated by using the formula:

PES = Percentage change in quantity supplied

Percentage change in price

The two determinants of price elasticity of supply are resource substitution possibilities and time frame for the supply decision (Parkin 9th edition pg97):

For resource substitution possibilities, it means that only some goods and services can be produced only by using special or rare productive resources. Such items have low and sometimes even zero elasticity of supply because items like that are hard to be substituted. For example, cars and tyres. As the price of rubber rises, the quantity supplied will reduce by only a little because people still need tyres for their cars. It is difficult to find another raw material for tyre because the input factor of production is rare and therefore, the price elasticity of supply will be inelastic.

The second determinant is time respond for the supply decision. For instance planting maize. It takes a few months to produce maize that even if the price changes, the farmer will not be able to do anything. Reason being so is that when the price of maize fluctuates, the time taken for maize production will remain constant. Thus, the price elasticity of supply will be inelastic if the production is long.

Price

QS

40%

20%

S

Based on the diagram, it shows that price increase is greater than the quantity supplied. The two determinants of price elasticity of supply are resource substitution and time frame for supply decision.

Part B

Price elasticity of demand (PED) is a unit free measure of the responsiveness of the quantity demanded of a good to a change in price, when all other determinants on buying plans remain the same. The formula used to calculate PED is(Parkin, 9th edition pg 86):

PED = Percentage change in quantity demanded

Percentage change in price

Businesses use the price elasticity concept to decide on their pricing strategy based on three ranges of elasticity namely inelastic, elastic and unit elastic demand.

When the percentage decrease in quantity demanded is less than percentage increase in price, it is said to be an elastic demand. Goods that are categorized under inelastic are considered necessities and therefore when business increase the price to obtain more revenue, the demand will still be there. An example would be smokers and cigarettes. If the price of cigarettes is now rm10 a pack, quantity demanded is 50 but when price increase to rm15 a pack, quantity demanded becomes 45.

The above diagram is an example of the relationship between the change in quantity demanded and change in price. The elasticity is more than zero but less than one, which means it is inelastic and smokers will still continue buying cigarettes despite the price increase.

When the percentage decrease in quantity demanded but greater than one exceeds the percentage increase in price, then it is an elastic demand. Goods that have an elastic demand are luxury goods because the goods have many substitutes, for example Nike shoes. If the price is rm200, then quantity demanded is 100 but once the price increases to rm220, the quantity demanded will fall to 70. This is because the customers can resort to other brands. The elasticity is more than one which means customers are sensitive to the change in price.

The diagram shows that even though the price increases only by a little bit, but the quantity demanded decreased by a lot because goods like that can be substituted easily.

When the percentage decrease in quantity demanded equals to the percentage increase in price, then it is a unit elastic demand. In cases like that, businesses should neither increase nor decrease the price of goods because a change in price will change the quantity demanded. An example would be chewing gum. The initial price is rm1, and quantity demanded is 200 but once the price increases to rm2, the quantity demanded will decrease to 100.

By using the concept of price elasticity, businesses can decide whether to increase price (inelastic demand), reduce price (elastic demand) or not to change the price (unit elastic demand) in order to maximize revenue.

Question 3

One of the factors of supply is the prices of factors of production. A decrease in price of production will directly correlate to an increase in supply. This is because if the price of a factor of production used to produce a good decreases the minimum price that a supplier is willing to accept for producing each quantity of those good decreases. So a decrease in the price of a factor of production decreases supply and shifts the supply curve rightward. Another factor is the price of related goods produced. A substitute in production of a good is another good that can be produced using the same resources. The supply of a good increase if the price of a substitute in production falls. Goods are complements in production if they must be produced together. The supply of a good increase if the price of a complement in production rises. Expected future prices are another determinant of an increase in supply. If the price of a good is expected to decrease in the future, the supply of the good today increases and the supply curve shifts leftward.

b) A price ceiling or price cap is a regulation that makes it illegal to charge a price higher than a specific level. If the price ceiling is set above the equilibrium price, it has no effect. The market works as if there were no ceiling in the first place. Inversely, if the ceiling were to be set below the equilibrium, its effects are far greater. If the level of price equilibrium is above the price ceiling, in order to achieve price equilibrium one would have to enter to illegal region. Other mechanisms thus come into place in order to eliminate the shortage created by the price cap. Search activity and black markets are some of those mechanisms and consumers are willing to pay a higher price in order to obtain the goods due to the shortage. A price ceiling decreases the quantity supplied to a less efficient quantity resulting in a deadweight loss. A further shrink in consumer and producer surplus further enhances the potential loss from search activity. A price floor is a regulation that makes it illegal to trade at a price lower than a specific level. If it is set below the equilibrium price, there is no effect. Effect only takes place if set above the equilibrium price. Price floor leads to an inefficient outcome. A minimum price is set above the equilibrium and decreases the quantity demanded. A deadweight loss thus arises due to a decrease in consumer and producer surplus.

Question 5

Part A

Demand refers to the quantity of a good that potential buyers would be willing and able to buy or attempt to buy at a different price level. The law of demand states that there is an inverse relationship between the price of a good and the quantity demanded in a defined time period. Quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.(McConnell,Brue & Flynn Economics 18th edition)

A decrease in demand will result in a leftward shift in the graph and there are six main factors influencing it. The first factor is the prices of related goods. Assume if a comparison is made between hamburger and hot dog. If the price of a substitute for hamburger rises, people buy less of the substitute and more hamburgers. The demand for hamburger will rise and demand for hot dogs will fall. Then there is also complement which is a good that is used in conjunction with another. For example, fries and hamburgers. If the price for hamburger increases, people will not buy so much fries and hamburgers. There will be a decrease in demand. The next factor is expected future prices. If a good, for now will decrease because people would want to buy it at a cheaper price. The third factor is income. When income rises, consumer will buy more goods but when it decreases, they will buy less of those goods. A normal good is one for which demand increases as income increases. Inferior good is one when demand will decrease as income increases. Next factor that will decrease a demand is when expected future income and credit falls. For example, when a sales person knows her income will fall in the future, she will have to spend wisely and not splurge on goods. Another factor is when the population decreases. For example in the 1990s in America, a decrease in the college-age population decrease the demand for college places. Lastly would be preference. If there is poor or no environmental awareness, it will shift the demand curve for recycled items or even eco-friendly bags to the left. The diagram shows a leftward shift on the demand curve.

Unlike the demand curve, the quantity demanded curve will bring an upward movement on the diagram, instead of a shift and the only factor that influences it is price with all other determinants on buying plans remain constant. According to the new law of demand, higher price will cause a decrease in demand.

From the diagram, a decrease in quantity demanded will cause an upward movement when price rise from P0 to P1, quantity demanded falls from QD2 to QD1. An example would be the rise of price of apple from P0 to P1. It will decrease the quantity demanded to QD1. There are a few differences between a decrease in demand and decrease in quantity demanded. First, decrease in demand will show a leftward shift in the graph but decrease in quantity demanded shows an upward movement. There are six factors influencing the demand to decrease but only one that influence the quantity demand; price.

Part B

Income elasticity of demand (YED) is the ratio of percentage change in the quantity demanded of a good or service to a given percentage change in income. YED indicates the responsiveness of demand to change of household income. To calculate YED.(McConnell,Brue & Flynn Economics 18th edition)

:

YED = Percentage change in quantity demanded

Percentage change in household’s income

The three degrees of YED are positive, negative and zero. For positive YED, it is further categorized into two types which are income inelastic (0<YED<1) and income elastic (YED>1). For income inelastic, the percentage increase in quantity demanded is positive but less than the percentage increase in income. When the demand for a good is income inelastic, the percentage of income spent on that good decreases as income increases. Those will be considered normal goods such as clothes, food and travel. But for income elastic demand, the percentage increase in quantity demanded exceeds the percentage increase in income. When the demand for a good is income elastic, the percentage of income spent on that good increases as income increases. For example, if the price of a doughnut is constant and 9 doughnuts an hour are bought. So when income rises from rm975 to tm1025 a week, the quantity of doughnuts sold rise to 11 an hour, ceteris paribus. The change in quantity demanded is 2 and the average quantity is 10 doughnuts, so the quantity demanded increases by 20% and the change in income is tm50 and the average is rm1000 so income increases by 5%. The income elasticity of demand for doughnut is:

20% = 4%

5%

Therefore, it is said that the income elasticity demand for pizza is elastic. Next is negative YED (YED<0) demand will fall if income rises. Those goods are inferior, for example second-hand goods and bus travel. The logic behind this is that when a person’s income rises, he will opt for normal or better goods rather than something of low quality. Lastly, is zero YED (YED=0), this means that the quantity demanded will not change as income changes. The good is a necessity, for example rice and toothpaste. People will still continue buying necessities no matter what their income is because it is necessary for them for living.

Question 6

Equilibrium is a situation in which opposing forces balance each other out. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. The equilibrium price is the price at which the quantity demanded equals the quantity supplied.

Consumer surplus is defined as the value of a good minus the price paid for it, summed over the quantity bought. It is measured by the area under the demand curve and above the price paid, up to the quantity bought.

Producer surplus is determined by subtracting the marginal cost from the price received for a good and summed over the quantity sold. It is measured by the area below the market price and above the supple curve.

b.) The production possibility frontier (PPF) marks the boundary between the combination of goods and services that can be produced. There are four assumptions that are made which are the economy is efficient, there are a fixed amount of resources, a fixed level of technology and there are only two goods. In order to achieve efficiency there must be full employment and full production. The opportunity cost of an activity is the value of the next best alternative that must be forgone to undertake the activity. Scarcity is a situation where there is not enough resources to produce enough a good to satisfy the needs of the consumers. Choice occurs when scarcity forces consumers to make a choice in order to maximise satisfaction. PPF illustrates these three principles of economics; choice, scarcity and opportunity cost. Because of scarcity, a society has to make choices between the productions of two goods with scarce resources available. Most choice involves opportunity costs.

Referencing

Parkin.M, Economics 9th edition ,Pearson International Edition

McConnell,Brue & Flynn Economics 18th edition