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P. 1
1.2 - Elasticity

1.2 - Elasticity

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Published by IB Screwed
IB Economics notes for topic 1.2
IB Economics notes for topic 1.2

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Published by: IB Screwed on Jan 18, 2012
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Price Elasticity of Demand (PED)
Price Elasticity of Demand and Its Determinants
Price elasticity is a measure of how
 the demand is to change in price. If demand is very elastic, then it is easily influenced by price. On the other hand, if demand is inelastic, then changing the price will have little effect on demand: the demand is less sensitive to price. The price elasticity of demand for any given demand curve can be calculated according to the equation:
=        
When doing these calculations, it is important to note that, although the calculated value is usually negative, it is treated as a positive number. The absolute value is used instead of the negative number. Values can be compared using the following measures: if the absolute value is between 0 and 1, the demand is said to be
, as changes in price have only a minor effect on demand. On the other hand, values above 1 indicate that the demand is
. When the value is exactly equal to 1, this is called
unit elastic demand
. This means that a change is price by one percent corresponds to a change in demand by one percent. When the value is equal to 0, the demand is known as perfectly inelastic. Changing the price would have no effect on demand. Likewise, when the value is
, the demand is perfectly elastic. A price change would cause an infinite change in demand.
The determinants of PED are:
Degree of necessity - i.e. is it addictive? a basic need? Food items like bread and milk would be largely inelastic because they are necessary to life.
The proportion of income spent on the purchase - expensive items like cars or houses cost a high proportion of income, making the demand for them more elastic
Number and closeness of substitutes - if there is a large number of similar products on the market, demand becomes more elastic. The greater the similarity of the products, the more likely consumers are to switch after a price change.
Timeframe between measurements - to accurately determine price elasticity, sufficient time must be allowed to measure the proportion of the market that stops purchasing the product. For example, if the price of insurance increased, consumers would need time to transfer to another company before the impact of the price change would be seen. Some products are inelastic in the short-term, but very elastic in the long-term. It is important to realise that PED varies along the demand curve and is not represented by the slope of the curve. Instead, PED is an arc that touches the straight-line demand curve. At lower prices, the gradient of the arc approaches 0 and at higher prices the gradient approaches
The gradient of the two lines are equal only at the point where they touch. The gradient of the PED curve is constantly changing as price changes.
 Applications of Price Elasticity of Demand
Role of PED for Firms Businesses use PED to determine the effect of price changes on their total revenues. This is crucial for their decision making - would it be worth it to increase the price of their product, or would it have too much of a negative effect on demand? Their revenue is represented by the area under the demand curve.
Firms will sell their product at the price that maximises their revenue. They must consider PED in order to compare the revenue at different prices. Role of PED for Governments PED can be used by governments to predict the effect of implementing taxes. They will compare the elasticity of different products and tax the most inelastic ones. Incidence of Taxation This is the question of whether producers or consumers pay the cost of taxes. If a product is price inelastic, the producers can pass on the cost of the tax to the consumers without much effect on demand. Consumers wear the cost of the tax. Looking at the graph on the right, it can be seen that a price increase for a price inelastic product only causes a small decrease in demand On the other hand, if the product is price elastic, the producers must absorb the cost of the tax, since the increase in price causes demand to fall, thereby decreasing the
producer’s revenue
. The graph, left, shows that increasing the price of a price elastic product would cause a large decrease in demand.

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