Elasticity Concepts

PED, YED, XED, PES

Price Elasticity of Demand (PED)
• Definition: PED measures the degree of responsiveness of qtydd of a good to a
change in its own price, ceteris paribus
• Direction/sign: always negative (qtydd falls with an increase in price)
• Magnitude:
|PED|>1  A change in price will lead to a more than proportionate change
in qtydd,
|PED|<1  A change in price will lead to a less than proportionate change in
qtydd
Price Elasticity of Demand (PED)
• Determinants:
 Number and closeness of substitutes  As the number and closeness of substitutes increase,
consumers find it easier to switch to substitutes when the price of the good increases. Thus,
demand becomes more price elastic
 Degree of necessity  The more necessary a good is to the consumer, the less likely the
consumer will stop consuming it or find alternatives when the price increases. Thus, qtydd
will fall less than proportionately. Demand is therefore less price elastic
 Adjustment time period  the greater the adjustment time period, the more time
consumers have to adjust to the increase in price and find suitable alternatives and qtydd
falls more than proportionately. Demand is therefore more price elastic
Price Elasticity of Demand (PED)
• Application:
 Changes to price/total revenue  When there is a change in price due to change in supply,
the value of PED can help us determine the corresponding change in price and/total revenue
Price Elasticity of Demand (PED)
• Application:
 Pricing strategy for firms  lower price when demand is price elastic and increase price
when demand is price inelastic
Income Elasticity of Demand (YED)
• Definition: YED measures the degree of responsiveness of demand of a good to a
change in consumers’ income, ceteris paribus
• Direction/sign:
0<YED<1: Normal goods
YED>1: Luxury
YED<0: Inferior goods
• Magnitude:
|YED|>1  A change in income will lead to a more than proportionate
change in demand
|YED|<1  A change in income will lead to a less than proportionate change
in demand
Income Elasticity of Demand (YED)
• Determinants:
Degree of necessity  the more a consumer views a good as a necessity, the
less the consumer would increase the demand for the goods when income
increases. This is because consumers will consume necessities with less
regard to income as compared to luxuries. Thus, demand will be more income
inelastic
Income Elasticity of Demand (YED)
• Application:
 Changes to demand  When there is a change in income due to a growing
economy/recession, the value of YED can help us determine the corresponding change in
demand and thus the price and/or total revenue
Income Elasticity of Demand (YED)
• Application:
 Strategies for firms reacting to economic outlook  identify goods which are normal goods
or inferior and set output accordingly as income level changes
 Recession  demand for inferior goods will rise so raise production of low-end/no frills
products such as budget flights
 Boom  demand for normal goods will rise, especially for luxury goods so introduce high-
end goods such as 3G handphones or locate shops at prime areas as people will shop more in
such areas
Cross Elasticity of Demand (XED)
• Definition: XED measures the degree of responsiveness of demand of good Y to
changes in the price of good X, ceteris paribus
• Direction/sign:
XED>0: Substitutes
XED<0: Complements
Cross Elasticity of Demand (XED)
• Determinants:
Closeness of substitute/complement  the closer the
substitute/complement, the easier it is for consumers to switch to good Y
when the price of good X increases (substitutes) or decreases (complements).
Thus, demand for the good will be more cross price elastic
Cross Elasticity of Demand (XED)
• Application:
 Changes to demand of complement/substitute  when there is a change in price of a related
good, XED can inform us on the extent of change in demand for a good
Cross Elasticity of Demand (XED)
• Application:
 Strategies for firms aiming to react to changes in prices of competitors/complements  firms
should follow suit by cutting price when market leader/rivals with high XED value lower price
 Firms can also try to do product differentiation to decrease value of XED for substitutes
 For complements, firms can consider doing joint promotions or discounts eg a firm offering
slimming packages may organize a joint promotion with a beauty salon/hairdresser
Price Elasticity of Supply (PES)
• Definition: PES measures the degree of responsiveness of quantity supplied of a
good to changes in its own price, ceteris paribus
• Direction/sign:
Always positive  Qtyss increases with an increase in price
• Magnitude:
|PES|>1  A change in price will lead to a more than proportionate change
in quantity supplied
|PES|<1  A change in price will lead to a less than proportionate change in
quantity supplied
Price Elasticity of Supply (PES)
• Determinants:
Production time period  as production time period increases, there is a
greater delay for qtyss to increase when producers respond to an increase in the
price of the good. Thus qtyss increases by a less than proportionate amount.
Supply is more price inelastic
Ease of accumulating stock  as the price of the good increases, if there is
plenty of existing stock, suppliers will find it easier to supply additional quantity
of the good when the price increases. Supply is more price elastic
Amount of spare capacity  the more spare capacity there is, the easier it is for
producers to supply additional qty of the good when the price increases. Supply
is more price elastic
Adjustment time period  the greater the adjustment time period, the more
time producers have to supply additional qty of the good when price increases.
Supply is more price elastic
Price Elasticity of Supply (PES)
• Application:
 Changes to price  when there is a change in demand, the value of PES can help us
determine the corresponding change in price
Limitations
• Ceteris paribus assumption
• Ignores cost side of the profits equation
• Informational problem
• Ignores supply side of the market
Incidence of tax
 2009 A Level Q3
There have been large changes in the price of crude oil over the past
years. Discuss what determines whether consumers or producers are
more likely to bear the cost of these oil price changes. [25]
Mind map of essay structure
Introduction
• The large changes in the price of crude oil over the past few years are
as a result of events which affect the determinants of DD and SS of
crude oil, exacerbated by the price inelastic nature of the good
• Since crude oil is a primary commodity and a crucial factor input in the
production of a wide range of g/s, 2 markets will be affected:
1. Market for crude oil itself
2. Market for final g/s
• Whether consumers or producers are more likely to bear the cost of
these oil price changes will depend on the direction of shifts in DD and
SS, and their relative price elasticities
Market for crude oil – Changes in Supply

• When change in price of crude oil is caused by change in SS, whether consumers
or producers bear the cost of the price change depends on the direction of shift
in SS as well as the PED
• PED measures the degree of responsiveness of qtydd of a good to a change in its
own price, c.p
• DD for crude oil is likely to be price inelastic especially in the SR dye to lack of
close substitutes and that crude oil is a basic necessity/important factor input in
the production in most g/s
Market for crude oil itself – Changes in Supply
Decrease in SS
Impact on P/Q • Decrease in SS eg due to political uncertainty
in oil producing countries will shift the SS from
S0 to S1
• Results in increase in equilibrium price from P0
to P1 and less than proportionate fall in qty
from Q0 to Q1 given PED<1
Impact on TR/CE • CE increases from 0P0AQ0 to 0P1BQ1 despite
lower qty consumed
• Hence, consumers bear the burden of the
increase in price since they end up paying
more per unit of crude oil
Diagram
Increase in SS
• Increase in SS eg due to discovery of new oil fields
will shift SS from S0 to S1
• Results in fall in equilibrium price from P0 to P1
and less than proportionate increase in qty from
Q0 to Q1 given PED<1
• TR of producers decreases from 0P0AQ0 to
OP1BQ1 despite higher qty sold
• Hence, producers bear the burden of the
decrease in price
Market for crude oil – Changes in Demand

• When change in price of crude oil is caused by change in DD, whether consumers
or producers bear the cost of the price change depends on the direction of the
shift in DD as well as the PES
• PES measures the degree of responsiveness of qtyss of a good to a change in its
own price, c.p
• SS of crude oil is likely to be price inelastic since “gestation” period required to
increase qtyss is fairly long given enormous lead time between discovery of new
oil reserves and time by which crude oil is delivered to the refinery
Market for crude oil itself – Changes in Demand
Increase in DD
Impact on P/Q • Increase in DD eg due to EG in emerging
markets will shift DD from D0 to D1
• Results in increase in equilibrium price from P0
to P1 and less than proportionate increase in
qty from Q0 to Q1 given that PES<1
Impact on TR/CE • CE increases from 0P0AQ0 to 0P1BQ1
• Hence, consumers bear the burden of the
increase in price since the increase in CE is
largely due to the increase in price rather than
increase in qty
Diagram
Decrease in DD
• Decrease in DD eg due to worldwide recession
reducing factory output will shift DD from D0 to
D1
• Results in fall in equilibrium price from P0 to P1
and less than proportionate fall in qty from Q0 to
Q1 given PES<1
• TR of producers decreases from 0P0AQ0 to
OP1BQ1
• Hence, producers bear the burden of the
decrease in price since decrease in TR is largely
due to fall in price rather than fall in qty
Markets for final g/s
• Crude oil is a crucial factor input used across various industries either directly in
the production of final g/s (lubricants, utilities service providers) or indirectly in
the production of intermediate fop (fuel for transport service providers,
electricity for factory producing manufactured goods)
• An increase in price of crude oil will increase COP for a wide range of g/s, causing
their SS to fall
• Whether consumers/producers will bear the cost of these price changes depend
on the relative PED and PES which are affected by their determinants
Markets for final g/s
Eg Market for Air Travel
PED PES
Determinants and • No. and closeness of substitutes • Amount of spare capacity
value • Nature of good • Adjustment time period
Egs Long-haul flights: SR:
• Few close substitutes to air travel • At least 1 fop is fixed, airlines have
especially in terms of time-efficiency, limited ability to change their flight
hence |PED|<1 capacity, hence PES<1
Short-haul flights: LR:
• Many viable and close substitutes to • All fops are variable and airlines can
air travel available eg rail, coach etc, change their resources in all areas,
hence |PED|>1 hence PES>1
Markets for final g/s
• Given the many final g/s in a multitude of industries which use crude oil as a
factor input, to examine whether consumers or producers bear the burden of any
increase in crude oil prices, we can examine 2 possible scenarios, namely when |
PED|<PES and when |PED|>PES
• Increase in crude oil price increases per unit COP by P1P2 and decrease SS from
S0 to S1
• Consumers pay the increase in price of the final g/s
• Producers pay the portion of the increase in per unit COP which is not covered by
increase in price of final g/s
Markets for final g/s
|PED|<PES |PED|>PES
Who bears a greater P0P1>P0P2  consumers bear greater P0P2>P0P1  producers bear greater
burden of cost? burden of cost increase burden of cost increase
Diag
Evaluation
• In the market for air travel, it can be observed that who bears the burden of the
cost increase due to the increase in the price of crude oil may change over time
and differs across the different segments of the market eg economy vs business
class, short-haul vs long-haul flights, hence the relative elasticities matter in the
determination of burden of costs
• In summary for market for final g/s, the more price inelastic side of the market
will pay more of the cost increase and bear a greater burden since it is less
responsive to price changes
2017 RVHS Prelim CSQ1
(a)(i) With reference to Table 1, what evidence is there to suggest
that China is shifting away from exports and investment-led growth
to consumption-led growth? [2]
• Investment as a % of GDP decreased from 47.6% in 2010 to 45.7% in 2015 while
exports as a % of GDP generally decreased from 26.3% in 2010 to 22.1% in 2015
• As such, investment and exports as a % of GDP fell from 73.9% in 2010 to 67.8%
in 2015
• On the other hand, consumption as a % of GDP increased from 35.9% in 2010 to
37% in 2015
• As such, the evidence seems to suggest that China has been shifting away from
exports and investment-led growth to one that is consumption-led
(a)(ii) With reference to Table 1, use the concept of opportunity cost to explain
how the change in composition of private consumption expenditure and gross
fixed capital formation may affect China’s current and future living standards. [4]

• Opportunity cost is defined as the benefit of the next best alternative forgone
• From Table 1, China’s private consumption expenditure increased by 1.1% of GDP from
2010 to 2015 whereas her gross fixed capital formation decreased by 1.9% of GDP during
the same period
• As larger proportion of resources are allocated to the production of consumer goods, this
could lead to an increase in material SOL as more g/s can be enjoyed
• However, when more resources are devoted to the production of consumer goods, fewer
resources will be allocated for production of capital goods
• As capital goods are the means which enable a country to produce more goods, a relatively
smaller amount of capital stock means China has to forgo a certain amount of increase in
future material SOL as a relatively smaller amount of goods can be produced in the future
(b) Explain why wages in China have been rising despite the
slowing economic growth. [2]

• Extract 3 mentioned that China ‘runs out of cheap labour from the villages’ and
this would mean a fall in supply of labour in the market
• Extract 3 also mentioned that ‘economic growth slowed to 5%’, which meant
national income was increasing albeit at a slower rate. As more g/s were
produced, this would increase demand for labour
• The increase in demand coupled with the fall in supply of labour will cause wages
to increase
(c) Explain, with a diagram, why the Chinese Yuan had
strengthened by 30% against currencies of some emerging
economies. [4]
• From Extract 2, the dollar soared on the back of stronger economic growth in the
US than its trading partners. Because of the stronger EG, it has increased
investors’ confidence to invest in US and that increases the demand for USD
OR
• In anticipation of the US Fed’s long-promised interest rate increase, investors
have increased the demand for USD as investors flee high-risk emerging market
bonds and gradually turn towards US bonds
• Since the Chinese Yuan is pegged to the USD, The People’s Bank of China has to
use its foreign reserves to defend the yuan peg and this increases the demand for
Yuan in the forex market. This is shown by the rightward shift in demand from
DD0 to DD1 in Figure 1
(c) Explain, with a diagram, why the Chinese Yuan had
strengthened by 30% against currencies of some emerging
economies. [4]
• As mentioned in Extract 1 and 2, the slower growth in China has resulted in a fall
in demand for commodities from emerging economies and this reduced the
supply of Yuan in the forex market, shown by the leftward shift in supply from SS0
to SS1 in Figure 1
(c) Explain, with a diagram, why the Chinese Yuan had
strengthened by 30% against currencies of some emerging
economies. [4]
• As mentioned in Extract 1 and 2, the slower growth in China resulted in a small
increase in demand for commodities from emerging economies and this
increased supply of Yuan in the forex market by a small amount, shown by a
rightward shift in supply from SS0 to SS1 in Figure 1
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]
Impact of China’s devaluation of Yuan on her economy
• Devaluation = deliberate attempt to peg Yuan at a lower e/r against a basket of currencies
• Weakening of Yuan will cause X to be cheaper in FC and M become more expensive in DC.
Assuming MLC is satisfied, this will increase NX and hence AD
• The effects of increase in AD on NY, Nt and GPL will depend on the state of China’s
economy
• Extract 3: labour market is still tight and employers are crying out for workers  shortage of labour, but
not necessary that economy is nearing or at Yf since other fops are available
• Extract 2: slower growth in China + Extract 3: X fell by 6.8% year-on-year  less DD for China’s
resources  neither operating near of at Yf
• Extract 4: inflation data for November showed there’s scope for looser MP, with consumer prices rising
about half the government’s targeted pace + other measures to stimulate the Chinese economy 
China had unemployed resources  not near Yf
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]

Impact of China’s devaluation of Yuan on her economy

• As such, AD will cut AS at the Keynesian range and the increase in AD will result in
a rightward shift of the AD curve from AD0 to AD1  multiplied increase in NY
from Y0 to Y1 as shown in Fig 2  decrease level of cyclical UNt since more
workers are employed to increase production
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]

Impact of China’s devaluation of Yuan on her economy

• This in NX also mean there will be net inflow of currency into China which will be
recorded as a credit item in the CA  possibly improve BOP position
• However, devaluation might lead to imported inflation as the price of M in terms
of Yuan will increase  domestically produced g/s which require large amount of
imports as rm will experience increase in COP  may be passed on to consumers
in terms of higher prices*
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]

Impact of China’s devaluation of Yuan on her trading partners

• In the LR, when increase in NY from devaluation of Chinese Yuan materialises, the
increase in Y level will lead to increase in PP of Chinese consumers  increase DD
for M from China’s trading partners  increase AD in their economies
• Assuming economies of trading partners are operating below Yf, will lead to
multiplied increase in NY and decrease UNt
• The extent of increase in DD for M from trading partners depends on YED of M. If
YEDm>1, increase in Y will lead to more than proportionate increase in DDm 
larger magnitude of increase in AD  Larger multiplied increase in NY for trading
partners
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]
Impact of China’s devaluation of Yuan on her trading partners
• Weaker Yuan will cause M to become more expensive in DC  decrease qtydd for X of
China’s trading partners. Since the prices of X of trading partners remain unchanged in
their respective DC, fall in qtydd for X will lead to a fall in X rev for trading partners
• Weaker Yuan will cause X from China to be cheaper in FC  reduce DD for exports from
other countries (as they are more expensive relative to China) assuming that X from China
and other countries are substitutes
• Taken tgt, this will decrease AD and result in a multiplied decrease in NY  increase UNt as
less fop are employed with fall in production
• Nevertheless, Extract 2 mentioned that X of China and that of her trading partners are
complements rather substitutes  weakened Yuan  increase qtydd of China’s X 
increase DD for X by China’s trading partners  increase their AD  multiplied increase in
their NY
(d) Discuss the potential impact of China’s devaluation of the Yuan
on her economy and her trading partners. [8]

Evaluation
• While devaluation usually suggests a more negative impact on trading partners
and a more positive impact on the host country itself, it must be noted that the
Chinese Yuan had appreciated 30% prior to the 2-3% devaluation  benefits
from devaluation for China and negative impacts for trading partners are minimal
• When China devalues her currency, might invite retaliation from trading partners
 such tit-for-tat moves are likely to hurt X-related industries  damaging to
both economies over LT
• Extract 1 mentioned that Fed might raise US i/r  ST capital inflow into US
economy leading to strengthening of USD. As China’s currency has been tightly
linked to US dollar, this will cause value of Yuan to increase, limiting the PBOC’s
intention of devaluation
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
Introduction:
• Extract 4: DD-mgmt policies + SSP to help Chinese government achieve minimum
annual average growth pace of 6.5% through 2020
Main:
1. EMP
• The inflation data for Nov showed there is still scope for looser MP  EMP involves
increasing money supply to reduce i/r so as to increase AD
• Fall in i/r  cheaper for firms to borrow to invest  projects which were not viable
in the past are viable at this lower i/r  increase I
• Fall in i/r  lower cost of borrowing and reduces monthly mortgage payments that
individuals and HHs have to pay  increase C
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
1. EMP
• Fall in i/r relative to that of other countries also cause financial capital outflow
from the country  increase supply of DC in forex market  weaken DC.
Assuming MLC is satisfied, increase NX
• Taken tgt, increase in C, I, NX  increase AD  multiplied increase in NY 
actual EG
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
2. EFP
• With a fiscal deficit that totalled just 2% of GDP, Chinese government can step up
on fiscal stimulus
• Increase G/reduce T to stimulate economy
• Spend more on improving infrastructure/roads  increase G
• Cut PIT/CIT  increase disposable income/increase after-tax profits  increase
C/I
• Taken tgt, increase in G, C, I  increase AD  multiplied increase in NY  actual
EG
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
Limitations of DD-mgmt policies:
• Might not achieve desired outcome if there are unpredictable effects of
tax/interest rate changes on C and I  Eg If economic outlook of China remains
bleak, firms will still not invest even if CIT is cut or interest rate is being reduced.
Similarly, consumers might not increase C even if PIT/interest rate is reduced 
AD and NY might not increase
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
3. SSP
• Extract 4: streamlining administrative procedures, reducing social security
contributions, reducing financing costs for companies and lower value-added
taxes on manufacturing  reduce COP for businesses
• As COP falls, SRAS will increase from SRAS0 to SRAS1 in Fig 3  NY will increase
from Y0 to Y1, achieving actual EG
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
3. SSP
• Reduction in CIT  increase after-tax profits, leaving more funds available for I
and to pursue innovation through more R&D  increase in qly and qty of capital
in economy
• In addition, mass entrepreneurship and innovation will be promoted, more
support will be offered for companies to upgrade technology and equipment and
infrastructure and technology in the agricultural sector will be modernized to
boost capability and qly
• All these increase in qty and qly of capital will lead to increase in productive
capacity in China’s economy  increase LRAS from LRAS0 to LRAS1 in Fig 4,
achieving potential EG
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
3. SSP
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
Limitations of SSP:
• Reducing CIT may result in firms paying higher dividends rather than undertaking
more I
• R&D and innovation have long time lag before they can reap returns and not all
innovation efforts bring about positive outcomes
• The government may also lack the required information and capabilities to
successfully determine the correct industries to assist
• SSP work after significant time lags, making their effects only seen in the LT
(e) Assess the policy options available to the Chinese government in
achieving “a minimum annual average growth pace of 6.5%
through 2020.”[10]
Evaluation:
• Both DD-mgmt and SSP must be undertaken
• With China experiencing slowing EG since 2013, her economy is definitely not operating
at Yf  DD-mgmt policies are more crucial than SSP in order to stimulate the economy
• FP is preferred over MP as China’s fiscal deficit to GDP ration is just around 2%, which is
relatively small  Chinese government might be able to increase G which will increase
AD more definitely compared to adjusting tax rates/interest rates
• However, G need to be spent more wisely or on projects which have SS-side effects and
not on unproductive activities mentioned in Extract 2 or on undustries where there is
already overcapacity
• SSP need to be in place for EG to be sustained in future
 A stronger fiscal budget supports jobs and
growth and instils confidence in an economy.
Strengthening the nation’s finances is key to a
government’s economic plan.
(a) Explain how economic shocks and uncertainties affect a country’s
exchange rate. [10]
(b) Governments should always work towards reducing the fiscal budget
deficit despite economic shocks and uncertainties. Discuss. [15]
Introduction
Main
Main
Introduction
• Fiscal budget deficit – an annual financial statement that represents
the government’s proposed revenue and spending for that financial
year. It is in deficit when revenue<expenditure
Thesis: The government should always work towards reducing a
budget deficit despite economic shocks and uncertainties because…
Anti-thesis: the government should not always work towards
reducing a budget deficit despite economic shocks and uncertainties
because…
Evaluation