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# EdExcel Micro Economics Unit 1

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### EdExcel Micro Economics Unit 1

1. 1. 20 Elasticity |ElasticityExplain the concept of elasticity. Elasticity is measure of the extent to which one variableresponds to a change in a second variable. For instance a variable such as demand can be eithersensitive to a change in price (price elastic) or unresponsive (price inelastic)Why is elasticity important? Elasticity estimates predict how consumers and producers arelikely to respond to a change in market conditions. Accurate elasticity data helps a firm estimatethe likely impact of, say, a price rise on demand for the product and for substitutesList the main types of elasticity.Type of elasticityPrice elasticity of demand The responsive of demand to a change in its own priceIncome elasticity of demand The responsive of demand to a change in incomePrice elasticity of supply The responsive of supply to a change in its own priceCross elasticity of demand The responsive of demand for one product to a change in the price of another itemWhat is an elasticity value? An elasticity estimate has a number value eg -0.5. 0, +2, etc. Anelasticity value greater than 1 means a variable such as demand is elastic ie responsivePrice elasticity of demandDefine price elasticity of demand (PED). The responsiveness of demand to a change in theprice of the product.How are price and quantity changes compared? Price is measured using £s; quantity in unitssold. Comparisons is made possible by contrasting the percentage in price and amountHow is PED calculated? Like all elasticity values, PED is a number. PED is estimated by dividingthe percentage change in demand by the percentage change in price, using the equation: PED =percentage change in demand/ percentage change in price, ie PED= %ΔQd/ %ΔP. Eg if a 10%fall in price results in a 5% increase in quantity demanded, PED = 5%/10% = -0.5How are percentage changes in a variable calculated? To calculate a percentage change(%Δ) in one variable (A), use the equation: %ΔA = (new A – old A) / old A x 100where A is a variable such as price or quantity demanded.Give a worked example of calculating PED. Suppose a price fall from £15 to £10 results in anincrease in quantity demanded from 20 to 45 %ΔP = (new P – old P) / old P x 100 = (10-15)/15 x 100 = -5/15 x 100 = -33% %ΔQ = (new Q – old Q) / old Q x 100 = (45-20)/20 x 100 = 25/20 x 100 = 125% PED = % change in quantity demanded / % change in price = 125%/33% = -3.8What is the range of PED estimates? PED can lie between zero and infinity. If PED is less than1, demand is price inelastic ie quantity demanded is unresponsive to price changes. If PED isgreater than 1, demand is price elastic ie quantity demanded is responsive to a price change.Why do PED estimates usually minus values? Price and quantity demanded are almostalways inversely related: they move in opposite directions. This means PED is a negative valueWhat does the phrase demand is price elastic mean? Demand is price sensitive ie responsiveto a change in price. This means a given change in price brings about a greater percentagechange in demand. Eg a 10% fall in price results in a 20% increase in demand. PED is -2.What does the phrase demand is price inelastic mean? Demand is price insensitive ieunresponsive to a change in price. A given change in price brings about a smaller percentagechange in demand. Eg a 10% price rise results in only a 4% fall in demand. PED is -0.4.
2. 2. | Elasticity 21What factors determines own price elasticity of demand? Main determinants include: Availability and closeness of substitutes. The greater the number of alternative products,the easier it is for consumers to switch if prices change. Demand becomes price elastic Definition of the market. The narrower the definition of a product eg sliced white bread,the greater the number of substitutes eg unsliced white bread. This means the demandfor sliced white bread is more price elastic than the demand for all types of bread Proportion of income spent on a good. Usually the smaller the proportion of income takenup purchasing the good or service the more price elastic demand Habit forming products such as cigarettes and drugs are price inelastic in demand. Consumers take time to adjust to price changes. This means PED becomes more priceelastic in the long run as consumers have time to find and switch products.How can PED affect a demand curve? The gradient (slope) of a demand curve generallyreflects its PED:A product with perfect substitutesPED = ∞ at all points on the curveA product with no substitutesPED = 0 at all points on the curveSpecial case: PED is -1 at all pointson the curveDemand is perfectly price elasticat all points on the curve D1;perfectly price inelastic at allpoints on the curve D2; andalways unitary (1) on D3Demand is mainly own priceelastic on most points on thecurve D4 and price inelastic atmost points on the curve D5A product with many close andavailable substitutes PED<1 atalmost all points on the curveAs price rises quantity demandednormally becomes more elasticA product with few close andavailable substitutes PED>1 atalmost all points on the curveIs PED constant along all a straight-line demand curve? Yes: perfectly price elastic (D1), perfectly price inelastic (D2) and unit elastic D3 No: for relatively price elastic (D4) or relatively price inelastic demand curves (D5) in theabove diagrams. PED becomes more price inelastic as you move down a demand curveQuantity (Qd)price(P)D1Perfectly price elasticdemand curveQuantity (Qd)price(P)D2 Perfectly priceinelastic demandcurveQuantity (Qd)price(P)D3Unit priceelastic demand curveQuantity (Qd)price(P)D4Relatively priceelastic demand curveQuantity (Qd)price(P)D5Relatively priceinelastic demandcurve
3. 3. 22 Elasticity |Income elasticity of demandDefine income elasticity of demand (YED). YED measures the extent to which of demand for aproduct responds to a change in income.How is YED calculated? The YED estimate is found by dividing the percentage change indemand by the percentage change in income, using the equation:YED = % change in demand / % change in income.Eg if a 10% rise in income results in a 8% increase in demand YED = 8%/10% = 0.8Give a worked example of calculating YED. Suppose an increase in income from £105 to £125results in an increase in demand of Good X from 75 to 110 %ΔY = (new Y – old Y) / old Y x 100 = (125-105)/105 x 100 = 20/105 x 100 = 19% %ΔQ = (new Q – old Q) / old Q x 100 = (110-75)/75 x 100 = 35/75 x 100 = 47%YED for Good X = percentage change in demand of good X / percentage change in income =47%/19% = 2.5. Demand is income elastic.What does a positive YED value means? Income and demand are positively related. A rise inincome results in a rise in demand. Items with a positive YED value are called normal goods.Explain the term income elastic. Income elastic products have a YED estimate greater than 1.A change in income leads to a proportionately bigger increase in demand eg if YED = 2 a 10%rise in income leads to 20% rise in demandExplain the term income inelastic. Income elastic products have a YED estimate less than 1. Achange in income leads to a proportionately smaller increase in demand eg if YED = 0.2 a 10%rise in income leads to 2% rise in demandExplain the term normal good. A normal good is a product with have a positive YED estimate.Consumers use an increase in income to buy more of the good.Can YED have a negative value? Inferior goods have a negative YED and are only boughtbecause consumers cannot afford normal goods. For instance some consumers use an increasein income results to switch from an inferior good (eg spam) to a normal good (eg meat).What is the range of YED values? If YED is positive, the product is a normal good. If YED is positive but less than 1, demand is income inelastic. A change in income results in aproportionately smaller change in demand – a characteristic of necessities eg bread If YED is positive and greater than 1, demand is income elastic. A change in income results ina proportionately larger change in demand. This is the characteristic of luxury goods eg cars If YED is negative, an increase income leads to fall in demand. The item is an inferior goodWhat is a superior good? If YED is positive and greater than one, then the good is a luxuryitem. Consumers use a given increase in income to buy proportionally more of the product.How do incomes change over time? Overtime economies enjoy economic growth. Economicgrowth increases income as households earn more from creating extra output.How does the economic cycle affect income? Many economies experience an economic cycle.A boom means output and income is growing, while output and income fall in a recession.How does a recession affect demand? A recession means falling output and incomes. Theimpact on demand for particular products depends on their YED. The higher the YED estimatethe greater the volatility of sales during an economic cycle.
4. 4. | Elasticity 23Price elasticity of supplyDefine price elasticity of supply (PES). The responsiveness of supply to a change in the priceof the product.How is PES calculated? PES is a numerical estimate. The PES value is found by dividing thepercentage change in quantity supplied by the percentage change in price, using the equation:PES = percentage change in quantity supplied / percentage change in price Eg if a 10% fall inprice results in a 2% decrease in quantity supplied, then PES = 2%/10% = 0.2.What is the range of PES estimates? PES can lie between zero and infinity. If PES is less than 1then supply is price inelastic ie quantity supplied is unresponsive to price changes. If PES isgreater than 1, then supply is price elastic ie quantity supplied is responsive to a price change.Price and quantity supplied are directly related which means they move in the same direction.This means PES has a positive valueWhat factors determines price elasticity of supply? The following factors affect the ability offirms to adjust output in response to a change in price: Manufacturing lead time: the amount of time take to make an item varies betweenindustries. Eg the time lags in agriculture can be a year before extra field yield crops Availability of stocks: Stocks are stored components, and goods held ready for future useor sale. Non-perishable goods can be added to stock following a price fall. Firms withlarge of stocks of finished products can respond quickly to a price increase. As servicescannot be stored their price elasticity of supply is perfectly price inelastic Availability of resources: supply is price elastic if staff are willing to work overtime or ifcurrently idle machines are bought into use. Capacity: Firms operating at capacity can only increase output by investing in newequipment and hiring extra staff thus making PES inelastic Time period: firms take time to adjust production to price changes. PES becomes moreprice elastic in the long run as producers have time to hire staff, install new capital etcHow can PES affect the slope of a supply curve? The slope of a supply curve reflects its PES.Supply is always perfectly priceelastic at all points on the curve S1and perfectly price inelastic at allpoints on the curve S2Always unit PES for any straight linesupply curve passing through theorigin eg S3 or S4Relatively elastic at all points on anylinear supply curve intersecting the yaxis eg S5 and relatively inelastic atall points on any linear supply curvecutting the x axis eg S6Quantityprice(P)S1Perfectly price elasticsupply curvesupply curvePerfectly priceinelasticsupply curveQuantityprice(P)S2Quantityprice(P)S3Unit priceelastic supply curvesS4Quantityprice(P)S5Relatively price elasticsupply curveQuantityprice(P)S6Relatively priceinelasticsupply curve
5. 5. 24 Elasticity |Cross elasticity of demandDefine cross elasticity of demand (XED). XED measures responsiveness of demand for oneproduct to a change in the price of another product. This means XED measures the strength ofrelationship between two different productsHow is XED calculated? XED is a numerical estimate. The XED value is found by dividing thepercentage change in quantity demanded of one product (A) by the percentage change in priceof a second product (B), using the equation: XED = percentage change in quantity demanded forgood A / percentage change in price of good B. Eg if a 10% rise in price of good B results in a5% rise in demand for good A, then XED = 5%/-10% = 0.5What does XED = +1.2 mean? The positive sign means the two goods are substitutes. 1.2means the demand for this product is responsive to a change in the price of the other item. Thetwo items are strong substitutesWhat does XED = -0.8 mean? The negative sign means the two goods are complements. 0.8means the demand for this product is unresponsive to a change in the price of the other item.The two items are weak complementsWhat does XED=0 mean? A change in the price of one item has no effect of the demand for thesecond product because they are not substitutes or complements. They are independent goodsWhat is the range of XED estimates? XED estimates can be positive negative or zeroXED value Relationship betweenproducts A and Ba 10% rise in the price of this productcauses a proportionatelyPositive and greater than oneeg +2Strong substitutes: demand isresponsive to a price changelarger rise in demand for a substituteproduct eg 20%. XED = 20%/10% = +2Positive and less than one eg0.5Weak substitutes: demand isunresponsive to a price changesmaller rise in demand for a substituteproduct eg 5%. XED = 5%/10% = +0.5Zero Independent goods no change in demand for the other itemNegative and less than one eg-0.8Weak complements: demand isunresponsive to a price changesmaller fall in demand for a complementproduct eg 8%. XED = -8%/10% = -0.8Negative and greater than oneeg -1.5Strong complements: demandis responsive to a price changeLarger rise in demand for a complementproduct eg 20%. XED = -15%/10% = -1.5