Unit 2: Microeconomics Part I - Elasticities
Understanding Elasticity in Economics! Elasticity measures responsiveness - how much one economic variable changes when another variable changes. This unit explores three crucial elasticity concepts that help businesses make pricing decisions, governments design tax policies, and economists predict market behavior. Mastering elasticity calculations and interpretations is essential for IB Economics success.
1. Introduction to Elasticity
Elasticity: A measure of the responsiveness (sensitivity) of one economic variable to changes in another variable. It is expressed as a ratio of percentage changes, making it unit-free and allowing comparisons across different goods and markets.
Elasticity answers the question: "By what percentage does quantity change when price (or another variable) changes by 1%?"
Why Elasticity Matters
- Business Decisions: Pricing strategies, revenue maximization, production planning
- Government Policy: Tax incidence, subsidy effectiveness, price control impacts
- Consumer Behavior: Understanding spending patterns and substitution effects
- Market Analysis: Predicting responses to market changes
2. Price Elasticity of Demand (PED)
Price Elasticity of Demand (PED): Measures the responsiveness of quantity demanded to a change in price. It shows the percentage change in quantity demanded resulting from a 1% change in price.
PED Formula
Price Elasticity of Demand:
\[ PED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}} \]
Or more precisely: \[ PED = \frac{\Delta Q_d / Q_d}{\Delta P / P} = \frac{\Delta Q_d}{\Delta P} \times \frac{P}{Q_d} \]
Where:
Or more precisely: \[ PED = \frac{\Delta Q_d / Q_d}{\Delta P / P} = \frac{\Delta Q_d}{\Delta P} \times \frac{P}{Q_d} \]
Where:
- • \(\Delta Q_d\) = change in quantity demanded
- • \(\Delta P\) = change in price
- • \(Q_d\) = original quantity demanded
- • \(P\) = original price
Important Note: PED values are typically negative (due to the law of demand), but economists often use the absolute value \(|PED|\) for classification and comparison. In IB exams, you may express PED with or without the negative sign, but be consistent and clear.
Calculating PED: Step-by-Step Example
Example 1: The price of a product increases from $10 to $12, and quantity demanded falls from 100 units to 80 units. Calculate PED.
Step 1: Calculate percentage change in quantity demanded \[ \% \Delta Q_d = \frac{80 - 100}{100} \times 100\% = \frac{-20}{100} \times 100\% = -20\% \]
Step 2: Calculate percentage change in price \[ \% \Delta P = \frac{12 - 10}{10} \times 100\% = \frac{2}{10} \times 100\% = 20\% \]
Step 3: Calculate PED \[ PED = \frac{-20\%}{20\%} = -1 \]
Interpretation: \(|PED| = 1\), so demand is unit elastic. A 1% increase in price leads to a 1% decrease in quantity demanded.
Step 1: Calculate percentage change in quantity demanded \[ \% \Delta Q_d = \frac{80 - 100}{100} \times 100\% = \frac{-20}{100} \times 100\% = -20\% \]
Step 2: Calculate percentage change in price \[ \% \Delta P = \frac{12 - 10}{10} \times 100\% = \frac{2}{10} \times 100\% = 20\% \]
Step 3: Calculate PED \[ PED = \frac{-20\%}{20\%} = -1 \]
Interpretation: \(|PED| = 1\), so demand is unit elastic. A 1% increase in price leads to a 1% decrease in quantity demanded.
Classifications of PED
| Classification | Absolute Value | Description | Example Goods |
|---|---|---|---|
| Perfectly Inelastic | \(|PED| = 0\) | Quantity demanded doesn't change when price changes. Vertical demand curve. | Life-saving medicines, insulin |
| Inelastic | \(0 < |PED| < 1\) | Quantity demanded changes less than proportionally to price change. Relatively steep demand curve. | Gasoline, salt, necessities |
| Unit Elastic | \(|PED| = 1\) | Quantity demanded changes proportionally to price change. | Theoretical benchmark |
| Elastic | \(|PED| > 1\) | Quantity demanded changes more than proportionally to price change. Relatively flat demand curve. | Luxury goods, branded products |
| Perfectly Elastic | \(|PED| = \infty\) | Any price increase leads to zero demand. Horizontal demand curve. | Perfect competition (theoretical) |
Determinants of PED
1. Availability of Substitutes
- Many close substitutes: Demand is elastic (consumers easily switch)
- Few/no substitutes: Demand is inelastic (consumers have limited alternatives)
Example: Brand-name cereal (elastic) vs. insulin (inelastic)
2. Necessity vs. Luxury
- Necessities: Inelastic demand (must buy regardless of price)
- Luxuries: Elastic demand (can postpone or avoid purchase)
Example: Basic food (inelastic) vs. vacation cruise (elastic)
3. Proportion of Income Spent
- Small proportion: Inelastic demand (price changes barely noticed)
- Large proportion: Elastic demand (consumers very price-sensitive)
Example: Salt (inelastic) vs. car (elastic)
4. Time Period
- Short run: More inelastic (consumers need time to adjust behavior)
- Long run: More elastic (consumers find substitutes and alternatives)
Example: Gasoline demand is inelastic short-run but more elastic long-run (people buy fuel-efficient cars, move closer to work)
5. Addiction/Habit
- Addictive goods: Highly inelastic demand
- Example: Cigarettes, alcohol (for dependent consumers)
6. Definition of Market
- Broadly defined: More inelastic (e.g., "food")
- Narrowly defined: More elastic (e.g., "organic strawberries")
PED and Total Revenue
Total Revenue (TR): The total amount of money firms receive from selling goods.
\[ TR = P \times Q \]
The relationship between PED and total revenue is crucial for business pricing decisions:
| Price Change | Elastic Demand \(|PED| > 1\) | Unit Elastic \(|PED| = 1\) | Inelastic Demand \(|PED| < 1\) |
|---|---|---|---|
| Price Increases | TR Decreases (Q↓ effect dominates) | TR Unchanged | TR Increases (P↑ effect dominates) |
| Price Decreases | TR Increases (Q↑ effect dominates) | TR Unchanged | TR Decreases (P↓ effect dominates) |
Business Application:
Scenario 1 - Elastic Demand: A restaurant selling gourmet meals (\(|PED| = 2.5\))
Scenario 2 - Inelastic Demand: A gas station (\(|PED| = 0.4\))
Scenario 1 - Elastic Demand: A restaurant selling gourmet meals (\(|PED| = 2.5\))
- Price decrease of 10% → Quantity demanded increases by 25%
- Original: P = $50, Q = 100, TR = $5,000
- New: P = $45, Q = 125, TR = $5,625
- Result: Lowering price increases total revenue by $625
Scenario 2 - Inelastic Demand: A gas station (\(|PED| = 0.4\))
- Price increase of 10% → Quantity demanded decreases by 4%
- Original: P = $2.00, Q = 1,000, TR = $2,000
- New: P = $2.20, Q = 960, TR = $2,112
- Result: Raising price increases total revenue by $112
PED and Indirect Taxes
PED determines the burden of indirect taxes between consumers and producers:
Tax Incidence (Tax Burden Distribution):
- Inelastic Demand: Consumers bear most of the tax burden (can't easily reduce consumption)
- Elastic Demand: Producers bear most of the tax burden (consumers switch to alternatives)
Real-World Example:
- Cigarette taxes: Demand is inelastic → consumers pay most of the tax through higher prices
- Luxury car taxes: Demand is elastic → manufacturers absorb much of the tax to remain competitive
3. Income Elasticity of Demand (YED)
Income Elasticity of Demand (YED): Measures the responsiveness of quantity demanded to a change in consumer income. It shows the percentage change in quantity demanded resulting from a 1% change in income.
YED Formula
Income Elasticity of Demand:
\[ YED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in income}} \]
Or more precisely: \[ YED = \frac{\Delta Q_d / Q_d}{\Delta Y / Y} = \frac{\Delta Q_d}{\Delta Y} \times \frac{Y}{Q_d} \]
Where:
Or more precisely: \[ YED = \frac{\Delta Q_d / Q_d}{\Delta Y / Y} = \frac{\Delta Q_d}{\Delta Y} \times \frac{Y}{Q_d} \]
Where:
- • \(\Delta Q_d\) = change in quantity demanded
- • \(\Delta Y\) = change in income
- • \(Q_d\) = original quantity demanded
- • \(Y\) = original income
Calculating YED: Examples
Example 1: When income increases from $40,000 to $50,000, demand for restaurant meals increases from 20 to 30 per month. Calculate YED.
Step 1: Calculate percentage change in quantity demanded \[ \% \Delta Q_d = \frac{30 - 20}{20} \times 100\% = 50\% \]
Step 2: Calculate percentage change in income \[ \% \Delta Y = \frac{50,000 - 40,000}{40,000} \times 100\% = 25\% \]
Step 3: Calculate YED \[ YED = \frac{50\%}{25\%} = 2 \]
Interpretation: \(YED = 2\) (positive and > 1), so restaurant meals are a normal good (luxury). A 1% increase in income leads to a 2% increase in demand.
Step 1: Calculate percentage change in quantity demanded \[ \% \Delta Q_d = \frac{30 - 20}{20} \times 100\% = 50\% \]
Step 2: Calculate percentage change in income \[ \% \Delta Y = \frac{50,000 - 40,000}{40,000} \times 100\% = 25\% \]
Step 3: Calculate YED \[ YED = \frac{50\%}{25\%} = 2 \]
Interpretation: \(YED = 2\) (positive and > 1), so restaurant meals are a normal good (luxury). A 1% increase in income leads to a 2% increase in demand.
Example 2: When income increases from $30,000 to $36,000, demand for instant noodles decreases from 40 packets to 32 packets per month. Calculate YED.
Step 1: \(\% \Delta Q_d = \frac{32 - 40}{40} \times 100\% = -20\%\)
Step 2: \(\% \Delta Y = \frac{36,000 - 30,000}{30,000} \times 100\% = 20\%\)
Step 3: \(YED = \frac{-20\%}{20\%} = -1\)
Interpretation: \(YED = -1\) (negative), so instant noodles are an inferior good. As income rises, demand decreases.
Step 1: \(\% \Delta Q_d = \frac{32 - 40}{40} \times 100\% = -20\%\)
Step 2: \(\% \Delta Y = \frac{36,000 - 30,000}{30,000} \times 100\% = 20\%\)
Step 3: \(YED = \frac{-20\%}{20\%} = -1\)
Interpretation: \(YED = -1\) (negative), so instant noodles are an inferior good. As income rises, demand decreases.
Classifications of YED
| Classification | YED Value | Description | Example Goods |
|---|---|---|---|
| Inferior Goods | \(YED < 0\) | Demand decreases as income increases (negative relationship) | Instant noodles, public transport, generic brands |
| Normal Goods (Necessities) | \(0 < YED < 1\) | Demand increases as income increases, but less than proportionally | Basic food, clothing, utilities |
| Normal Goods (Luxuries) | \(YED > 1\) | Demand increases as income increases, more than proportionally | Designer clothes, fine dining, luxury cars, overseas vacations |
YED and Business Strategy
Implications for Businesses:
During Economic Growth (Rising Incomes):
During Economic Recession (Falling Incomes):
During Economic Growth (Rising Incomes):
- Luxury goods (YED > 1): Experience rapid demand increases → Invest heavily, expand capacity
- Normal goods (0 < YED < 1): Steady demand growth → Maintain production
- Inferior goods (YED < 0): Declining demand → Consider product repositioning or market exit
During Economic Recession (Falling Incomes):
- Luxury goods (YED > 1): Severe demand drops → Reduce capacity, cost-cutting
- Normal goods (0 < YED < 1): Mild demand decreases → Maintain core operations
- Inferior goods (YED < 0): Increasing demand → Opportunity to expand market share
Real-World Application:
During the 2008 financial crisis:
During the 2008 financial crisis:
- Luxury brands (Gucci, Rolex): Experienced significant sales declines due to high positive YED
- Discount retailers (Walmart, Aldi): Saw increased market share as consumers switched from expensive to cheaper alternatives
- Fast-food restaurants: Gained customers from expensive restaurants (lower YED)
YED and Economic Sectors
YED helps explain structural changes in economies as they develop:
- Primary Sector (Agriculture): Low YED → Share of economy declines as incomes rise
- Secondary Sector (Manufacturing): Moderate YED → Grows then stabilizes
- Tertiary Sector (Services): High YED → Expands rapidly as economies develop
4. Cross Price Elasticity of Demand (XED)
Cross Price Elasticity of Demand (XED): Measures the responsiveness of quantity demanded of Good A to a change in the price of Good B. It shows whether goods are substitutes, complements, or unrelated.
XED Formula
Cross Price Elasticity of Demand:
\[ XED = \frac{\% \text{ change in quantity demanded of Good A}}{\% \text{ change in price of Good B}} \]
Or more precisely: \[ XED = \frac{\Delta Q_{d_A} / Q_{d_A}}{\Delta P_B / P_B} = \frac{\Delta Q_{d_A}}{\Delta P_B} \times \frac{P_B}{Q_{d_A}} \]
Or more precisely: \[ XED = \frac{\Delta Q_{d_A} / Q_{d_A}}{\Delta P_B / P_B} = \frac{\Delta Q_{d_A}}{\Delta P_B} \times \frac{P_B}{Q_{d_A}} \]
Classifications of XED
| Classification | XED Value | Interpretation | Example |
|---|---|---|---|
| Substitute Goods | \(XED > 0\) | Price of B increases → Demand for A increases (positive relationship) | Coca-Cola and Pepsi, butter and margarine |
| Strong Substitutes | \(XED >> 1\) | Large XED indicates close substitutes | Different brands of identical products |
| Complementary Goods | \(XED < 0\) | Price of B increases → Demand for A decreases (negative relationship) | Cars and gasoline, coffee and sugar |
| Unrelated Goods | \(XED \approx 0\) | Price of B has no effect on demand for A | Shoes and bread, laptops and bananas |
Example: The price of coffee increases from $5 to $6 per kg, and demand for tea increases from 100 to 120 kg. Calculate XED.
\[ \% \Delta Q_{d \, \text{tea}} = \frac{120 - 100}{100} \times 100\% = 20\% \]
\[ \% \Delta P_{\text{coffee}} = \frac{6 - 5}{5} \times 100\% = 20\% \]
\[ XED = \frac{20\%}{20\%} = 1 \]
Interpretation: \(XED = 1 > 0\), confirming coffee and tea are substitutes. A 1% increase in coffee price leads to a 1% increase in tea demand.
\[ \% \Delta Q_{d \, \text{tea}} = \frac{120 - 100}{100} \times 100\% = 20\% \]
\[ \% \Delta P_{\text{coffee}} = \frac{6 - 5}{5} \times 100\% = 20\% \]
\[ XED = \frac{20\%}{20\%} = 1 \]
Interpretation: \(XED = 1 > 0\), confirming coffee and tea are substitutes. A 1% increase in coffee price leads to a 1% increase in tea demand.
Business Applications of XED
Strategic Pricing Decisions:
- Competitive Strategy: Firms monitor competitors' prices closely when XED is high (close substitutes)
- Complementary Products: Lower price of razors to increase demand for blades
- Product Bundling: Offer complements together at discount (computers with software)
- Market Definition: High XED suggests products compete in same market
5. Price Elasticity of Supply (PES)
Price Elasticity of Supply (PES): Measures the responsiveness of quantity supplied to a change in price. It shows the percentage change in quantity supplied resulting from a 1% change in price.
PES Formula
Price Elasticity of Supply:
\[ PES = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}} \]
Or more precisely: \[ PES = \frac{\Delta Q_s / Q_s}{\Delta P / P} = \frac{\Delta Q_s}{\Delta P} \times \frac{P}{Q_s} \]
Where:
Or more precisely: \[ PES = \frac{\Delta Q_s / Q_s}{\Delta P / P} = \frac{\Delta Q_s}{\Delta P} \times \frac{P}{Q_s} \]
Where:
- • \(\Delta Q_s\) = change in quantity supplied
- • \(\Delta P\) = change in price
- • \(Q_s\) = original quantity supplied
- • \(P\) = original price
Important Note: PES values are always positive (due to the law of supply - positive relationship between price and quantity supplied). Unlike PED, we don't use absolute values.
Calculating PES: Example
Example: The price of wheat increases from $200 to $250 per ton. Quantity supplied increases from 1,000 to 1,400 tons. Calculate PES.
Step 1: Calculate percentage change in quantity supplied \[ \% \Delta Q_s = \frac{1,400 - 1,000}{1,000} \times 100\% = 40\% \]
Step 2: Calculate percentage change in price \[ \% \Delta P = \frac{250 - 200}{200} \times 100\% = 25\% \]
Step 3: Calculate PES \[ PES = \frac{40\%}{25\%} = 1.6 \]
Interpretation: \(PES = 1.6 > 1\), so supply is elastic. A 1% increase in price leads to a 1.6% increase in quantity supplied.
Step 1: Calculate percentage change in quantity supplied \[ \% \Delta Q_s = \frac{1,400 - 1,000}{1,000} \times 100\% = 40\% \]
Step 2: Calculate percentage change in price \[ \% \Delta P = \frac{250 - 200}{200} \times 100\% = 25\% \]
Step 3: Calculate PES \[ PES = \frac{40\%}{25\%} = 1.6 \]
Interpretation: \(PES = 1.6 > 1\), so supply is elastic. A 1% increase in price leads to a 1.6% increase in quantity supplied.
Classifications of PES
| Classification | PES Value | Description | Example Goods |
|---|---|---|---|
| Perfectly Inelastic | \(PES = 0\) | Quantity supplied cannot change regardless of price. Vertical supply curve. | Original artworks, land (fixed supply), tickets to sold-out events |
| Inelastic | \(0 < PES < 1\) | Quantity supplied changes less than proportionally to price change. Steep supply curve. | Agricultural products (short-run), electricity, hotel rooms (short-run) |
| Unit Elastic | \(PES = 1\) | Quantity supplied changes proportionally to price change. | Theoretical benchmark |
| Elastic | \(PES > 1\) | Quantity supplied changes more than proportionally to price change. Flat supply curve. | Manufactured goods, services (with spare capacity) |
| Perfectly Elastic | \(PES = \infty\) | Infinite supply at a given price. Horizontal supply curve. | Perfectly competitive firm (theoretical) |
Determinants of PES
1. Time Period
This is THE most important determinant of PES
- Momentary Period: Supply is perfectly inelastic (no time to adjust)
- Short Run: Supply is relatively inelastic (limited adjustment possible)
- Long Run: Supply is elastic (full adjustment possible, new firms enter)
Example: Agricultural products - cannot immediately increase harvest (momentary), can work harder (short-run), can plant more acres next season (long-run)
2. Spare Capacity
- Spare capacity exists: Elastic supply (easy to increase production)
- Operating at full capacity: Inelastic supply (cannot easily expand)
Example: Factory operating at 60% capacity can quickly increase output vs. factory at 100% capacity
3. Ability to Store Stock
- Storable goods: More elastic (can release inventory when prices rise)
- Perishable/non-storable: More inelastic (must sell immediately)
Example: Canned food (storable, elastic) vs. fresh fish (perishable, inelastic)
4. Production Lag
- Short production time: More elastic supply
- Long production time: More inelastic supply
Example: T-shirts (quick to produce) vs. commercial aircraft (years to produce)
5. Factor Mobility
- Mobile factors: Elastic supply (resources easily shifted between uses)
- Immobile factors: Inelastic supply (specialized resources)
Example: Unskilled labor (mobile) vs. specialized surgeons (immobile)
6. Ease of Entry
- Low barriers: Elastic supply (new firms easily enter)
- High barriers: Inelastic supply (difficult to expand industry supply)
Example: Food trucks (low barriers) vs. pharmaceutical manufacturing (high barriers)
PES and Market Adjustment
PES determines how quickly markets adjust to changes in demand:
Scenario: Sudden increase in demand
If PES is elastic:
If PES is inelastic:
If PES is elastic:
- Producers can quickly increase quantity supplied
- Price rises moderately
- Most adjustment occurs through quantity increase
- Market reaches new equilibrium quickly
If PES is inelastic:
- Producers cannot quickly increase quantity
- Price rises sharply
- Most adjustment occurs through price increase
- May take long time to reach new equilibrium
PES and Tax Incidence
Similar to PED, PES affects how the burden of indirect taxes is distributed:
Tax Burden Distribution:
- Inelastic Supply: Producers bear most of the tax burden (can't reduce production easily)
- Elastic Supply: Consumers bear most of the tax burden (producers can reduce supply easily)
- Combined Effect: The more inelastic side (supply or demand) bears greater tax burden
6. Comparing Elasticities
| Elasticity Type | Measures | Formula | Key Use |
|---|---|---|---|
| PED | Responsiveness of Qd to price change | \(\frac{\% \Delta Q_d}{\% \Delta P}\) | Pricing decisions, tax incidence, revenue |
| YED | Responsiveness of Qd to income change | \(\frac{\% \Delta Q_d}{\% \Delta Y}\) | Business cycle impacts, long-term planning |
| XED | Responsiveness of Qd of A to price of B | \(\frac{\% \Delta Q_{d_A}}{\% \Delta P_B}\) | Competitive strategy, market definition |
| PES | Responsiveness of Qs to price change | \(\frac{\% \Delta Q_s}{\% \Delta P}\) | Market adjustment speed, tax incidence |
7. Real-World Applications and Case Studies
Case Study 1: Gasoline Markets
PED Analysis:
Policy Implications:
- Short-run PED: Approximately 0.2-0.3 (inelastic)
- People need to drive to work, limited immediate alternatives
- 10% price increase → only 2-3% decrease in quantity demanded
- Long-run PED: Approximately 0.7 (more elastic)
- People buy fuel-efficient cars, use public transport, move closer to work
Policy Implications:
- Gas taxes effective at raising revenue (inelastic demand)
- Environmental impact limited in short-run but significant long-run
Case Study 2: Smartphone Market
XED Analysis:
YED Analysis:
- Smartphones and Apps: XED < 0 (strong complements)
- Lower smartphone prices increase app demand
- Strategy: Price phones competitively to drive app revenue
YED Analysis:
- Premium smartphones: YED > 1 (luxury)
- Sensitive to economic conditions
- Budget smartphones: YED between 0 and 1 (necessity)
- More stable demand during recessions
Case Study 3: Agricultural Markets
PES Analysis:
Result:
- Momentary period: PES ≈ 0 (harvest is fixed)
- Short-run: PES < 1 (can increase labor, irrigation)
- Long-run: PES > 1 (can expand farmland, use new technology)
Result:
- Demand increase → sharp price spike initially
- Prices moderate as supply gradually increases
- Price volatility common due to inelastic short-run supply
8. IB Economics Exam Skills
Calculation Tips
Step-by-Step Calculation Approach:
- Identify: Which elasticity? (PED, YED, XED, PES)
- Calculate % changes: Use \(\frac{\text{new} - \text{old}}{\text{old}} \times 100\%\)
- Apply formula: Divide % change in quantity by % change in price/income
- Interpret: State what the value means (elastic/inelastic, normal/inferior, etc.)
- Show work: Write all steps clearly for maximum marks
Common Calculation Errors to Avoid
- Using wrong base: Always use ORIGINAL values for percentage calculations
- Forgetting negative signs: PED is negative, XED can be negative for complements
- Incorrect formula: Make sure numerator and denominator match the elasticity type
- No interpretation: Always explain what your calculated value means
Diagram Drawing
Drawing Elasticity on Diagrams:
- Elastic demand: Relatively flat (gentle slope)
- Inelastic demand: Relatively steep
- Elastic supply: Relatively flat
- Inelastic supply: Relatively steep
- Always label: Axes (P and Q), curves (D, S), elasticity type
Sample Exam Questions with Answers
Question 1: A firm increases price from $80 to $100. Quantity demanded falls from 500 to 400 units. Calculate PED and recommend whether the firm should maintain this price increase. [6 marks]
Model Answer:
Calculation:
\(\% \Delta Q_d = \frac{400-500}{500} \times 100\% = -20\%\)
\(\% \Delta P = \frac{100-80}{80} \times 100\% = 25\%\)
\(PED = \frac{-20\%}{25\%} = -0.8\)
Interpretation: \(|PED| = 0.8 < 1\), so demand is price inelastic.
Recommendation: The firm should maintain the price increase because:
Model Answer:
Calculation:
\(\% \Delta Q_d = \frac{400-500}{500} \times 100\% = -20\%\)
\(\% \Delta P = \frac{100-80}{80} \times 100\% = 25\%\)
\(PED = \frac{-20\%}{25\%} = -0.8\)
Interpretation: \(|PED| = 0.8 < 1\), so demand is price inelastic.
Recommendation: The firm should maintain the price increase because:
- Original TR = $80 × 500 = $40,000
- New TR = $100 × 400 = $40,000
- With inelastic demand, price increases typically raise revenue
- While TR remained constant here, costs may have decreased due to lower production volume
- Profit likely increased
Question 2: Explain two factors that would make the demand for a product price elastic. [4 marks]
Model Answer:
Factor 1: Availability of close substitutes
If a product has many close substitutes, consumers can easily switch to alternatives when price increases. For example, if Brand A coffee increases price, consumers can buy Brand B, making demand for Brand A elastic.
Factor 2: Product is a luxury rather than necessity
Luxury goods have elastic demand because consumers can postpone or avoid purchases when prices rise. For example, demand for vacation cruises is elastic because people can delay or cancel trips, unlike essential goods like medicine.
Model Answer:
Factor 1: Availability of close substitutes
If a product has many close substitutes, consumers can easily switch to alternatives when price increases. For example, if Brand A coffee increases price, consumers can buy Brand B, making demand for Brand A elastic.
Factor 2: Product is a luxury rather than necessity
Luxury goods have elastic demand because consumers can postpone or avoid purchases when prices rise. For example, demand for vacation cruises is elastic because people can delay or cancel trips, unlike essential goods like medicine.
Question 3: Using diagrams, analyze how PED and PES affect the incidence of an indirect tax. [8 marks]
Model Answer Structure:
Model Answer Structure:
- Define: Tax incidence is how tax burden is distributed between consumers and producers
- Diagram 1: Inelastic demand, elastic supply → consumers bear most burden
- Explain: Consumers cannot reduce consumption much, so accept higher prices
- Diagram 2: Elastic demand, inelastic supply → producers bear most burden
- Explain: Consumers switch to substitutes, forcing producers to absorb tax
- Conclusion: The more inelastic side of market bears greater tax burden
- Real example: Cigarette taxes (inelastic demand) vs. luxury car taxes (elastic demand)
9. Summary Table: Key Elasticity Values
| Elasticity | Value Range | Classification | Meaning |
|---|---|---|---|
| PED | \(|PED| < 1\) | Inelastic | Quantity responds weakly to price changes |
| \(|PED| = 1\) | Unit Elastic | Quantity responds proportionally | |
| \(|PED| > 1\) | Elastic | Quantity responds strongly to price changes | |
| YED | \(YED < 0\) | Inferior Good | Demand decreases as income rises |
| \(0 < YED < 1\) | Normal (Necessity) | Demand increases less than income | |
| \(YED > 1\) | Normal (Luxury) | Demand increases more than income | |
| XED | \(XED > 0\) | Substitutes | Price of B rises, demand for A rises |
| \(XED < 0\) | Complements | Price of B rises, demand for A falls | |
| \(XED \approx 0\) | Unrelated | No relationship between goods | |
| PES | \(PES < 1\) | Inelastic | Supply responds weakly to price changes |
| \(PES = 1\) | Unit Elastic | Supply responds proportionally | |
| \(PES > 1\) | Elastic | Supply responds strongly to price changes |
10. Quick Reference Formulas
Price Elasticity of Demand:
\[ PED = \frac{\% \Delta Q_d}{\% \Delta P} = \frac{\Delta Q_d}{\Delta P} \times \frac{P}{Q_d} \]
Income Elasticity of Demand: \[ YED = \frac{\% \Delta Q_d}{\% \Delta Y} = \frac{\Delta Q_d}{\Delta Y} \times \frac{Y}{Q_d} \]
Cross Price Elasticity of Demand: \[ XED = \frac{\% \Delta Q_{d_A}}{\% \Delta P_B} = \frac{\Delta Q_{d_A}}{\Delta P_B} \times \frac{P_B}{Q_{d_A}} \]
Price Elasticity of Supply: \[ PES = \frac{\% \Delta Q_s}{\% \Delta P} = \frac{\Delta Q_s}{\Delta P} \times \frac{P}{Q_s} \]
Percentage Change: \[ \% \text{ change} = \frac{\text{New Value} - \text{Original Value}}{\text{Original Value}} \times 100\% \]
Total Revenue: \[ TR = P \times Q \]
Income Elasticity of Demand: \[ YED = \frac{\% \Delta Q_d}{\% \Delta Y} = \frac{\Delta Q_d}{\Delta Y} \times \frac{Y}{Q_d} \]
Cross Price Elasticity of Demand: \[ XED = \frac{\% \Delta Q_{d_A}}{\% \Delta P_B} = \frac{\Delta Q_{d_A}}{\Delta P_B} \times \frac{P_B}{Q_{d_A}} \]
Price Elasticity of Supply: \[ PES = \frac{\% \Delta Q_s}{\% \Delta P} = \frac{\Delta Q_s}{\Delta P} \times \frac{P}{Q_s} \]
Percentage Change: \[ \% \text{ change} = \frac{\text{New Value} - \text{Original Value}}{\text{Original Value}} \times 100\% \]
Total Revenue: \[ TR = P \times Q \]
Conclusion
Elasticity is one of the most important concepts in microeconomics, providing quantitative measures of how markets respond to changes. Understanding PED helps businesses optimize pricing and revenue, YED guides long-term business strategy and explains sectoral shifts, XED reveals competitive relationships between products, and PES determines how quickly markets adjust to changing conditions.
Key Takeaways for IB Success:
- Master the formulas and be able to calculate elasticities accurately
- Understand the determinants that make demand/supply elastic or inelastic
- Connect elasticity to real-world applications (pricing, taxation, business strategy)
- Practice interpreting elasticity values - don't just calculate, explain what they mean
- Use diagrams effectively to show relative elasticity (slope of curves)
- Apply elasticity concepts to evaluate economic policies and business decisions
Exam Excellence Strategy:
- Always show calculation steps clearly for full marks
- State formulas before calculations
- Interpret results in economic terms (elastic/inelastic, etc.)
- Connect to total revenue when discussing PED
- Consider time period when analyzing PES
- Use real-world examples to strengthen evaluation answers
- Remember: Analysis requires diagrams + explanation in IB Economics!