Tag Archives: Elasticity

A Level revision – Elasticity – PED

Doing some last minute revision with students resitting the AS Level exam. Went over elasticity and here are some key points that I covered. Might be useful for those doing AS at the moment.

Price Elasticity of Demand (PED)
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:

% change in Quantity ÷ Demanded % change in Price

How is PED calculated?

Consider the following demand schedule for buses in a city centre.

Price (average fare)          Quantity of passengers per week
100c                                      1000
60c                                        1300
30c                                        2275

Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?

The percentage change in QD is equal to:
• The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%

The percentage change in price is equal to:
• The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%

These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75
Let us now consider the PED when the average fare is cut from 60c to 30c

The percentage change in QD is equal to:
• The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%

The percentage change in price is equal to:
• The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%

These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5

Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as:
PED = (-) 0.2

What price elasticity of demand figures tell us.



Determinants of Elasticity of Demand

The elasticity of a product is influenced by:
• the number of substitutes available
• whether it could be described as a luxury or a basic commodity
• the proportion of the purchaser’s income it represents
• the durability of the product.

Usefulness of Price Elasticity of Demand

The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:

1. The effect of a change in price on the total revenue & expenditure on a product.

The relationship between elasticity and total revenue.

                      Elastic         Inelastic            Unitary
Price ↑           TR↓                TR↑                      No Change
Price ↓           TR↑                TR↓                      No Change

2. The likely price volatility in a market following unexpected changes in supply.

3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.

The Euro and Export Revenue

Here is a graphic from the Wall Street Journal. It shows a strong correlation between the exchange rate and the revenue from selling exports. Remember the following:

Effects of a declining €
Imports: Should in theory discourage imports. However if goods are inelastic(necessities) the end result is a much higher import bill.
Exports: Should lead to an increase in the value of exports sold. But it takes time for exporting firms to adjust their marketing and production schedules to take maximum advantage of falling currency values.
Inflation: Because of dearer imports this may lead to an increase in domestic inflation.

Effects of a rising €
Imports: Eurozone imports become cheaper. Will improve the B of P provided demand is inelastic. If demand is elastic, cheaper imports will lead to an increase in the volume of imports and a worsening of B of P position.
Exports: Eurozone exports become dearer. If demand is inelastic export earnings increase and B of P position improves. If demand is elastic their will be a fall in sales and a consequent worsening of the B of P position.
Inflation: Eurozone imports are cheaper therefore this helps to reduce inflationary pressures.

AS Revision: Elasticity

With the essay and data response paper on Monday it might be appropriate to go through elasticity. You should know the following for PED, YED, CPED, and PES:

1. Characteristics
2. Equation for calculation
3. Values – what do they mean?
4. Graphs
5. Usefulness to businesses

This topic comes up in a variety of guises:
– Indirect taxes and subsidies
– Market failure
– Trade – J curve
– Macroeconomy

Here is a reminder of some of the main points for PED:

Also a key graph for Income Elasticity of Demand.

Elasticity and climbing Everest

Been doing Elasticity wtih my AS class and came across a good example from the book ‘Into Thin Air” by Jon Krakauer. Remember this theory measures the responsiveness of the quantity demanded to a change in price of the good/service. Licences for climbing Everest are only a small part of the cost of such activities – for most people the largest costs concern the long periods of time they must spend awy from their families and job, not to mention the risk of death and injury. Over the last ten years the volume of people wishing to climb Everest has increased hugely and the Nepalese government realised that this had an environmental impact and created problems in terms of safety, aesthetics etc. The Nepalese government come up with a plan to limit the amount of climbers and also gain some well needed revenue.

1991 – US$2,300 for any size of team
1992 – US$10,000 for a team up to 9 climbers – US$1,900 for each additional climber.

However, climbers continued to show their face at Everest and in 1993 a record number of climbers (294) attempted to scale the peak. Later that year they changed the fee again to climb Everest

1993 – US$50,000 for a team up to 5 climbers and $10,000 for each additional climber.

However at this point demand became more elastic as the Nepalese authorities didn’t consider China only charged US15,000 to allow a team of any size to climb Everest from the Tibet side. Sure enough Everest expeditions now shifted from Nepal to Tibet, leaving hundreds of sherpas out of work. Nepalese authorities, realising this, cancelled the four-expedition limit but still increased the permit fee:

1996 – US$70,000 for up to seven climbers plus and $10,000 for each additional climber.

As 16 out of the 30 expeditions in 1997 climbed via the Nepal side, it seems that the high cost of obtaining a permit doesn’t seem to have been a notable dampner on their desire.

Demand↑ and Supply↓ = Food Prices↑

Paul Krugman has simplified the recent increase in global food prices. On his blog he had the following graph which shows the % declines in grain production.

Demand Pressures

With the exceptional growth in China and a change in diet, there is more pressure on imports of food. The US Grains Council, which in October pegged China’s 2011 corn imports at 2m-3m tonnes, said that the figure could reach 3m-9m. However, as Krugman, points out the demand for grain is highly inelastic. For the United States, they put the price elasticity of demand for breads and cereals at 0.04 — that is, it would take a 25 percent rise in price to induce a 1 percent fall in consumption.

Supply Pressures
Most of the decline in world wheat production, and about half of the total decline in grain production, has taken place in the former Soviet Union — mainly Russia, Ukraine, and Kazakhstan. As you may know this was due to unique heatwave that was prevalent in the area. I blogged on this on 5th September last year – Wheat Prices – what’s driving them up? And it’s not just the FSU (Former Soviet Union): extreme weather elsewhere has played a role in bad harvest around the world.

NZ winegrowers want change to excise tax

This morning on Radio New Zealand Morning Report programme there was an interview with New Zealand Wine Growers Chief executive Philip Gregan concerning the Government’s intention to raise the tax from July 2011, which will cost wineries another $1.00 per case.

His worry is that the winegrowers will have to bear the whole tax themselves because they can’t pass it on to the retailers. There are 600 – 700 wineries in New Zealand, but only two major players in the retail sector, which are the supermarkets. Mr Gregan says that gives power to the retailers which are very reluctant to accept price increases so it becomes impossible to pass on the annual tax increases. He says the Government should tax the consumer directly at retail, rather than producer level. Furthermore, despite the excise tax on wine going up more than 60% since 1991, the increase in the cost price index for wine in the past 19 years is only about half the overall CPI increase.

Excise tax: a tax collected by Inland Revenue Department (IRD) which is usually on a specific good within the country. Excises are distinguished from customs duties, which are taxes on importation.