PED and PES
1. Applications of Demand Analysis
1.1 Price Elasticities of Demand
Price Elasticity of Demand (PED): Measures how responsive quantity demanded is to price changes.
Example: Luxury goods like designer bags are highly elastic, while necessities like water are inelastic.
1.2 Formula
1.3 Interpretation of PED Sign and Value
PED is typically negative because of the inverse relationship between price and quantity demanded (Law of Demand). However, the absolute value is used for interpretation.
Value of PED:
PED > 1 (Elastic): Quantity demanded is highly responsive to price changes.
Example: Luxury goods like designer bags.PED = 1 (Unitary Elastic): Percentage change in quantity demanded equals percentage change in price.
Example: Some everyday goods over a narrow price range.PED < 1 (Inelastic): Quantity demanded is not very responsive to price changes.
Example: Necessities like food or medicine.PED = 0 (Perfectly Inelastic): Quantity demanded does not change regardless of price.
Example: Life-saving drugs.PED = ∞ (Perfectly Elastic): Any small price change causes an infinite change in quantity demanded.
Example: Identical goods in perfect competition.
1.4 Determinants of PED
1. Availability of Substitutes
Goods with more substitutes tend to have higher elasticity, as consumers can easily switch to alternatives if the price increases.
Fewer substitutes make demand less elastic, as consumers have limited options to replace the good.
Example:
If the price of Coca-Cola rises, consumers may switch to Pepsi, making demand for Coca-Cola elastic.
Salt has few substitutes, so its demand remains inelastic regardless of price changes.
2. Presence of Close Substitutes
The closeness of substitutes also affects elasticity. The closer the substitute, the more elastic the demand.
Consumers are more likely to switch if the substitute offers similar benefits or quality.
Example:
Butter and margarine are close substitutes, so an increase in the price of butter can lead to a significant rise in demand for margarine.
Cars and public transportation are substitutes, but they are not as close, so a rise in car prices may not immediately increase demand for public transport.
3. Proportion of Income Spent on the Good
Goods that take up a large proportion of income tend to have elastic demand, as price changes significantly impact purchasing power.
Goods that represent a small proportion of income are inelastic, as price changes have little financial impact.
Example:
A rise in car prices significantly affects demand due to the high cost of cars (elastic demand).
A rise in the price of chewing gum has little effect on demand because it represents a small portion of income (inelastic demand).
4. Duration of Price Change
The length of time consumers have to respond to price changes affects elasticity:
Short-term: Demand is more inelastic, as consumers may not have enough time to find substitutes or adjust their consumption habits.
Long-term: Demand becomes more elastic as consumers adapt to the price change by finding alternatives or modifying their behavior.
Example:
A sudden increase in fuel prices may not immediately reduce demand, but over time, consumers may switch to public transport or purchase fuel-efficient vehicles.
5. Degree of Necessity
Goods classified as necessities tend to have inelastic demand because consumers cannot easily reduce consumption regardless of price changes.
Conversely, luxury goods have elastic demand, as consumers can delay or forgo their purchase.
Example:
Electricity is a necessity with inelastic demand, as it is essential for daily life.
Designer handbags are luxuries, and their demand is elastic because consumers can opt not to purchase them if prices rise.
2. Applications of Supply Analysis
2.1 Price Elasticities of Supply and Market Outcomes
Price Elasticity of Supply (PES): Measures how responsive quantity supplied is to price changes.
Example: Agricultural goods have inelastic supply in the short term due to growing cycles.
2.2 Formula
2.3 Interpretation of PES
PES > 1 (Elastic Supply): Quantity supplied responds significantly to price changes.
PES = 1 (Unitary Elastic Supply): Quantity supplied changes proportionally to price changes.
PES < 1 (Inelastic Supply): Quantity supplied responds minimally to price changes.
PES = 0 (Perfectly Inelastic Supply): Quantity supplied remains unchanged regardless of price changes.
PES = ∞ (Perfectly Elastic Supply): Any small price change causes an infinite change in quantity supplied.PES > 1 (Elastic Supply): Quantity supplied responds significantly to price changes.
2.4 Determinants of PES
Length and Complexity of the Production Process
Goods with short and simple production processes have more elastic supply because producers can quickly adjust output in response to price changes.
Goods with long and complex production processes have inelastic supply because adjustments require significant time and resources.
Example:
Bread production is elastic as it involves simple processes.
Airplane manufacturing is inelastic due to its complexity and long production time.
2. Availability and Mobility of Factors of Production
More availability and mobility of factors like labor, capital, and raw materials make supply more elastic because producers can easily reallocate resources to increase production.
Limited availability or immobility leads to inelastic supply.
Example:
An abundant supply of skilled workers in a technology sector increases supply elasticity.
Specialized industries like luxury watchmaking often face inelastic supply due to limited skilled labor.
3. Production Spare Capacity
Firms operating with spare capacity (unused resources or machinery) can easily increase output when prices rise, making supply elastic.
Firms operating at full capacity have inelastic supply because they cannot increase production without additional investment.
Example:
A clothing factory with idle machines can quickly increase output when prices rise, demonstrating elastic supply.
4. Storage Capacity
Goods that can be stored for long periods have more elastic supply because producers can release stored goods when prices rise.
Perishable goods with limited storage options have inelastic supply.
Example:
Non-perishable items like canned goods have elastic supply.
Fresh produce like strawberries is inelastic due to limited storage capacity.
5. Level of Stocks or Inventories
Firms with high inventory levels can respond quickly to price changes, making supply elastic.
Firms with low inventory levels struggle to adjust supply, making it inelastic.
Example:
A furniture manufacturer with a large stockpile of finished products can meet rising demand, showing elastic supply.
6. Nature of Goods (Perishable vs. Non-Perishable)
Non-perishable goods have elastic supply because they can be stored and sold later.
Perishable goods have inelastic supply because they cannot be stored for long.
Example:
Canned fish is elastic, while fresh fish is inelastic due to perishability.
7. Duration Considered
Short Run: Supply is often inelastic because firms cannot adjust production quickly.
Long Run: Supply becomes more elastic as firms have time to increase production capacity or enter the market.
Example:
Farmers cannot immediately increase crop supply when prices rise but can plant more crops in the next growing season.
3. Consumer and Producer Surplus
Consumer Surplus: The difference between what consumers are willing to pay and what they actually pay.
Producer Surplus: The difference between what producers receive and their minimum acceptable price.
These surpluses illustrate market efficiency at equilibrium.