ECONOMICS

PAPER 2

MICROECONOMICS

TOPIC 7: PRICE ELASTICITY:

Candidates should cover the following:

Marginal utility Price elasticity of demand Definitions of:

Price elasticity of supply Income elasticity
Factors that determine price elasticity of demand Cross elasticity

Vocabulary list:

Learners must first give a description of the following words in their notebook.

DEMAND Income elasticity of demand

Price elasticity of demand Normal goods
Perfect elastic demand Inferior good
Elastic demand Cross Elasticity of Demand
Unitary elasticity demand Substitute products
Inelastic demand Complementary products
Perfect inelastic demand Unrelated products
Supply
Price elasticity of supply
Factors of production

MEASURING UTILITY:

Total Utility
Total utility is the utility derived from all the units that were consumed in succession.

Number of slices of bread Total Marginal utility

utility
1 16 16
2 28 12
3 36 8
4 40 4
5 40 0
6 36 -4

John is consuming bread and he eats 7 slices of bread consecutively.

When he eats his 1 slice, he derives 16 units of utility, 2 slices he derives 28 units of utility, 3
slices = 36 units of utility, 4 slices = 40, 5 slices = 40 and 6 slices = 36 units of utility.

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Marginal utility

Marginal utility is the utility derived from the last additional (extra) unit of a given good that
was consumed by the consumer.

 From the above it is clear that up to the fourth slice of bread marginal utility is positive
and total utility increases.
 When the fifth slice of bread is consumed the marginal utility is zero and the increase
in total utility stops. This is the point of complete satisfaction.
 All the extra slices of bread consumed from six slices onwards will cause disutility
and this means that there is a negative marginal utility. Total utility starts to diminish
(decrease).

 John will derive no further satisfaction from eating six slices of bread or more
consecutively because consuming too much bread at the same time will cause
negative utility.

Economies of scale:

Economies of scale: the shape of the long-run average total cost curve conveys important
information about technology for producing a good. When long-run average total cost
declines as output increases, it is said to be economies of scale

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Constant costs: when long-run average total cost does not vary with the level of output, it is
said to be constant returns to scale

Diseconomies of scale: when long-term total cost rises as output increases, there are said
to be diseconomies of scale
In this example the business experiences economies of scale at low levels of output,
constant returns to scale at intermediate levels of output and diseconomies of scale at high
levels of output

PRICE ELASTICITY OF DEMAND

 Price elasticity of demand (PEd) = how and to what extent the quantity demanded
will be influenced by a change in price.
 Elasticity is calculated in terms of percentage change in price and quantity.
 Price elasticity of demand (PEd)= % change in quantity demanded% change in price
 PEd= % ∆Qd% ∆P
Example:
 Assume the price (P) of a product increases from R200 to R240 and the
quantity demanded decreased from 400 to 300 units (Q).

 Step 1: Price change= Change in priceOriginal price ×100

=(240-200)200 ×100=20%

 Step 2: Quantity change= Change in quantityOriginal quantity ×100

=(400- 300)400 ×100=25%

Important: quantity decreased, must change 25% to -25%.

 Step 3: PEd= % ∆Q%∆P = -25%20%= -1.25 or only 1,25

(The negative sign is ignored because of the inverse relationship

between price and quantity demanded – law of demand.
The answer is a coefficient – has no identity of its own, e.g.
rand/kilogram/percentage.)

 Price elasticity of demand is normally negative, because price and demand have an
inverse relationship (law of demand).

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Degrees of price elasticity of demand / Types of price elasticity of demand
The demand for most goods and services is either elastic or inelastic.
The table below illustrate the different degrees and influence of each PEd.

Value of
Graph Classification Explanation
PEd

 %∆ in P < %∆ in Qd.
 Ex. an increase of 20% in P, will lead to a decrease of
25% in Q.
Between  An increase in P will lead to a decrease in the revenue of
1 and Elastic the business. A decrease in P will result in a big increase
demand in Q, revenue of businesses will increase.
(coeff > 1)
 Examples: close substitute (red/white meat), luxury
goods

 %∆ in P > %∆ in Qv.
 Ex. an increase of 20% in P, will lead to a decrease of
10% in Q.
Between 0  If P increases, consumer expenditure increases, revenue
and 1 Inelastic of business increases.
demand
 Examples: necessities (food), addictive goods and
(coeff < 1)
services (cigarettes/TV), g + s with no substitutes
substitute (needles for needle work), goods with different
uses.

 %∆ in Qd = %∆ in P.
Unit price  Ex. a change of 10% in P, will lead to a change of 10% in
elasticity Q.
1  Consumer spending and income received by businesses
(Unitary does not change, stays the same.
demand)  Examples: non-essential products (meat)

 %∆ in P will lead to no %∆ in Qd.

 Vertical line – irrespective what happens to price,
demand will remain the same.
Perfect  As the price increase, consumer expenditure will
0 increase.
inelasticity
 Example: insulin which is required by diabetes sufferers
need to survive – they will demand the same quantity
irrespective the price.

 %∆ in P will lead to an %∆ in Qd.

 Irrespective what happens to P, Qd will remain the same.
 If P increases or decreases, Qd for the product will not
increase.
Perfect
 Any ∆P will not lead to a bigger income or consumer
elasticity
spending, demand = zero.
 Example – customers buy cd’s at a concert, a competitor
reduces the price, more customers will buy from the
competitor.

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Factors determining the demand elasticity for a product

 Nature of the good

 The type of a good or service affects the elasticity of demand.

 Essential goods for example, food, medicine has a inelastic demand. Price
increases does not influence demand because it is used for survival
 Comfort goods for example, washing machine, dishwasher, etc. has an elastic
demand. The consumption thereof can be postponed for a period of time.
 Luxury good for example Cars, TV, etc. has a relatively high elastic demand.

Availability of substitute goods and services

 The availability of substitute goods can affect demand elasticity.
 When a large number of close substitutes are available, the quantity demanded is
highly sensitive to changes in the price level and vice versa. (Price elasticity is very
high).
 A small increase in the price levels of goods causes consumers to buy its
substitutes.
 For example, the demand for Chips is highly price-elastic because there is a large
number of substitutes available. If the price of one type chips increase, consumers
will buy a cheaper substitute.

Price levels
 The price level of an item affects the demand for a good or service
 The price elasticity of demand can be used to measure the sensitivity of a change in
the quantity demanded of a good or service relative to a change in price

 For example, Luxury goods have a high price elasticity of demand because they are
sensitive to price changes.
 For example; If the price of Televisions decreases more people who previously were
unable to buy it will no buy TV.

Income
 Income levels of consumers plays a role in the demand elasticity of goods and
services.
 Different types of goods are affected by income levels.
 For example, inferior goods, such as generic products, have a negative income
elasticity of demand because the quantity demanded for generic products tends to
fall as consumers' incomes increase.

PRICE ELASTICITY OF SUPPLY

 Price elasticity of supply indicates how sensitive supply of a product is for a change
in price.
 In other words, if there is a big increase in the price of a product, will there be a big or
small change in the quantity supplied.

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Measuring price elasticity of supply
 PEs measures how responsive sellers (producers) are for a change in price.
 Price elasticity of supply(PEs)= % change in quantity demanded% change in price
 PEs= % ∆Qs% ∆P
 Example:
 Assume the price (P) of a product increase from R4 toR5 and the quantity
supplied change from 200 to 260 units (Qs).

 Step 1: Price change= Change in priceOriginal price ×100

=14 ×100=25%

 Step 2: Quantity change= Change in quantityOriginal quantity ×100

=60200 ×100=30%

 Step 3: PEs= % ∆QA%∆P = 30%25%= 1.2

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Degrees of price elasticity of supply (types of price elasticity of supply)
The table below illustrate the different degrees and influence of each PEs.

Graph Value of PEs Classification Explanation

 %∆ in P < %∆ in Qs.
 Ex. an increase of 10% in P, will lead to an
increase of 30% in Qs.
Between 1
Elastic supply
and

 %∆ in P > %∆ in Qs.
 Ex. an increase of 10% in P, will lead to an
Between 0 increase of 5% in Qs.
Inelastic supply
and 1

 %∆ in Qs = %∆ in P.
 Ex. an increase of 10% in P, will lead to an
increase of 10% in Qs.
1 Unit price elasticity

 %∆ in P will lead to no %∆ in Qs.

 Vertical line – irrespective what happens to
price, supply remains the same.
Perfectly inelastic  As price increases, no change will occur in
0
supply quantity supplied.

 %∆ in P will lead to %∆ in Qs.

 Producers will offer any quantity at price P.

Perfect elasticity

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Description of income elasticity of demand
Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain
good to a change in the real income of consumers who buy this good.
The formula for calculating income elasticity of demand is the percent change in quantity
demanded divided by the percent change in income. With income elasticity of demand, you
can tell if a particular good represents a necessity or a luxury.

Description of cross elasticity of demand

The cross elasticity of demand is an economic concept that measures the responsiveness in
the quantity demanded of one good when the price for another good changes. Also called
cross-price elasticity of demand, this measurement is calculated by taking the percentage
change in the quantity demanded of one good and dividing it by the percentage change in
the price of the other good.

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TOPIC 7: SELF ASSESSMENT ACTIVITIES:

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