Markets: How They Work - Kevin Bucknall

5 downloads 83 Views 1MB Size Report
This is how the price mechanism really works – that is, how it allocates resources to wherever the .... better at organising financial markets and insurance.

AN INTRODUCTION TO ECONOMICS

By Kevin Bucknall BSc(Econ), PhD

Copyright © Kevin Bucknall

Module 2881 The Market System, Unit 1: “Markets: How They Work” The course is the GCE Advanced Level in Economics, following the Edexcel syllabus but if you are following a different syllabus then you can simply select the parts of this book that you can use. Economics is economics! The GCE A level is normally taken in the UK in the Sixth Form (grades 11 and 12) and it is most commonly used for selecting students for university entrance. This is a series of teaching notes I used until I stopped teaching recently. If you spot any errors, please email me and let me know. I maintain a few email addresses for different purposes; currently they are:[email protected] and [email protected] If you receive no reply it may mean that somewhere along the line a spam trap has nabbed your message. You can try sending it again, but try taking out any words that you thing a spam trap might not like. An alternative explanation is that Hotmail thought it was spam and deleted it after a few days when I was on holiday or something and was not checking my junk mail box regularly. Converting my files to PDF format resulted in the occasional strange error appearing. I corrected all that I noticed but if I missed any and you spot them, please email me! Now down to business. If you want good marks, these notes should be read and reread until you really know them. Practise drawing the diagrams until you can do them from memory without making mistakes. It is a good idea to revise something and practise drawing diagrams for a short period every day.

1-1. INTRODUCTION POSITIVE AND NORMATIVE THINKING Positive economics deals with what is; normative thinking deals with what ought to be and is value-laden. All sciences and fields of learning try to be positive and deal with facts and models based on facts. You should try to be positive i.e. scientific in your statements, especially when writing essays and in the exam room. Words like "ought", or "should" or “as a nation we must” are all normative statements and you should do your best to avoid them. Try not to say things like “It would be better if…”,or “the government should….” “it would be a good thing for X to do Y”. Many policy prescriptions you might wish to make are normative, e.g., “The economy would be better off if we….” and it can raise an examiner’s hackles. You might get away with a general statement such as “Some advocate…”, “It has been suggested that…” or “Many believe that….” as these are positive statements and sound less normative. Note that the words used in an otherwise scientific study can themselves carry a normative feeling, e.g. "freedom", "democracy", "efficiency", or "welfare" may all seem to be “good words to many people; whereas words such as “inequitable”, “exploitation”, "unsound", "interference", "fascist", or "police state" seem "bad" to many people.

OPPORTUNITY COST

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a result we must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk in the park or go to a movie, or whether to produce this or that. Every time we make a choice to do something we automatically exclude something else that we did not do we have given it up. We call this the “opportunity cost”.

Definition “Opportunity cost is the best forgone alternative” i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be a lunch forgone. 1-1

· ·

The opportunity cost of buying a new shirt might be not going to the cinema. The opportunity cost of taking a part-time job might be not being able to hang out in the mall with your friends.

For a producer The opportunity cost of buying plastic packaging material might be the cardboard he did not buy. NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add them up and say they are all the opportunity cost, because it must be a choice between them. Opportunity cost can be thought of as: 1. The cost in pounds (represents a real thing given up); or 2. The cost in time. Opportunity cost is important 1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a pizza instead. 2. It always arises with budget allocations. At some point in your life you may have to draw up a budget and allocate money for different purposes. You will be forced to weigh up what is really needed in your tennis club, computer society, your country or whatever. 3. It lies behind the cost curves that we draw. How does this work? Consider two producers, A and B. Producer A might have to pay £20 a ton to get the iron ore to make into motor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources, rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw. Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only the price of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. that went into making it. This prevented these resources from going into making something else. After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from a wholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. to make another of whatever you bought! In this way, resources keep on going into making whatever people demand. 4. This is how the price mechanism really works – that is, how it allocates resources to wherever the demand is the greatest.

1-2

THE PRODUCTION FRONTIER OR PRODUCTION POSSIBILITY CURVE What is it? It shows us the maximum that a country can produce. There is clearly a limit to this at any one time just like there is a limit to the weight that you can lift over your head or eat at any time. We assume two goods (I will use apples and bananas as these easily can be represented by A and B) for ease of explanation – but it is true of any number of goods. Drawing the diagram – we start with the maximum amount of good A we can produce if all our resources are devoted to producing A which gives us a point on the vertical axis; then we do the same for the case if we only produce B to give us a point on the horizontal axis. Then we join the two positions with a straight line. Once we have drawn the line, we do not have to have all apples or all bananas but we can chose somewhere along it. Any point on it represents a mix of the two goods that people wish to buy. At the point selected above, people consume 0A1 apples and 0B1 Bananas.

Apples

A1 PPC1

0

Bananas B1

[DIGRESSION: DRAWING THE CURVES You should practise drawing all the diagrams regularly – several times each day is a good idea. In the end, they need to be second nature to you so that you can recall and correctly draw the appropriate diagram whenever you want. It is most important to be able to this so that you can quickly gain good marks. The wrong diagram, a mislabelled one, or one lacking labels, more or less dooms you to fail. It shows that you do not really understand what you are saying and examiners hate that. Labels, by the way, are the words on the diagram, like “apples”, “bananas” or “ppc 1” in this diagram. When tutoring, I would draw each diagram again in front of the student, and explain the importance of getting it right (and remind them of this now and then later). It is important to see how a diagram is built up as they are really easy to do, but to be suddenly presented with a complicated finished product can be a bit daunting. For this reason, I have put in a sensible order of drawing the diagram for the first few times I present them. It is just about impossible to get a good mark in economics without drawing diagrams, so start practicing without delay! Warning! It may seem easy, but it helps you much less if you download diagrams from the Internet and paste them into essays. It is more valuable for you to draw them, and learn them, for yourself. END OF DIGRESSION] 1-3

The way the diagram of the production possibility curve is drawn.

Apples

Apples

Apples

A1 PPC1

0

0

Bananas

PPC1

Bananas

0

B1

Bananas

We usually draw the production function curved , to reflect the law of diminishing returns. Some factors of production are better at producing A and not as good at B, as you might imagine. Some land is simply better at growing bananas than apples, just as some of your friends are better at doing maths, swimming or playing the guitar than others. So as we move down the production possibility curve and get more bananas, we can expect to get a few less bananas than we might expect; perhaps we used to give up 5 apples to get 5 more bananas, but as we slide down the curve we will get, say, only 4 more bananas, then only 3 more, or 2 more, as we keep sliding down. The line curves in at each end to show this as in the diagram below.

Apples A A2

A1

0

PPC

Equilibrium point where ppc is just tangent to the price line AB

B1 B2

B Bananas

[Digression. It is unlikely in my view that you will be asked why the production frontier is curved as opposed to a straight line, but if you do, the reasoning above and the diagram explains it. In the diagram you can easily see that if we had a straight line production possibility curve (like AB) we could produce the maximum amount of apples at the end of it, that is, at A, and have no bananas at all. But as diminishing returns do exist, we are actually on the curved A2B2. The maximum apples possible are at A2 (not A which we could reach if we were on the straight line ppc ). As diminishing returns put us on the curve not the straight, the difference between A2 and A is the quantity of apples lost because of diminishing returns, End of digression] It is common to use straight line production frontiers in text books because they are easier to draw and manipulate, so they often look like the diagram below. 1-4

Apples

A1 PPC1

Bananas

0

B1

What happens if we swivel the curve? If society learns to get better at producing Apples alone, it would swivel the curve out along the vertical axis of apples. This reflects the fact that we can get more output from the resources and factors of production that we have. The swivel that gives us more apples reflects a productivity increase in apples, but not in bananas.

Apples A2

A1

0

B

Bananas

After the productivity increase in the apple growing industry, withe same quantity and quality of factors of production, society can increase the output of apples from 0A1 to 0A2, that is, by the distance A1 to A2.

If we swivel it the other way, and push out B , we would get a productivity increase in bananas, but not in apples. What if we move the whole curve out? If a country has learned to get better at producing everything, this would physically move the production frontier upwards and outward, which is economic growth.

1-5

Apples A

A2 A1

ppc1 = now

0

ppc2 = 4 years time

B Bananas

B1B2

We return to the subject of economic growth in the unit “Managing the economy”.

SPECIALISATION AND FOREIGN TRADE If people specialise they are more productive – if you are like me, you probably could not make a good pair of shoes, do brain surgery or advise on investing for pensions! We tend to do what we are best at. Imagine the result if we did what we are worst at! Countries are the same – if they concentrate on what they are best at, they produce more and better goods or services. As a rule of thumb, countries that follow a protectionist policy (protecting their industries from foreign competition) are trying to do what they are worst at, or at least not trying to do what they could be best at. Most economists would probably think that protectionism is not exactly a good idea. Two concepts of “advantage” Absolute advantage – this means a country can produce more of almost everything than another, i.e., it is a wealthy country. The USA can produce more than Egypt for instance – clearly, the USA has an absolute advantage over Egypt. It is of no particular interest as an idea: the rich are just rich! Comparative advantage – this means that a country is better at producing something, but not necessarily everything, than another. For instance, Sweden is better at making marine engines than the UK, but we are better at organising financial markets and insurance. All countries are better at doing a few things more than others. Comparative advantage is the one that matters in economics and it is the main reason why countries trade with each other. We do not simply buy pineapples from tropical countries because it is too cold to grow them here. We could in fact grow them under glass and with heating, but we clearly lack a comparative advantage in the pineapple producing business. Hawaii on the other hand has a strong comparative advantage in that area.

The gains from trade If a country tries to produce everything for itself, it will stay poor. Examples: China under Mao Zedong and Russia under Stalin both followed such a policy and the people suffered a very low standard of living as a result. The message is that trade helps the people in a country to gain wealth! 1-6

The gains from trade consist of: ·

Comparative advantage – we do what we are best at and thus produce more. We then exchange our surplus with other countries for something we are less good at. Both the other countries and our country do better and enjoy higher living standards as a result.

·

Economies of scale – if we specialise we can follow a system of mass production, and lower our costs. We can then exchange the surplus with other countries. Economies of scale are examined in Unit 2.

·

We can gain wider consumer choice e.g., we can drive Volvos, Renaults or BMW’s, as well as locally-made Fords!

1-7

1-2. DEMAND AND SUPPLY: INTRODUCTION (Abbreviations: S = “supply”; D = “demand”; Y = “income”; r = “rate of interest”) At the equilibrium price, the quantity demanded just equals the quantity supplied. There are unsatisfied consumers who could not buy at that price even though they were willing. What do we mean by equilibrium? Equilibrium is the state of affairs in which there is no tendency to change. How do we show this equilibrium price? We use demand and supply curves.

Demand What is the demand curve? It is a curve showing the quantity that will be bought on the market at different prices. The lower the price, the more will be demanded; the higher the price the less will be demanded. Think! If all Nike trainers were £2 a pair, would you buy more than if they were £200 a pair? It seems probable!

Price

So the demand curve is drawn sloping downward, left to right. Examine the one here at a high price, high up on the price axis, little is demanded as we trace a line down to the quantity axis. But at a lower price, a greater quantity is demanded.

D

Quantity

0

In economics, “demand” means demand is backed by money – it is not just a need or a desire, but people do have the money to buy and are prepared to buy.

Supply What is the supply curve? The supply curve is a curve showing the quantity that will be offered on the market at different prices. We believe that higher prices cause more people to sell. Imagine: in your classroom, if I offer to buy each T shirt for £500, almost everyone will sell to me; but if I offer £1 each, probably few if any would be willing If however I were to offer £7, more would sell but probably not everyone. That is why the supply curve slopes upward.

1-8

Price S

Quantity

0 Let’s put both the demand and supply curves on the same diagram .

Price D

S

P

Quantity 0

Q

Guess where the equilibrium price will be? Right! Where the two curves cross! As said earlier, at the equilibrium price, the quantity demanded just equals the quantity supplied. There are no unsatisfied consumers who could not buy at that price even though they were willing and everyone who wanted to sell at that price could do so. This happy situation happens at the intersection of D and S with price P and quantity Q. When I started in economics, I had to chant along with the rest of the class: "price is determined by supply and demand!” It certainly made it stick in my mind and might help you too!

1-9

Let us return and look at demand in more detail (We’ll look at supply later too)

What determines the D curve? i.e., why is it where it is and not somewhere else?

Price

D here?

Or why not here?

D

D

Quantity

0

1. There are four main personal determinants of demand · · · ·

Income Taste Prices of other goods or service Expectations about future prices of this good or service

2. AND several other market determinants ·

Income distribution - if you think of all the other people in your house and you as you are now, then if you suddenly got all the total income and savings and the others had none, there would be a different pattern of demand from what it is now. They probably do not eat lunch every day if they have no money. It is the same in society in general: change the income distribution and a new pattern of demand curves follows.

·

Wealth distribution (as opposed to income distribution). If 10% of the population have 90% of the wealth, probably more Porsche motor cars will be demanded than if we all have the same rather lowish amount!

·

Population size - the larger the population, the bigger the demand, ceteris paribus. That is a Latin tag meaning “all other things remaining the same” and you might come across it in a lot of economics books.

·

Population age distribution - if there are many old people, important demands in society will be for medicines, hip replacement operations and Zimmer frames but fewer Beastie Boys CDs, or prams.

·

The interest rate. This is especially important for house purchases, motor cars, long-life consumer goods often on a credit card, or hire purchase generally. A higher rate of interest means more to repay, so people tend to borrow less. 1-10

What can cause a shift in the demand curve? (= a new curve) A change in any of the above determinants of demand will do it! If demand increases, overall, more of the good/service is bought at any unchanged (the same) price. You can see this in the diagram below, where at P1 an amount OQ1 is demanded, but after demand increases to D2, at the same price an large amount is demanded, i.e., OQ2. It is easy to remember what “an increase in demand” means; there must be a new curve and it will move upwards and to the right. Price D1

D2

P

Quantity

0

Q1

Q2

The effects of an increase in demand are usually analysed using the equilibrium positions determined by the intersection of demand and supply.

Price D1

D2

S

P2 P1

0

Quantity Q1 Q2

You can see that the increase in demand means we move from the equilibrium position P1Q1 to the new equilibrium position P2Q2. More is demanded - we shift from the position Q1 to the position Q2, so the difference (OQ2 minus OQ1) is Q1Q2.

1-11

The way the diagram of a shift in demand is drawn,(shown not moving to the new equilibrium, so you can see that more is demanded at the same price) Price

Price

Price

Price

S1

S1

P1

D1

P1

D1

Quantity

S1

D1 Q1

Quantity

Quantity

D1 D2 Q1 Q2 Quantity

The way the diagrams are built up should be reasonably clear by now. If you have any worries, check back and examine those supplied earlier. The general principles are: 1. Draw the axes and label them immediately (“one axis, two axes”). 2. Put in the first curve and label it. 3. Add the second curve and label it. 4. Draw the equilibrium position – preferably using dotted lines. 5. Make the necessary changes, such as shift a curve inwards or outwards by drawing a new curve and labelling it. 6. Draw the new equilibrium position – preferably using dotted lines. 7. And finally you compare the new equilibrium position with the first one, using your own words but trying to get in the necessary jargon phrases such as “increase in demand”, or “economic growth”, whatever is relevant to the question you are tackling. Henceforth I shall not be supplying the series of pictures showing how the diagrams are built up, as you should be able to follow the above principles for yourself. Before long, it will become second nature to examine a finished diagram and work out how it was built up.

If demand decreases, the demand curve shifts the other way, downward and to the left. Again we have a new curve, as in the diagram below. Price D2

D1

P

0

Quantity Q2

Q1

You will notice that less is bought at any given price, such as P. 1-12

Again, a decrease in demand is usually analysed by determining the new equilibrium position and the comparing it with the original one. For this we need to put the supply curve in.

Price D2

D1

S

P1 P2

Quantity

0

Q2 Q1

As you can see, if demand decreases, then less is bought (as you might imagine!) and the quantity demanded falls from Q2 to Q1; price also falls, in this case from P1 to P2

Let us look at supply in more detail

What determines the supply curve, i.e. why is it where it is and not somewhere else?

Price S??

S??

Quantity

0

The answer is, the price, quantity, and quality of inputs used. These consist of things like machinery, equipment, staff and workers, raw materials, and fuel. These are collectively known as “the factors of production”, and are often summarised as land, (L) labour (N) and capital (K) plus a remainder term, R. 1-13

·

Land - is what it says but can include things like diamonds or oil that are found there.

·

Labour mostly means workers, but also includes managers.

·

Capital means machinery and equipment. A subset of this is“social overhead capital” - like roads, bridges and docks.

[Digression: The whole production of the nation can be summed up as: O = f(L, N, K) + R or put into words, “output is a function of (= is in some as yet undefined way caused by) land, labour, capital, and a few other things”. You will need this later; I am just sowing a few seeds.] ·

The remainder term “R”, which covers things in both labour and capital is the really interesting one

The labour component of “R”. This consists of things like entrepreneurial ability, the managerial methods in use, labour motivation and how good it is, labour skills, the strength of the trade union and its attitudes, the bonus and other incentive systems in force, the quality of the education system, and the retraining facilities available in society. The capital component of “R”. This consists of things like: The level of technology, knowledge about what technology is available, the adequacy of factory organisation, and economies of scale. They can obviously affect the supply curve, or the output possible, if they are good or bad. ·

Maybe the weather, e.g. floods can destroy crops, effect transport, reduce supply, and raise price.

·

Joint supply - if we increase the number of sheep to supply an increased demand for mutton, it automatically increases the wool supply. So the price of related good can be a determinant of supply. Examiners like questions on joint supply, but it is not often encountered in the world in which we live.

·

The productivity of the factors of production – this is closely related to technology; but it can also be how hard workers are prepared to work, motivation, and incentives systems etc. (it too can appear separately, or be included in the remainder term, R, as above).

·

The size and number of firms in the industry, including the marketing conditions.

·

War and social unrest.

What can cause an increase or decrease in supply?(a shift in the curve) Like demand, it needs a change in one or more of the determinants. For supply these include things like: · A change in the price of a factor of production. · A change in the productivity of a factor. · New technology invented. · The discovery of a new raw material or fuel. · More worker enthusiasm. This occurs often in war time, because of patriotism. An increase in supply = the curve shifts downward and to the right (more is supplied at the unchanged price) - e.g., if labour productivity increases or someone finds a new cheap source of materials.

1-14

Price S1

S2

P1

0

Q1

Quantity

Q2

You will notice that the quantity supplied at the unchanged price P1 increases - well, that’s what an increase in supply does! And if we put in a demand curve we can see both the equilibrium positions and work out that an increase in supply means a fall in price and an increase in the quantity purchased. Price S1

S2

P1 P2

D

0

Quantity Q1 Q2

1-15

A decrease in supply is the opposite; the supply curve shifts up and to the left: Price S1

S2

P1

0

Q2

Quantity

Q1

Again, less is supplied at any chosen price; we move from a supply of OQ1 to the smaller quantity OQ2.

The new and old equilibrium positions need both a supply curve and a demand curve.

Price S2

S1

P2 P1

D

0

Quantity Q2 Q1

More analysis! A decrease in supply means a fall in the quantity supplied and an increase in price. Work out for yourself the old and new quantities and prices - good practice!

1-16

Time Periods And Supply Three time periods matter: · · ·

the very short run (VSR) (or “momentary supply”), the short run (SR) , and the long run (LR).

They have different slopes to their curves and different elasticities (more later!). The very short run. This is defined as the time when no change can be made in any of the factors of production – the supply curve is vertical. Examples are the fruit and vegetables that appear in the wholesale market each day. The short run. This is defined as the period in which the variable factors can be altered but not the fixed factors, i.e. we can make some changes. ·

Fixed factors = those that do not vary with output such as factory building, transport fleet, office staff, and the bill for heating and lighting the premises.

·

Variable factors = those that vary directly with output such as raw materials, the energy used, the petrol in the trucks, and the wages of some unskilled workers who might be taken on when needed, perhaps part-time.

The supply curve we usually draw is the short run one. The long run Is defined as the period when all factors can be varied i.e., the producer can do any changes s/he wants. This means a flatter curve, possibly even downward sloping sometimes.

How the supply curve can vary with the time period we are considering: The flatter the curve, the more elastic it is (“quantity stretches more”). Producers will only make changes that help them produce more or reduce costs.

Price S very short run totally inelastic

S short run fairly inelastic S short run close to unit inelastic

S long run high elasticity Falling long run S curve (modern hi tech goods for example get cheaper over time)

Quantity

0 1-17

NOTE that all the curves are drawn on the one diagram; this means the scale is the same for all; if you draw each in a separate diagram, the flatter one (S long run) is not necessarily the most elastic, as the horizontal axis might be on a much wider scale. If this seems incomprehensible to you, Do Not Worry! Just remember to put them all on the same diagram. Remember that you should practise drawing the diagrams regularly!

Increases and Extensions of Supply And Demand We know that the word "increase" means a shift of the curve – but what about extensions? "Extensions" are movements along an existing curve. Questions are often set to see if you know the difference between an ”increase” and an “extension”.

[A digression: if a line crosses two others, an increase in one curve always means an extension of the other! The diagram here shows that.

We see two upward sloping lines that cross a single line. The upward sloping lines reflect an increase (or decrease) and we slide down (or up) the single line.

For supply and demand: With an increase in demand we slide up an unchanged supply curve.

Price S1 The shift of D1 to D2 is an increase in demand

P2 P1

The sliding up the unchanged S curve is an extension of supply

D1 Q1 Q2

D2

Quantity 1-18

It’s clear that an increase in demand goes with an extension of supply.

NOTE that we start on demand curve D1 and supply curve S1 to ascertain the equilibrium price and quantity; then we look at D2 to get the second equilibrium position. Reminder: In economics, at this level we always start in equilibrium, then we alter something, and move to the new equilibrium position. We then compare the two equilibrium positions for the analysis. And we can see an increase in supply goes with an extension of demand, as we slide down an unchanged demand curve:

With an increase in supply we slide down an unchanged demand curve Price S1

P1 P2

S2

The shift of S1 to S2 is an increase in supply

Sliding down the unchanged D curve is an extension of demand

D

0

Quantity S1 S2

Decreases and contractions of supply and demand A decrease means a new curve, which shifts backwards; a contraction means sliding back along an unchanged curve. A contraction of demand following a decrease in supply : Price S2

P2 P1

S1

The shift of S1 to S2 is a decrease in supply

Sliding up the unchanged D curve is a contraction of demand

D

0

Quantity S2 S1

1-19

A contraction of supply following a decrease in demand Price S The shift of D1 to D2 is | a decrease in demand P1 P2

Sliding down the unchanged S cuve is a contraction of supply

D1 D2

0

Quantity S1 S2

Here is one of the hoary old trick questions. "Demand increases, so price rises. The rise in price means fewer can afford the good, so demand decreases and prices fall again." Do you agree with this statement?

Question: what do you think? At first glance it might seem to make sense. But it is in fact false! Why is it false? You draw the diagram now on a piece of paper. First increase the demand curve and you will see the price rise as we extend up the supply curve. Then think about the new equilibrium. Why on earth should it change? It is an equilibrium position! That was why you learned the definition of equilibrium a little while ago - to be able to detect fallacies in argument. This is a proposition in logic, designed to test if you really understand supply and demand. You should try to get the words “extension” and “increase” in to show you can use them properly and you definitely need a diagram.

1-4. THE CONCEPT OF ELASTICITY: MEASURING THE RESPONSIVENESS OF DEMAND AND SUPPLY (very popular with examiners)

ELASTICITIES Elasticities are a sort of measure of supply and demand. If demand increases, and we ask how much does supply extend, we need more than an answer like "quite a lot"!! Government may be trying to raise tax to get a certain amount of revenue for instance. The question is “How much will quantity change, a lot or a little?” 1-20

WE START WITH THE ELASTICITY OF DEMAND

Three broad types of elasticity of demand 1. Price elasticity = the usual one, it deals with 1 good. 2. Cross elasticity = a special one, it deals with 2 goods. 3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand Definition: "Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a small change in price". Learn this by heart! [In simpler terms, “is the proportional change in quantity greater or lesser than the change in price?” As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); and if quantity then increases from 100 to 200, the increase is 100%. We can see that the increase in Q is greater (100% compared with 10%) - i.e., it stretches out a lot - it is elastic!]

How do we actually measure price elasticity? Price elasticity of demand is measured by the percentage change in Qd, divided by the percentage change in price: %∆Qd %∆P

So the price elasticity of demand is: ∆Q Q -----------∆P P = ∆Q x ∆P Q P

= ∆Q x Q ∆P P

(to divide by fraction invert and multiply)

(gathering the change terms all on side for neatness. If this shuffling makes you unhappy, just remember that 3 x 4 is the same as 4 x 3)

1-21

In the example above, the percentage change in Q was 100 and the percentage change in price was 10 so the elasticity is 100 divided by 10 = 10.0 In the world in which we live this is actually very high! (Anything over 2 in the real world is pretty high.) Logically the answer can have only 1 of 3 results: 1 (< stands for “less than”; > stands for “more than”; if we are looking at “

Suggest Documents