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IB ECONOMICS HL

# Elasticity

UPDATED ON - 01 JAN 1970

This Economics HL talks about elasticity. Elasticity is an economic measure of how sensitive an economic factor is to another, for example, changes in price to supply or demand, or changes in demand to changes in income. It also talks about four types of elasticities in the economy

## Elasticities

Elasticities are used to measure the effect of a change in some factor (income, price of a good, price of another good, etc.) have on supply and demand of a good. For your IB exam, you must know of four different elasticities which we will discuss here.

## Price Elasticity of Demand (PED)

The price elasticity of demand is used to measure the effect a change in price has on the demand for a certain good. It can be calculated as follows:

The outcome of PED is typically negative (because there is a negative relationship between price and quantity demanded) but in economics, we do not write the minus symbol of the PED.

What does the outcome mean? If price increases by a certain percentage, the quantity demanded will decrease by PED × that percentage. (If for example, PED = 2 and price increased by 10%, demand would decrease by 20%).

The outcome of the PED can be placed into one of five categories:

There are two exceptions to the rule above:

When PED is elastic, firms should lower their price to get more revenue because in that case demand will increase more than the price will decrease. The opposite will be the
case when PED is inelastic. When PED = 1, the firm should leave the price at the current level; revenue is maximized at this point.

Governments want to tax goods with an inelastic PED because demand changes less than the price increase due to the tax, so they can make more tax revenue on these goods.

The size of the price elasticity of demand is influenced by the following factors:

The number and closeness of substitutes: The more substitutes, the higher PED. If there are a lot of substitutes, consumers can easily switch to another product when the price of the product increases.

The degree of necessity: The higher the need for the product, the lower PED. Consumers will buy goods they need anyway, regardless of the price. Examples include food and gasoline.

The time period over which PED is measured: The longer this time period, the higher PED. In the long run, consumers have more time to look for alternatives/substitutes for a good. They will switch more often if the price of the good increases.

The proportion of income spent on the good: The smaller this proportion, the lower PED. When the proportion of income spent on a good is low, consumers will not notice or care about a price change and still buy the same proportion of the good.

The type of good: Primary commodities (i.e. materials in the raw unprocessed state) have a lower PED than manufactured commodities. Primary commodities are necessary for producers in order to produce. They will buy them anyway, regardless of the price that is asked for them.

## Price Elasticity of Supply (PES)

The price elasticity of supply is used to measure the effect a change in price has on the supply for a certain good. It can be calculated as follows:

The outcome of PES is typically positive (because there is a positive relationship between price and quantity demanded).

What does the outcome mean? If price increases by a certain percentage, the quantity supplied will increase by PES × that percentage. (If for example, PES = 2 and price increased by 10%, supply would increase by 20%).

PES is different at each point of the supply curve, but there are two exceptions to the rule above:

The size of the price elasticity of supply is influenced by the following factors:

Mobility of factors of production: The more mobile factors of production are, the easier it is for producers to buy and sell them. This means it is easier for producers to increase or decrease production, therefore the PES will be more elastic.

Unused capacity: When producers have a lot of unused capacity, it will be easier to increase production if necessary, therefore the PED will be more elastic.

Ability to store stocks: If a firm is able to store high levels of stock of their product, they will be able to react to price increases with swift supply increases and therefore the PES for the product will be relatively high.

The time period over which PES is measured: PES will be higher when it is measured in the long run since companies will have more time to adjust production to price levels. In the short run producers often can’t change supply by that much.

Type of goods: Primary commodities typically have a low PES while manufactured commodities often have a high PES. This is due to the higher necessity of primary goods (in manufacturing and general usage) compared to manufactured goods.

## Cross Price Elasticity of Demand (XED)

The cross-price elasticity of demand is used to measure the effect a change in the price of one product has on the demand for a certain other good. It can be calculated as follows:

The outcome of XED can be positive or negative:

What does the outcome mean? If the price of good Y increases by a certain percentage, the quantity demanded of good X will increase by XED × that percentage.

(If, for example, XED = −2 and the price of good Y increased by 10%, demand for good X would decrease by 20%).
The closer XED is to 1 (or −1), the closer the relationship between the two goods.

## Income Elasticity of Demand (YED)

The income elasticity of demand is used to measure the effect that a change in income of consumers has on the demand for a certain product. It can be calculated as follows:

The outcome of XED can be positive or negative:

What does the outcome mean? If the price of good Y increases by a certain percentage, the quantity demanded of good X will increase by XED × that percentage. (If, for example, XED = −2 and the price of good Y increased by 10%, demand for good X would decrease by 20%).

Goods can also be placed into two categories based on the size of the YED:

1. If YED > 1, YED is said to be income elastic and the good of which YED is calculated is a luxury good because an increase in income will lead to a spectacular increase in demand for these goods. Examples of luxury goods include jewelry and sports cars.
2. If YED < 1, YED is said to be income inelastic and the good of which YED is calculated is a necessity good because an increase in income won’t change the demand for these goods that much, consumers will need them anyway. Examples of necessity goods include food and medicine.