Module-B:Concepts of Elasticity, Basics of Microeconomics

1. Define the price elasticity of demand and the income elasticity of demand.

Price elasticity of demand: The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price. Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price.

Income elasticity of demand: Income elasticity is about how much a change in consumer income causes a change in quantity demanded. Normal goods (most goods fall into this category) are goods that consumers buy more of when their incomes rise, and less of when their incomes fall. Inferior goods are goods like one-ply toilet paper, top ramen, or generic brand products. When consumers’ incomes rise, consumers buy less of these goods, and when incomes fall, they buy more. One of the non-price determinants of demand is changes in income. Income elasticity tells us how much a change in income will shift the demand for a good or service. The formula for income elasticity is %ΔQ/%Δ Income.

 

2. List and explain the four determinants of the price elasticity of demand discussed in the chapter.

Availability of Close Substitutes Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount.

Necessities versus Luxuries Necessities tend to have inelastic demands, whereas luxuries have elastic demands. When the price of a doctor’s visit rises, people will not dramatically reduce the number of times they go to the doctor, although they might go somewhat less often.

Definition of the Market The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods. For example, food, a broad category, has a fairly inelastic demand because there are no good substitutes for food. Ice-cream, a narrower category, has a more elastic demand because it is easy to substitute other desserts for ice cream. Vanilla ice cream, a very narrow category, has a very elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla.

Time Horizon Goods tend to have more elastic demand over longer time horizons. When the price of gasoline rises, the quantity of gasoline demanded falls only slightly in the first few months. Over time, however, people buy more fuel efficient cars, switch to public transportation, and move closer to where they work. Within several years, the quantity of gasoline demanded falls more substantially.

Expenses The product with relatively higher prices tend to be elastic. For example, demand for a perennial may not be affected because of the high percentage change in price, which may not be true for an expensive item like care.

3. If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals zero, is demand perfectly elastic or perfectly inelastic?

If the elasticity is greater than 1, the demand is elastic. If the elasticity equals zero, demand is perfectly inelastic. When demand is elastic, there will be a relatively significant response to a price change. If elasticity equals zero, demand is perfectly inelastic. This would be a vertical demand line on a graph with price on the vertical axis and quantity on the horizontal axis. This is achievable only in theory, but there are products like insulin that come close to it. Insulin is needed by diabetics to live. They must buy it regardless of a price increase.

4. On a supply-and-demand diagram, show the equilibrium price, equilibrium quantity, and the total revenue received by producers.

The above diagram shows a supply and demand diagram, showing the equilibrium price as P, the equilibrium quantity as Q, and the total revenue received by producers.

Total revenue = (the equilibrium price × the equilibrium quantity) which is the area of the rectangle shown in the figure.

5. If demand is elastic, how will a price increase change total revenue? Explain.

If demand is elastic, then a price increase reduces the total revenue. When the price increases, then the demand falls by a considerable percentage. Then, total revenue starts moving in contradictory directions. Therefore, total income declines when the price of any commodity rises."

An increase in the price of a good leads to a decrease in the demand for the good. Also, the revenue of that product begins falling. Due to price increase, total revenue starts moving in the opposite direction, resulting in a change in the percentage of quantity demand.

In the above graph, when the price increases, it leads to a constant fall in demand resulting in a decrease in total revenue. The price increases from $5 to $6, market demand falls from 60 to 20, resulting in a reduction of Total revenue from $300 to $120. Therefore, when demand is elastic, a decrease in total revenue is due to increased prices.

6. What do we call good with an income elasticity less than zero?

When elasticity is less than zero, it means that the value is negative. Inferior goods are those goods whose income elasticity is less than zero. When income increases, then the demand for goods automatically got declines.

 Inferior goods are those goods whose income elasticity is less than 0. With the rise in income, the demand for commodities decreases. It is due to the demand and income that moves in contradictory directions. Inferior goods are those goods whose elasticities are negative or less than 0.

For example, suppose the individual earns a low income, so the person buys only potatoes to eat. When the income rises, the individual buys meat, and the demand for potatoes falls.

7. How is the price elasticity of supply calculated? Explain what it measures.

The law of supply states that higher prices raise the quantity supplied. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to change in the price.

The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce. In most markets, a key determinant of the price elasticity of supply is the time period being considered. Supply is usually more elastic in the long run than in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity supplied is not very responsive to the price. By contrast, over longer periods, firms can build new factories or close old ones. In addition, new firms can enter a market, and old firms can exit. Thus, in the long run, the quantity supplied can respond substantially to price changes.

Price elasticity of supply is calculated as the percentage change in the quantity supplied divided

by the percentage change in the price. Because the price elasticity of supply measures the responsiveness of quantity supplied to the price, it is reflected in the appearance of the supply curve.

 

8. If a fixed quantity of a good is available, and no more can be made, what is the price elasticity of supply?

When a fixed quantity of a good is available and no more can be manufactured, the price elasticity of supply is zero. In this, even if the price of the commodity changes, there is no effect on the quantity supplied.

Price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in the price of goods. In price elasticity of supply, it is kept in mind that there is no effect on the other factors.

Price elasticity of supply calculated as:

 

Therefore, the price elasticity of supply is zero. It means that even if the price goes higher, there is no effect on the quantity supplied as it remains fixed.

9. A storm destroys half the fava bean crop. Is this event more likely to hurt fava bean farmers if the demand for fava beans is very elastic or very inelastic?Explain.

If the demand for fava beans is elastic, destroying half of the crop is more likely to affect fava bean growers. Because half of the crop is destroyed, the supply curve shifts to the left, resulting in a higher price for fava beans. When demand is highly elastic, a price rise results in a drop in total revenue because the decrease in quantity sought outweighs the price increase.

If the demand for fava beans is elastic, destroying half of the crop is more likely to affect fava bean growers. Because half of the crop is destroyed, the supply curve shifts to the left, resulting in a higher price for fava beans. When demand is highly elastic, a price rise results in a drop in total revenue because the decrease in quantity sought outweighs the price increase.

If the demand for beans is inelastic, the price of beans will rise to compensate for the discrepancy in quantity supply and demand. As a result, if the demand for beans is inelastic, the bean grower will benefit.

10. ‘A life-saving medicine without any close substitutes will tend to have a small elasticity of demand.’- Do you agree? Explain your answer.

The elasticity of demand is determined by dividing the percentage change in quantity demanded by the percentage in its price. The quantity demanded of a life-saving medicine without any close substitutes is hardly changed due to an increase in its price. Hence, one can say that the demand for a life-saving medicine without any close substitutes is inelastic or the elasticity of demand for such medicine is small

11. A price change causes the quantity demanded of a good to decrease by 30 percent, while the total revenue of that good increases by 15 percent. Is the demand curve elastic or inelastic? Explain.

Now in this case, price was increased, which led to a 30% decrease in sales (Qd). And, in the end, revenue went up by 15%. So the price hike was more than enough to offset the decrease in sales. Thus, because the percent change to price was more than the percent change in Qd, we have inelastic demand.

As we can see, we started at a price of $1 and selling a quantity of 30, which gave us $30 in revenue. A 30% drop in quantity would bring sales down to 21. And a 15% increase in revenue would raise total revenue to $34.50. Dividing this new total revenue by the new quantity (sales), that gives us the new selling price of $1.64. And calculating the percentage change to price gives us just over 64%. So as you can easily see, the percent change to price was greater than the percentage change in quantity demanded. And that means we have inelastic demand.

12. ‘Utility concept is also relevant for the banking and financial products/services’-Explain the statement.

The utility concept is indeed relevant for the banking and financial product/services industry. The concept of utility refers to the satisfaction or value that individuals derive from consuming or using a particular product or service. In the context of banking and financial products/services, utility can be understood as the benefits or value that customers obtain from utilizing these offerings.

1. Financial Products and Services: Banks and financial institutions offer a wide range of products and services such as savings accounts, loans, credit cards, investment options, insurance, and more. Each of these offerings is designed to fulfill specific customer needs and provide utility. For example, a savings account provides utility by offering a safe place to store money, earn interest, and access funds when needed. Similarly, loans provide utility by enabling individuals and businesses to make important purchases or investments that they might not be able to afford upfront.

2. Convenience and Accessibility: Utility in the banking and financial sector is also closely associated with convenience and accessibility. Customers value services that are easy to use, provide quick access to their funds, and allow them to manage their finances efficiently. With advancements in technology, online banking, mobile apps, and digital payment solutions have become prevalent, offering customers greater convenience and utility. These tools enable users to perform transactions, check balances, make payments, and track their financial activities conveniently from their devices, saving time and effort.

3. Risk Mitigation and Financial Security: Another aspect of utility in the banking and financial industry is the provision of risk mitigation and financial security. Banks and financial institutions offer various products and services that help customers protect themselves against financial risks and uncertainties. For instance, insurance products provide utility by offering coverage against potential losses due to accidents, health issues, property damage, or other unforeseen events. Similarly, investment products aim to grow wealth over time, providing customers with a sense of financial security and utility in the form of potential returns.

4. Customization and Personalization: Banks and financial institutions strive to tailor their products and services to meet the diverse needs and preferences of their customers. The ability to customize offerings based on individual requirements enhances utility. For example, credit card providers may offer different reward programs or benefits based on customers' spending patterns and lifestyle. Investment advisors may provide personalized investment strategies based on clients' risk tolerance and financial goals. This customization adds value and increases the utility of these products and services.

In summary, the utility concept is highly relevant in the banking and financial product/services industry. Banks and financial institutions aim to provide customers with products and services that fulfill their needs, offer convenience, mitigate risks, and provide financial security. By understanding and delivering on customer utility, these institutions can create valuable and satisfying experiences for their customers.