What Do You Know About Elasticity of Demand Flashcards

Elasticity of demand concerns the responsiveness of demand to a change in a variable. An inferior good is one that is bought in smaller quantities as income rises, as it is replaced by a superior good. It involves income elasticity which has a negative value. An example might be motor cycles replaced by cars. Complementary goods are ones that are jointly demanded, such as coffee and cream. Cross price elasticity of demand is relevant and is negative as the rise in price of one good reduces the quantity demanded of a complement.Understanding of the two types of good 4 marksExplanation of the relevant elasticities 4 marks

A normal demand curve slopes downward from left to right and shows a negative relationship between price and quantity demanded. Consumer surplus is the difference between what a consumer is willing to pay for a good and what he actually pays for it. It arises because of the downward sloping nature of the demand curve and the fact that the price paid is that for the last worthwhile purchase. The consumer might be willing to pay $10 for one item of a product but the market price is $2, this gives consumer surplus of $8, for the second he might value it at $7 so consumer surplus is $5 and so on until the surplus disappears. Consumer surplus is zero when the market price matches the buyer’s valuation. The more elastic the demand curve, the lower the level of consumer surplus. Price changes will directly affect the level of consumer surplus.Understanding of consumer surplus and demand curve 4 marksExplanation of varying levels of consumer surplus 4 marks

An indirect tax is a tax on consumption. An effective maximum price sets the highest price at which a good can be sold and is below the market price. An indirect tax shifts the supply curve to the left and raises the price. This reduces the amount of consumer surplus with less consumed and surplus per item reduced. The consumer pays a higher price and consumes less of the product. This does not benefit the consumer although the way the tax is spent may be to their advantage and a tax on a demerit good may raise their welfare. An effective maximum price is set below the market price and results in a smaller quantity supplied, greater quantity demanded and excess demand. Unofficial black markets may develop. The reduced consumption will reduce the consumer surplus as less is consumed, while the lower price will increase consumer surplus for those who continue to consume. Some consumers will benefit while others will lose. Whether the overall effect is an increase or decrease will depend on the level of the maximum price and the elasticities of demand and supply. The maximum price has the potential to raise consumer surplus, an indirect tax does not.Understanding and diagram of an indirect tax and effective maximum price 4 marksDiscussion of tax impact 4 marksDiscussion of maximum price impact 4 marks

Consumer surplus is the excess the consumer is prepared to pay over the amount actually paid for a good and is shown by the area between the demand curve and price line. An indirect tax is levied on a good and will usually raise the price of a good and reduce the quantity demanded by shifting the supply curve to the left. The result will be a reduction in consumer surplus as a result of the reduced consumption and higher price. The effect will depend upon the price elasticities involved.For knowledge of consumer surplus up to 2 marksFor a labelled diagram showing impact of indirect tax up to 4 marksFor explaining a reduction in consumer surplus up to 2 marks

Normal goods have positive YED while inferior goods have negative YED. Examples might be eating out and public transport respectively but may vary between economies. A decrease in demand for normal goods would lower demand (curve shifts to left) causing a lower price and reduced quantity traded. For inferior goods demand would rise (curve shifts to right) price would rise and quantity traded increase.Definitions and examples up to 4 marksDiagrams with outcomes up to 4 marks

Maximum prices cannot be exceeded and are set below the market price, e.g. rents and fuel. They act as a ceiling price. Quantity demanded will exceed quantity supplied and a shortage will result. A system for allocation will be needed. This might be rationing or queues. A black market may develop and the intention of helping the poorest may be thwarted. Home rental market is a frequently used example. This may be illustrated by a diagram.Understanding of a maximum price up to 2 marksExplanation of outcomes up to 6 marks

A subsidy will reduce the cost of production and shift the supply curve to the right. This will reduce price and increase quantity traded. The degree to which price falls will depend upon the elasticities involved. The consumer will benefit from lower prices and producers will gain higher incomes. It is also a way to increase the production of goods with external benefits which will improve welfare. This can be shown in a diagram. Problems arise because the expenditure will have an opportunity cost, might involve increased taxation and may contradict the efficiency of the market outcome.Analysis of impact of subsidy with diagram up to 4 marksDiscussion of benefits up to 6 marksDiscussion of drawbacks up to 6 marks

A decrease in supply results from rising costs, unfavourable natural influences, higher taxes etc. and causes supply to shift to the left. This will result in a rise in the price of the product. Equilibrium, the tendency not to change when D=S, is restored as the higher price discourages the quantity demanded as consumers adjust their spending levels. Price will continue to rise until the balance is restored.Knowledge of equilibrium and of decrease in supply up to 2 marksDiagram showing original and new equilibrium up to 3 marksExplanation of the process of change up to 3 marks

Government may intervene to correct market failures or for non-economic reasons. It may use regulation, price control and taxes and subsidies. It may succeed with the provision of public and merit goods or the discouragement of external costs and demerit goods or subsidies to increase provision and so increase welfare. It may fail because of poor information, costs of administration and misjudgement of policy impacts. There may be interference with the efficiency of the market. Non-economic motivation may cause undesirable side effects.For understanding of government intervention and market up to 4 marksFor analysis of the success of intervention up to 4 marksFor discussion of the limitations of intervention up to 4 marks

Proportionate (%) change in quantity demanded/proportionate (%) change in income,exact (2), no proportionate element or price rather than income or inverted (1)

Cutting fares will raise revenue when demand is elastic but not when it is inelastic or unit elastic (1). Comment on motive e.g. revenue or profit or sales maximisation (1) It will raise revenue with short-distance leisure flights (1) but not with long distance leisure flights (unchanged) (1) nor the 2 types of business flights (1).

Nominal relates to the selling/market price (1), real relates to quantities or inflation adjusted value (1)

A subsidy will lower costs and shift the supply curve to the right and the outcome will be more traded at a lower market price. Producer revenue made up of price and subsidy willincrease. Government expenditure will increase by the amount of the subsidy times the new quantity traded.Diagram of impact on market 4 marksExplanation of effect on producer 2 marksExplanation of effect on government expenditure 2 marks

Rising food prices will help producers, farmers and rural areas, will stimulate food production and help those countries which export food. They will hurt low income earners, foodimporters and food processors and contribute to inflationary pressure. The poorest subsistence farmers who buy additional food will be hurt. The effects differ according to theproduction pattern and level of income of countries and individuals. One side 4 marks max.Meaningful conclusion (1)

Within the air travel market a sub-market may emerge with increased supply of services, lower prices and a restricted service. Former rivals may be able to maintain their positionwith different customers or may respond by cutting their own price. The size of the market should expand with more people able to afford flying. Rivals such as ferry services orrailways may face falling demand, depending upon the elasticity involved. Providers of complementary services e.g. airport parking, travel insurance may face increased demandwith upward pressure on their prices. Aircraft manufacturers or leasers may benefit as theirs is a derived demand arising from more flying.Understanding of the impact on market for air travel 4 marksDiscussion of rival transport market effects 4 marksDiscussion of complementary market effects 4 marks