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PRINCIPLES OF MICROECONOMICS
TABLE OF CONTENTS
TITTLE PAGES
1.0 INTRODUCTION (ELASTICITY) 2
2.0 PRICE ELASTICITY OF DEMAND 3-12
3.0 CROSS ELASTICITY OF DEMAND 13-14
4.0 INCOME ELASTICITY OF DEMAND 15-17
5.0 ELASTICITY OF SUPPLY 17-19
6.0 TAX BURDEN 20-22
7.0 BENEFITS OF SUBSIDIES 23
8.0 CONCLUSION 26
WHAT IS ELASTICITY?
Elasticity known as a measurement for sensitivity of a particular variable due to a
changes in one of the determinants (price, income). Elasticity also known as a concept
which includes probing how responsive demand (or supply) is to a change in another
variable such as price or income.In business and economics, elasticity states the degree to
which involves individuals, consumers or producers can change their demand or the
amount supplied in reaction to price or income changes. It is primarily used to evaluate
the change in consumer demand as a result of a change in a good or service's price.
PERCENTAGE CHANGEQUANTITY
ELASTICITY=
PERCENTAGE CHANGE DETERMINANT
Usually we calculate elasticity with percentage of change due to number of reasons such
as elasticity allows assessments to be made towards the change for two subjects
restrained in different units .For example, we can relate the change of quantity with the
change of price in the rate of currency. We also can elude the problem of defining the
size of units used. For example, an increase from RM 2 to RM 3 is considered as
increase of 1 price unit but change from 200 unit cents to 300 cents shows an increase of
100 price units. Turning it into the form of percentage, without considering the price units
being used the same value will be attained. Then, complete change is not able to define
whether a change is relevant or irrelevant. It can only be recognized if the initial
value is given. For example, the change of RM 1 for a good with an initial price of RM10
is considered relevant. But if the initial price of good is RM500 a change of RM1 is
considered as an irrelevant change. In other words, we look at the percentage of change
defining the size of price change. The concept of elasticity can be used by policy makers,
producers, and even consumers. For example, firms can use the elasticity concept to
define the substitution of resource utilisation when one of the input price increases. If
capital price decreases, firms can replace labour into capital but the rate of replacement is
defined by rate of elasticity.
TYPES OF ELASTICITY
There are four types of elasticity generally used specifically price elasticity of demand,
price elasticity of supply, income elasticity of demand and cross elasticity of demand.
A 20 percent rise in price causes 40 percent reduction in quantity demanded, the price of
elasticity of demand is -40% / 20% = -2
The point elasticity is used to measures the value of elasticity on one point on a curve,
while arc elasticity is the average elasticity between two points on a curve.
ARC ELASTICITY
To measure the arc elasticity, we need to identify two points on the demand curve. In the
formula above, dQ/dP is the part derivative of quantity with respect to price, and P and Q
are price and quantity, respectively, at a specified point on the demand curve.
POINT ELASTICTY
To abridge the theory, we assume mid-point of the demand curve as a point (C) where
elasticity is unity (Ed=1). Elasticity of demand declines (Ed<1) when we move to the
exact direction from point C and upsurges (Ed>1) the other way around.
The value of elasticity can be measured using two methods, such as point elasticity and
arc elasticity or midpoint elasticity.
Q1 Qo X 100
Qo = Q X Po
= P Qo
P1 Po X 100
Po
Qo is the initial quantity and Q1 is the new quantity ,while PO is the initial price and P1 is
the new price. The symbol is used to signify change for example:
Q=Q1 Q0
Q1 Qo X 100
Qo /2 = Q X (P1 + Po)
= P (Q1 + Qo)
P1 Po X 100
Po /2
THE DEGREES OF ELASTICITY
Some goods have very elastic demand, while others have less elastic demand. A minor
drop in the price of a goods may lead to a significant increase in the quantity demanded,
but occasionally even a substantial fall in price may not lead to any increase in demand.
Different goods have different price elasticitys. Some supplies have more elastic
demand while others have relative elastic demand. Essentially, the price elasticity of
demand varies from zero to infinity. It also can be equal to zero, less than one, greater
than one and equal to unity. According to DR. Alfred Marshall in the Principles of
Economics: Unabridged Eighth Edition book. The elasticity of demand in a market is
great or small conferring to the total demanded increases much or little for a
specified fall in price and reduces much or little for a specified growth in price. The
degree of elasticity of demand to small change in price varies according to goods.
PRICE ELASTICITY OF DEMAND, TOTAL REVENUE AND TOTAL
EXPENDITURE.
Total revenue in economics states to the total earnings from sales of a given quantity of
goods. It is calculated by multiplying the quantity of goods sold by the price of the goods.
FOR EXAMPLE:
5 X 10 =50
DEGREES OF ELASTICITY OF DEMAND
The ruling price OP, the demand is infinite. An insignificant increase in price will pact
the demand to zero. A slight decrease in price will attract more consumers but the
elasticity of demand will remain infinite (ed=). The cases of perfectly elastic demand
are exceptionally rare and not practical in the real world.
In figure 4, the demand curve which specifies that price is OP and the quantity demanded
is OQ1. Now the price falls from OP to OP1, the quantity demanded rises from OQ 1 to
OQ2. The quantity demanded changes more than change in price.
Relationship
No Value/ Degree of Exy Examples between Good
Coefficient X and Good Y
Ey = % change in Qdx
% change in Y
= Q X Y
Y Q
QS Q
1. SIZE OF INDUSTRY
Small industry are flexible in regulating production inputs, supply is relatively
elastic.
Large industry have large immovable inputs and difficult to adjusting production
size, supply is relatively inelastic.
2. Mobility of resources / production factors
Resources that are portable are easily substitutable with other uses or have more
than one use, supply is elastic.
For example, if production uses labor and labor can be replaced by machines,
supply becomes elastic.
For example, machinery of production of one good can be used to produce
another good, then supply is elastic.
3. Time period and production speed
Length of time producers take to adjust production or output.
Very short run firms not able to alter production, supply is fixed (perfectly
inelastic).
Short run-producers able to alter supply by adjusting some input. For example,
variable input such as labour, supply is inelastic.
Long run producers have sufficient time to vary production by changing all
input. For example, increase in plant and factory size, supply is elastic.
Tax incidence refers to a person who ultimately bears the burden to pay the tax such as
the producer or consumer and the causing societal effect that. The tax incidence or tax
burden depends on the price elasticity of demand and price elasticity of supply.
Taxes are an important source of income for the government. Taxes can cause decrease in
both supply and demand in the market because buyers have to pay a higher price and
sellers obtain a lesser price for their product. The government attempts to divide the
burden of the tax such as payroll tax which is requiring both employer and employee to
pay of the tax, which, for 2013 onward, is 15.3% of wages paid.
How the elasticity of demand and supply does affects tax burden? For example, the
government decides that the buyer should pay the 10% tax for a packet of sugar. Does
this mean that the buyers will be paying 10% more, or the sellers have to share the tax
burden? The higher prices will cause the decrease in demand notwithstanding the reason
for the higher prices, sellers will have to share the burden of tax.
If either demand or supply was perfectly elastic or inelastic, the tax burden will fall
entirely on either the buyer or the seller. The tax incidence difference can be seen in two
different case, where the tax burden be bear by the buyer if demand is inelastic or
supply is elastic, and tax burden will fall on the seller if demand is elastic or supply is
inelastic.
A classic demand or supply curve illustrates the relationship between the price and the
quantity (demanded or supplied). If a demand or supply changes because of changes in
other demand or supply elements, it will cause a shift in the demand or supply curve,
where the quantity will be different for every price point.
Buyer's Tax Burden = Price Buyer Pays - Market Price without the Tax = Pb Pm
Seller's Tax Burden = Market Price without the Tax - Price Seller Receives = Pm Ps
In the 4 diagrams below, a tax on a specific goods increases its price and deduct the
quantity supplied, since suppliers are getting fewer revenue for their goods. The
calculated tax shifts the supply curve upward, from S to St, when the price increases from
P to Pt, and the quantity will decreases from Q to Qt. The buyer bears the tax burden
when either demand is inelastic or supply is elastic, as shown in diagrams # 1 and # 4,
respectively. When demand is elastic or supply is inelastic, then the seller bears the tax,
as shown in diagrams # 2 and # 3, respectively.
SUBSIDIES
A subsidy is a sum of money given to firms by the government to boost the production
and consumption. Subsidies can be presumed as a negative tax because it is a payment
made by government to retailers, consumers, producers and to anyone to endorse
production.
The effect of a specific per unit subsidy is to shift the supply curve vertically
downwards by the sum of the subsidy. The new supply curve will be parallel to the
original. The effect to reduce price and increase the output depends on elasticity of
demand.
THE INCIDENCE OF A SUBSIDY
The economic incidence of a subsidy specifies who is made better off by the subsidy.
While, the legal incidence shows who is helped by the subsidy through law. In the
diagram below, the subsidy per unit is A B, and the new quantity disbursed is Q1.
The price paid by consumer
does not fall by the full sum
of the subsidy but it decrease
from P to P1. Even though
the purpose of the subsidy is
to reduce the price of
consumer by the full sum of
the subsidy. The producer
still gets some of the benefit
in terms of extra revenue. The gain of the consumer is P - P1 per unit, and the total gain
of the consumer is the area PFBP1.
The gain of the producer is C P per unit and the total gain of the producer is CAFP.
The total cost of the subsidy by the government is the area CABP1.
CONCLUSION
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