A Level Economics: Understanding Price Mechanisms and its Applications (Part 2)

In a previous article, Zenith covered Parts 2.1.1 and 2.1.2 from Theme 2.1: Price Mechanism and its Applications of the A Level Economics syllabus (applicable to both H1 and H2 students). Do check out the article before reading this one, as it outlines the key definitions and concepts of demand and supply which are necessary for understanding this article. In this article, Zenith covers Theme 2.1.3 as shown in Fig 1.

Carrying on from the previous article, Zenith will be introducing the concepts of Price Elasticity of Demand (PED) and Price Elasticity of Supply (PES). These two concepts are especially relevant to the government and producers of any good or service as they indicate the number of units of a good or service consumers in a market consume when changes in price occur.

The key thing to remember about PED and PES is that PED affects supply while PES affects demand. Students often get confused about which concept of elasticity to apply, and the best way around this is to understand exactly how each concept works. In this article, Zenith breaks down the Price Elasticity concepts applicable to the A Level Economics syllabus in two simple tables which provide a definition of the concept before explaining its magnitude and the factors which affect it. Feel free to copy and paste them onto a word document and print them out as your very own “cheat sheets” for Price Elasticity!

Price Elasticity of Demand

Price Elasticity of Demand (PED) is a way of measuring how responsive the quantity demanded of a good is towards a change in its own price, ceteris paribus.

Magnitude of PED:

• When 1 < |PED| < ∞ , we say that the demand is price elastic. This means that a change in the own price of the particular good or service results in a more than proportionate change in the quantity demanded of the good or service, ceteris paribus. Take for example the price of Good A dropping from $20 to $10, which is a 50% decrease in own price. If the quantity demanded of the good rises from 100 units to 300 units (a 300% increase), due to the 50% drop ($10) in price, it means that the demand of the good is price elastic.

• When 0 < |PED| < 1 , we say that the demand is price inelastic. This means that a change in the own price of the particular good or service results in a less than proportionate change in the quantity demanded of the good or service, ceteris paribus. Take for example the price of Good A increasing from $10 to $20, which is a 100% increase in own price. If the quantity demanded of the good drops from 100 units to 90 units (a 10% decrease), due to the 100% ($10) increase in price, it means that the demand of the good is price inelastic.

• When |PED| = 1, we say that the demand is unit elastic. This means that a change in the price of the particular good or service results in a proportionate change in the quantity demanded, ceteris paribus. Take for example the price of Good A increasing $10 to $20 ($100 increase). If the quantity demanded of the good similarly reduces by 100%, for instance, from 200 units to 100 units, it means that the demand of the good is unit elastic.

• When |PED| = ∞, we say that demand is perfectly price elastic. This means that a change in the price of the particular good or service results in an infinite decrease in quantity demanded, ceteris paribus. Take for example the price of Good A increasing from $10 to $20. If the quantity demanded of the good drops immediately to 0 units, it means that the demand of the good is perfectly price elastic.

• When |PED| = 0, we say that the demand is perfectly price inelastic. This means that a change in the own price of the particular good or service results in no change in quantity demanded of the good, ceteris paribus. Take for example the price of Good A increasing from $10 to $20. If the quantity demanded of the good remains at the same number of units as before the change in own price, it means that the demand of the good perfectly prices inelastic. Examples of each type of good:
• Price Elastic Goods: Electronics, Clothing, Branded Goods
• Price Inelastic Goods: Water, Electricity, Daily Necessities
• Perfectly Price Inelastic Goods: Life-Saving Medications
• Perfectly Price Elastic Goods: this is theoretical and in reality, no good is perfectly price elastic

Necessity

Goods that are essential for everyday life tend to be price inelastic in demand. For instance, many Asian households consume rice regularly. If there is an increase in the price of rice, the quantity demanded for rice is unlikely to experience a significant decrease as people still need to consume rice as a staple food on a daily basis.

Availability of Substitutes

Imagine if KOI got too expensive for you. You would have to choose between Gong Cha, Liho, ShareTea, ChiChaSanChen and any of the other bubble tea brands that are in Singapore. If a good has many substitutes which are highly similar to the original good, it is price elastic in demand. This is because consumers are likely to switch to an alternative when the price of the original good increases.

Income

Imagine that you only have $100 in your bank account. You are unlikely to want to spend $70 on a shirt, as it is 70% of the amount of money you have. On the other hand, if the same shirt was only $10, you are more likely to purchase it. This is likely to be true for all rational consumers who are looking to maximise utility. As such, the change in price of the shirt from $70 to $10 would cause a significant change in the quantity demanded of it. This illustrates how, as the proportion of income required for purchasing a particular good increases, the more price elastic its demand is.

Time Period

Taking a general overview of the entire market, it is reasonable to conclude that the demand for most goods and services are likely to be relatively price inelastic in the short run and relatively price elastic in the long run. This is as consumers require time to adapt to changes in prices. When the price of a particular good rises, consumers require time to find other goods to replace it. Over time, when they find replacements for the good whose price has increased, the demand for the good will become more price elastic as they no longer need to purchase the more expensive item.

Price Elasticity of Supply

Price Elasticity of Supply (PES) is a way of measuring how responsive the quantity supplied of a good is towards a change in its own price, ceteris paribus.

Magnitude of PES

• When PES < 1 , we say that the supply is price inelastic. This means that a change in price of the particular good or service results in a less than proportionate change in quantity supplied, ceteris paribus. Take for example the price of Good A increasing from $10 to $30 (a 300% increase). If the quantity supplied of the good rises from 100 units to 150 units (a 50% increase), it means that the supply of the good is price inelastic. For instance, the supply of electricity is price inelastic, as an increase in price does not cause a more than proportionate change in quantity supplied. This is as the quantity demanded for electricity will not increase as price decreases, which means that there is no incentive for producers to increase quantity supplied as they will not generate more profit from doing so.

• When PES > 1 , we say that the supply is price elastic. This means that a change in price of the particular good or service results in a more than proportionate change in quantity supplied, ceteris paribus. Take for example the price of Good A increasing from $10 to $15 (a 50% increase). If the quantity supplied of the good rises from 100 units to 300 units (a 300% increase), it means that the supply of the good is price elastic. For instance, the supply of branded goods are typically price elastic, as an increase in own price causes a more than proportionate change in quantity supplied, since producers seek to maximise profits by selling every unit of a good at a higher price.

• When PES = 0 , we say that the supply is perfectly price inelastic. This means that a change in price of the particular good or service results in no change in the quantity supplied of the good, ceteris paribus. Such a situation typically occurs for goods whose quantity supplied cannot be changed at short notice. For instance, the quantity supplied of wheat cannot be changed after the wheat has been harvested, regardless of changes in own price. The producers will need to wait for next season’s harvest to increase the quantity supplied of wheat.

Nature of Production

The length of production periods plays a significant role in deciding the price elasticity of supply. The shorter the amount of time required for firms to transform their factors of production into the good or service they are producing, the more price elastic the supply of the good is. Conversely, the longer the amount of time required for firms to transform their factors of production into the good or service they are producing, the more price inelastic the supply of the good is. For instance, as previously mentioned, agricultural produce tends to be price inelastic in supply as farmers (the producers) cannot do much to increase the quantity supplied of the goods once the crops have been harvested.

Inventory

Inventory refers to a producer’s stock of unsold goods. These goods have already been produced, however, they are either unsold or not yet put on the market. Inventories are not counted as part of a producer’s current supply. This way, producers are able to meet sudden changes in price by adjusting the number of units of goods in their current supply. As such, the supply of these goods with a high inventory is likely to be price elastic. For instance, canned goods are non-perishable goods and there is likely a high stock count of that in factories. Such goods can then be easily pushed out in a short amount of time, not limiting down its supply.

Spare Capacity

A producer has spare capacity when it is not fully utilising all the resources (e.g. land and labour) in production. If the factors of production of a particular good are readily available, it is highly possible for producers to increase the production of a good at short notice. In such a situation, the supply is considered price elastic. Conversely, if the factors of production of a particular good are not readily available, it is going to be difficult for producers to increase the production of the good at short notice. In such a situation, the supply is considered price inelastic. For instance, a clothes manufacturer may have additional sewing machines that are previously unused. With the spare capacity of these sewing machines that are readily available, supply can thus be easily increased.

Time Period

Similar to PED, the supply for most goods and services are likely to be relatively price inelastic in the short run and relatively price elastic in the long run. This is as producers require time to increase the quantity supplied of a good in response to higher demand. Over time, when they are able to overcome these bottlenecks in the supply chain, increasing production to meet demand such that a change in own price of the particular good or service results in a more than proportionate change in quantity supplied.

Enjoyed Zenith’s easy-to-understand compiled notes on Price Elasticity? The truth is that however complex a concept might appear to be, it can be easily broken down and understood if you relate to real-world examples! If you join Zenith’s Singapore JC Tuition Programme, you will be provided with even more simplified notes which clearly explain how various concepts can be applied to various questions at the A Level Economics examinations. You will also be exposed to a trove of relevant and current examples you can use during the A Level Economics examinations.

Next, we move on to understand how the government intervenes in the market economy to increase the welfare of its people, as the price mechanism can result in exploitation of both consumers and producers in different situations, as we will see later on. There are 4 types of government intervention that can take place, which will affect the demand and supply of goods and services in the market economy.

1. Tax

A government imposes taxes on goods to reduce consumption of them. Before the imposition of the tax, as seen in Fig 2, the demand curve and the supply curve for Good A met at Point D. Consumers were willing to consume E units of the good at price B. However, with the introduction of the tax, producers now have to sell the good at price G instead, to recoup the costs of the tax. However, at G price, consumers only want to consume C units of the good, due to an increase in price. This results in a reduction in the quantity exchanged of goods from E units to C units. Governments tend to impose such taxes on undesirable goods such as cigarettes and alcohol to reduce the consumption of them since they have negative effects on health. Zenith will be introducing the concept of market failure in the following articles. We will be further explaining how government intervention can both be a solution and cause for inefficiencies in the market.

2. Subsidy

In contrast to taxes, a government may provide subsidies on certain goods to increase their consumption. Before the provision of subsidies, as seen in Fig 3, the demand curve and supply curve for Good A met at Point D. Producers were willing to produce C units of the good at price B. However, with the introduction of the subsidy, producers were able to increase production, leading to an increase in supply to E units. Since the government absorbs the price increase from Price B to Price G, consumers continue to pay Price B for E units of the good, while producers now achieve an increase in revenue as the government is paying for the people’s increased consumption. Governments typically subsidise goods and services such as education and housing, which are seen as desirable for the development of the country.

3. Price Control

There are two types of price controls that can be implemented by the government. The first is a price floor, which fixes a minimum price. The second is a price ceiling, which fixes a maximum price.

Fig 4. Graph showing the effect of a price floor on the market economy for Good A

Minimum prices are prices set above the market equilibrium price. This is typically done to prevent the exploitation of workers and is the same mechanism that governs the minimum wage policy in many countries. As seen in Fig 4, the market equilibrium for Good A is at Point D. However, with the introduction of the minimum price at Price B, the quantity demanded for the good falls to C, whereas quantity supplied increases to G. This, however, creates a surplus of Good A produced, which results in inefficient resource allocation in the market economy as there are too many units of the good being supplied for the quantity demanded. Unfortunately, this is an inevitable unintended consequence when implementing the price floor.

Maximum prices are prices set below the market equilibrium price. This is typically done to prevent producers from exploiting consumers by overpricing their goods and services when they are in high demand. As seen in Fig 5, the market equilibrium for Good A is at Point D. However, with the introduction of the maximum price at Price B, the quantity demanded for the good increases to G, whereas quantity supplied decreases to C. This, however, creates a shortage of Good A produced, which results in inefficient resource allocation in the market economy as there are insufficient units of the good to meet quantity demanded. Unfortunately, similar to the implementation of the price floor, this is an inevitable unintended consequence when implementing the price ceiling.

4. Quota

Instead of controlling the price of goods and services to affect quantity supplied and demanded, the quota restricts the quantity of a particular good or service which can be sold. It is most commonly used in Singapore within the car industry, where a fixed number of Certificates of Entitlement (COEs) are given out each month. As seen in Fig 6, if unregulated, the supply and demand for Good A meet at Point D, at Price A and Quantity E. However, the quota regulates the market such that only C units of Good A can be sold. Therefore, to make up for the loss in revenue from the decrease in the number of units of Good A sold, producers now sell Good A at Price B. Consumers who desire Good A when there is a quota in place will have to pay Price B for it.

With that, Zenith has come to the end of Part 2 of Theme 2.1: Price Mechanism and its Applications. As a quick recap, this is what we have covered in this article:

• Price Elasticity of Demand (PED)
• Price Elasticity of Supply (PES)
• Government Intervention
• Tax
• Subsidy
• Price Control
• Quota

We hope that this article has been useful for you! Keen to find out more about the Zenith experience? Discover our JC Economics Tuition program and contact us for a trial lesson today!