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Microeconomics: How competitive markets work > Elasticity
Learners should be able to:
- explain what is meant by elasticity
- explain what is meant by price elasticity of demand (PED)
- calculate PED using point elasticity
- explain, with the aid of a diagram, the different values of PED
- explain why price elasticity of demand varies along a straight line demand curve
- explain, with the aid of a diagram, the relationship between PED and a firm’s total revenue
- evaluate the factors which determine the degree of PED
- evaluate the effect of PED on the impact of an indirect tax and of a subsidy
- explain what is meant by income elasticity of demand (YED)
- calculate YED
- evaluate the significance of the numerical value and sign of YED
- explain the difference in YED of inferior, normal and superior goods
- explain what is meant by cross elasticity of demand (XED)
- calculate XED
- evaluate the significance of the numerical value and sign of XED
- explain the difference in XED of substitute, complementary and non-related goods
- explain what is meant by price elasticity of supply (PES)
- calculate PES using point elasticity
- explain, with the aid of a diagram, the different values of PES
- evaluate the factors which determine the degree of price elasticity of supply
- evaluate the usefulness of and significance of PED, YED, XED and PES to all economic agents.
Students need to understand that all forms of elasticity are about the responsiveness of one dependent variable to a change in a determinant variable, the key word here being “responsiveness”. The determinant variable in PED, PES and XED is price, whilst in YED it is income. In each case, a change in the determinant variable causes a change in a dependent variable and it is the size of this second change in relation to the first that is the focus of the study of elasticity.
Approaches to teaching the content
It is well worth spending time on whichever type of elasticity you choose to teach first, usually PED, in order to establish the features of elasticity common to all types: the issue of responsiveness; the calculation of the coefficient of elasticity. When teaching each individual type, one should make clear the determinants of elasticity for that type and the relevance to firms of the results of the calculation of the coefficient of elasticity.
Common misconceptions or difficulties students may have
Some students struggle with negative numbers and the way in which they indicate the degree of elasticity for PED, XED for complements and YED for inferior goods. They know that -2 is smaller than -1 and thus find it difficult to understand that a coefficient of -2 is more elastic than a coefficient of -1. A useful way to overcome this is to draw on the board a number line of coefficients of elasticity from -2 to +2 and to explain to students that values between -1 and +1 indicate that the response of the dependent variable is proportionally lower than the initial change in the determinant variable and can thus be categorised as inelastic. Responses outwith this range i.e. from -1 to -2 and beyond, also from +1 to +2 and beyond, indicate that the response of the dependent variable is proportionally larger than the initial change in the determinant variable and can thus be categorised as elastic.
Conceptual links to other areas of the specification – useful ways to approach this topic to set students up for topics later in the course
Links: ‘The concept of the margin’ (A level only); ‘Supply and demand and the interaction of markets’; ‘Business objectives’ (A level only); ‘Alternative methods of government intervention’.
Degrees of elasticity of demand will be a factor which influences business decision making and so will bear recapping during the teaching of ‘Business objectives’. When studying ‘Alternative methods of government intervention’, it is worthwhile revisiting PED and the impact of an indirect tax and a subsidy, and in particular the respective burdens borne by consumer and producer.
To illustrate what is meant by elasticity, you will need some rubber bands of different thickness for this activity – school/college office may be able to help. Put this definition on the board: “Elasticity is the responsiveness of one variable to a change in another variable”. Give out the rubber bands and tell the students to stretch them. Ask if all the rubber bands stretched by the same amount. Ask if it would be possible to measure the amount of stretch. Tell the students that the rubber bands represent measurable quantities. The force that they apply represents the other variable. You may then move from this to any of the different types of elasticity.
Duration: 10 minutes.
On the whiteboard, show a diagram of an earthquake – any pictorial representation will do, as long as it shows the earthquake starting underground. Explain to the students that, in order to remember how to calculate elasticity, they need to remember the Earthquake Rule – the cause [change in the determinant variable] is underneath [is the denominator]; the response [change in the dependent variable] is on top [is the numerator]. This holds true for PED, YED, XED & PES. Give the students some numerical examples to work through. Some examples are given in the PED section below.
Duration: 10 minutes.
1) Put up a list of 5 goods on the board e.g. strawberries, holidays, books, train journeys, pasta, with a ruler with one end labelled ‘most elastic i.e. responsive to change in price’ and the other ‘most inelastic i.e. unresponsive…’.
2) Give students 5 minutes to discuss and decide how to rank the goods in responsiveness to price change.
3) Discuss the results and link to theory.
The activity can be repeated with a focus on factors affecting PES.
After being introduced to the concepts of normal, inferior and superior goods, students could create a Venn diagram with these categories and locate a selection of shouted out ‘goods’ in the ‘right’ areas.
Using 2 goods such as Pepsi and Coca Cola, students could discuss the demand for Coca Cola when price of Pepsi increases and create diagrams to represent the relationship.
Duration: 30 minutes.
This presentation explains what is meant by PED, how it is calculated, why it varies along a straight line demand curve, and relationship between PED and a firm’s total revenue as well as the factors which determine the degree of PED. It also includes practice questions.
Duration: At least 120 minutes (68 slides).
To introduce the topic, give students the following activity to do:
List three goods which you buy – Firstly, one where you are likely to buy a lot more if your income rises. Secondly, one where your income rises and you buy only a little more. Thirdly, one where an increase in income does not change your demand for the good at all.
Start with an imaginary annual income of £25,000 – how many of each good would you buy each year? How many would you buy if your income were increased to £50,000? Use this to lead in to a discussion of inferior, normal and superior [a.k.a. luxury, Veblen] goods.
Get students to draw out a table with 3 columns: inferior goods [-YED]; normal goods [YED between 0 and 1]; superior goods [YED >1]. Students should complete the table with examples.
Duration: 15–20 minutes.
Remind students of the earthquake rule – elasticity is calculated by response/cause, in this case % change in quantity demanded/% change in income. Now they need to learn how to interpret the coefficients by looking at the sign and the size. Write the following on the board: if the sign is – the good must be inferior, so a rise in income will cause a fall in demand. If the sign is + and the size is between 0 and 1, this must be a normal good, often a necessity. If the sign is + and the size is greater than 1, this is a superior good.
Get students to draw a table with 4 columns: YED; change in income; change in demand; type. Go through the following example: -2.1; inferior; +3%; -6.3%; inferior.
Fill in the following figures for YED: +0.4; =1.6. Make the change in income 3% both times and get the students to complete the table [answers are +1.2%, normal and +4.8%, superior]. Students should then make up an example of their own and test it out on class members.
To learn the determinants of income elasticity, students should memorise the acronym “LAD” – level of income; availability of substitutes; degree of necessity. Students should discuss and write down how each determinant affects income elasticity.
Duration: 15 minutes.
Remind students of the earthquake rule and tell them that for XED, the response is the change in quantity demanded, whilst the cause is a change in the price of a related good. Remind students of the 2 categories of related good, substitutes and complements. They should discuss for each category whether XED will be positive or negative and why [substitutes positive, complements negative].
Students should draw up a table with 4 columns, headed product, strong complements, weak complements and no relationship. They should complete the table with examples.
Students should then draw up a table with 4 columns, headed product, close substitutes, weak substitutes and no relationship. They should then complete the table with examples. Students could go on to compare the two tables.
Duration: 25–30 minutes.
Click on the link for a presentation with exercises on XED.
Duration: 45–60 minutes (17 slides).
Remind students of the earthquake rule – elasticity is calculated by response/cause, in this case % change in quantity supplied/% change in price. The coefficient of elasticity of supply will be positive due to the direct relationship of price and quantity supplied, thus the response and cause will either both be positive for an increase in price or both negative for a decrease in price. In the latter case dividing one negative number by another will give a positive answer. Tell students to create 3 examples of their own and to test them on their classmates.
The concept of point elasticity can now be revisited. Get students to make a table with four columns: price; quantity supplied; TC [Total Cost]; PES. Give them the following figures for Price: 100; 90; 80; 70; 60; 50; 40; 30; 20; 10. Give them the following figures for quantity supplied: 40; 36; 32; 28; 24; 20; 16; 12; 8; 4. They should then complete the table and discuss their findings.
Teach students the acronym FITS to help them remember the determinants of PES: factor substitution; inventory available; time frame [short run / long run]; spare production capacity. Students should discuss and write down how each factor can affect price elasticity of supply.
Get students to put the following products in order of most elastic supply to least elastic supply: tractors; paper clips; tinned tuna; fresh tuna. Next to each item, they should give a reason why they have placed it there.
Duration: 45 minutes.
Divide the class into 3 groups: households, firms and governments. Each group should research the ways in which their given economic agents are affected by the 4 different types of elasticity and what strategies they can use to deal with this. Each group should make a presentation of their findings to the whole class.
Duration: 50–60 minutes.
To evaluate the effect of PED on the impact of an indirect tax and a subsidy, this tutorial provides a recap of the concepts of consumer and producer surplus.
Duration: At least 60 minutes (29 slides).
Further ideas on how to explain elasticity includes
- a summary presentation on different types of elasticities
- several approaches and ideas for a lesson (see resources).
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