Skillsfirst Level 5 Diploma in Financial Trading (RQF) - Module 1 - Trading Introduction
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Skillsfirst Level 5 Diploma in Financial Trading (RQF) - Module 3 - Economic Principles
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PRICE ELASTICITY

Referring to our previous definition of economic as the study of incremental changes, price elasticity serves as a measure of how responsive buyers and sellers are to changes in price. In the real-world where actual supply and demand curves may be difficult if not impossible to measure, price elasticity serves as a powerful tool to determine how a firm’s revenues may be impacted by a 5% increase in prices for example. Price elasticity can therefore be expressed by the following formula:

e = (percentage change in quantity) / (percentage change in price)

So, for example, if a 1% increase in price results in a 1% decrease in purchases from buyers, we generate a price elasticity of demand equal to -1. Similarly, if a 1% increase in price results in a 1% increase in production from sellers, we generate a price elasticity of supply equal to +1. Price elasticities of supply and demand therefore represent the most common measures of price responsiveness.

Because of their quantitative nature, these measures can also be used to indicate exactly how responsive supply and demand may be to changes in prices, depending on whether values are higher or lower than 1. Therefore, goods and services with a price elasticity higher than 1 would be described as elastic, while those with a price elasticity lower than 1 would be termed as inelastic.

Typically, the price elasticity of most goods and services is determined largely by how easily they can be substituted for other goods and services – both on the demand and the supply side. For example, a product such as Coca Cola may be relatively elastic in terms of demand compared to a bottle of 1996 Chateau Lafite Rothschild, since soft drinks have many different substitutes for one another compared to a vintage bottle of red wine.

In extreme cases though, we can visually represent perfect elasticity and inelasticity using horizontal and vertical lines respectively as shown in the two charts below:

Finally, time is another important factor regarding how responsive buyers and sellers may be in relation to price changes, since generally people will be able to adjust their consumptions and production patterns the longer they should make those actual adjustments. A good example of this occurred with the oil price spikes which occurred during the 1970’s because of action taken by OPEC members in retaliation against perceived Israeli aggression during the Yom Kippur War. Although petrol prices increased significantly as a direct consequence of the embargo, consumers soon changed preferences over time by buying smaller, more fuel-efficient vehicles for example. This meant that over time, subsequent attempts by the OPEC cartel to manipulate oil prices had significantly less impact.

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