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Economics - Theme 1 > 1.2 - Price, income, cross elasticities of demand > Flashcards

1.2 - Price, income, cross elasticities of demand Flashcards

how markets work

1
Q

what is price elasticity of demand (PED)?

A

The responsiveness of demand to a change in price of the good
> responsiveness is
different for different
types of goods

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2
Q

how do you calculate PED?

A

= % change in quanitity demanded / % change in price

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3
Q

What does a PED value of 0 mean?

A
  • Perfectly inelastic
    > The QD is completely unresponsive to a
    change in P
    > Demand curve is a vertical line
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4
Q

What does a PED value between 0 - 1 mean?

A
  • Relatively inelastic
    > Quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price
    > Steep demand curve
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5
Q

What does a PED value of 1 mean?

A
  • Unitary elastic
    > percentage change in QD is exactly equal to percentage change in price
    > demand is a reciprocal curve
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6
Q

What does a PED value >1 mean?

A
  • Relatively elastic
    > Quantity demanded changes by a larger percentage than price so demand is relatively responsive to price
    > demand curve is more sloping
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7
Q

What does a PED value of ∞ mean?

A
  • Perfectly elastic
    > change in price means quantity demanded falls to zero so demand is extremely responsive to price
    > demand curve is a horizontal line
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8
Q

What factors influence PED?

A
  • Availability of substitutes
    > high availability of substitutes results in a higher value of PED (relatively price elastic)
    > if there are no substitutes, PED is inelastic because people have to buy that good - no alternative.
  • Addictiveness of the product
    > addictiveness turns products into necessities and habitual consumption, resulting in a low value of PED (relatively price inelastic)
    > despite high prices, consumers will pay to fulfill their additions.
  • Price of product as a proportion of income
    > the lower the proportion of income the price represents, the lower the PED value will be.
    > Consumers are less responsive to price changes on cheaper products (relatively price inelastic)
  • Time period
    > In the short term, consumers are less responsive to price increases, resulting in a low value of PED (relatively price inelastic). > Over a longer time period, consumers may feel the price increase more and find it easier to look for substitutes, resulting in a higher value of PED (relatively price elastic)
  • Necessity
    > If a consumer needs something the demand curve will be inelastic because they need to buy the good even if prices rise
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9
Q

What is income elasticity of demand (YED)?

A

The responsiveness of demand to a change in income

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10
Q

How do you calculate YED?

A

= % change in quantity demanded / % change in income

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11
Q

What does a YED value < 0 means?

A
  • Inferior good
    >Demand decreases when income increases or vice versa so YED is negative
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12
Q

What does a YED value > 0 mean?

A
  • Normal good
    > rise in income will lead to a rise in quantity demanded
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13
Q

What does a YED value >1 mean?

A
  • Luxury good (type of normal good)
    > Demand increases proportionately more when income increases. Income elastic, which means demand is relatively more responsive to a change in income
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14
Q

YED can be elastic and inelastic, if the value is greater than 1 it is (1) and if it is less than 1 it is (2)

A

(1) Elastic
(2) Inelastic

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15
Q

What factors influence YED?

A
  • YED is influenced by any factors in an economy which change the wages or salaries of workers
    > During a recession, incomes usually fall so the demand for inferior goods rises and the demand for normal goods fall
    > During a period of economic growth and rising incomes, demand for normal goods rises and the demand for inferior goods fall
    >Other influences on income include minimum wage legislation, taxation, and increased international trade
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16
Q

What does it mean if YED is - and what does it mean if it is +

A
  • = inferior
    + = normal

(The number shows the strength of the relationship. For example, YED = +2.5 means there is a strong relationship between a change in income and demand)

17
Q

What is cross elasticity of demand (XED)?

A
  • The responsiveness of the demand of one good (A) to the change in price of another product (B)
18
Q

How do you calculate XED?

A

= % change in quantity demanded for good A / % change in price of good B

19
Q

What does it mean if XED>0 ?

A
  • Substitutes
    > The positive value indicates the two goods are substitutes.
    The higher the value of the integer, the stronger the relationship
20
Q

What does it mean if XED<0

A
  • Complementary goods
    > The negative value indicates the two goods are complementary.
    The higher the value, the stronger the relationship
21
Q

What does it mean if XED = 0?

A
  • Unrelated goods
    > A value of zero indicates that there is no relationship between the two goods. The closer to zero, the weaker the relationship is
22
Q

What is the significance of knowing PED to firms and to governments?

A
  • Determines the effects of the imposition of indirect taxes and subsidies

> If government tax inelastic goods, they can increase tax revenue without harming firms too much ( incidence of tax passed more onto consumer burden rather than producer burden as producers can increase prices without big decrease in demand)
However quantity demanded doesn’t fall by much so it is ineffective at reducing output of demerit goods.

> Subsidies lower prices of goods and services by lowering production costs for firms. If demand for the good is elastic then lowering a firms production costs will mean that producers only need to lower prices a little bit to see an increase in quantity demanded
more producer gain than consumer gain and an increase in demand for the good/service (helps promote consumption of merit goods)
vice versa for inelastic demand

23
Q

What is the significance of knowing the PED for firms?

A
  • Knowledge of PED is important to firms seeking to maximise their revenue
    > If their product is price inelastic in demand, they should raise their prices
    > If price elastic in demand, then they should lower their prices
24
Q

What is the significance of knowing YED of goods for firms?

A
  • Knowledge of YED is important to firms as they seek to maintain sales and maximise profits through periods of recession or economic growth
    > Firms should consider providing more inferior goods in a recessionary environment
    > Firms should consider providing more income elastic normal goods/ luxury products during periods of economic growth
25
Q

What is the significance of knowing XED of goods for firms?

A
  • Knowledge of XED is important to firms as they seek to maximise their revenue
    > It can help them adjust pricing strategies for substitute and complementary products
    > It can help them understand the likely impact of competitors’ pricing strategies on their sales
26
Q

What is the relationship between price elasticity of demand and total revenue?

A
  • When demand curve is elastic
    > A decrease in price leads to an increase in revenue
    > An increase in price leads to a decrease in revenue
  • When demand curve is inelastic
    > A decrease in price leads to a decrease in revenue
    > An increase in price leads to an increase in revenue
  • When demand curve is unitary
    > A change in price does not affect total revenue
27
Q

What is the revenue rule of PED?

A

The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are price inelastic in demand and decrease prices on products that are price elastic in demand

28
Q

How do you calculate whether a firm has made the right decision in changing the price of a good/service?

A

1) calculate initial sales revenue
> price of product x quantity sold

2) calculate sales revenue after price change
> new price of product x new quantity sold

3) compare revenue and see if firm has maximised total revenue

Economics - Theme 1 (8 decks)

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