1.2.3 and 1.2.5

Question 1

What is meant by price elastic ?

Answer 1

quantity demanded changes by more than price

Question 2

What is meant by price inelastic ?

Answer 2

quantity demanded changes by less than price

Question 3

What is price elasticity of demand ?

Answer 3

PED measures how responsive quantity demanded is to changes in price

Question 4

What is the formula for PED ?

Answer 4

% change in the quantity demanded/ % change in price

Question 5

What are the rules for PED ?

Answer 5

• perfectly inelastic: = 0 (price doesn’t effect demand) ➡️ vertical
• price inelastic: between 0 & -1
• price elastic: between -1 & infinity
• unitary elastic: = -1 (perfectly proportional price & qnty)
• perfectly elastic: - infinity ➡️ horizontal

🔔 the higher the number the more price elastic
🔔 the answer will always be negative (inverse relationship between price and demand)

Question 6

What is PED affected by ?

Answer 6

• number of substitutes: more substitutes= more elastic demand will be (customers can easily switch products)
• time: demand is more price elastic, the longer that consumers have to respond to a price change ➡️ more time to search for cheaper substitutes eg. petrol prices stay high for a long time - people can carshare or take the bus/train (their behaviour adjusts)
• necessities or luxuries: luxury = more price elastic (can live w/o them) necessities = price inelastic
• % of consumer income allocated on the good: higher % = more elastic, lower the cost = more inelastic
• cost of switching between products: lower cost = more elastic eg. mobile phone service providers may require a contract therefore inelastic

Question 7

What are the uses of PED ?

Answer 7

helps firms:

• serves as a pricing policy: telling producers how to change prices to increase revenue (optimum price?) eg. elastic demand ➡️ decrease price to increase revenue
• decide on non-price strategies for increasing demand ➡️ eg. if PED is elastic firms cannot increase revenue by increasing price, but if they cannot lower it either due to cost levels, then they know they will need to use other strategies to increase demand and shift the curve to the right to increase revenue
• predict the effect of a change in an indirect TAX on price and quantity demanded + whether the business is able to pass on some or all of the tax onto the consumer
• used for price discrimination: charge different prices to diff segments of the market eg. peak & off peak rail travel

🔔businesses are keen to make demand for their goods/services more price inelastic
🔔 usually a business will aim to charge a higher price to consumers whose demand is price inelastic (PED <1)

Question 8

What are the limitations of PED ?

Answer 8

• values are based on estimates
• info used to calculate PED may become outdated
• data changes overtime ➡️ needs to be revised
• other factors may shift the demand curve cancelling out the QD affect
• whilst helpful in determining revenue, does not necessarily follow that an increase in revenue leads to more profit (PED ignores any cost data)
• elasticity is likely to change overtime ➡️ calculations only useful in the short term

Question 9

What is the relationship between PED and total revenue ?

Answer 9

🔔 total revenue = price x quantity bought

• inelastic demand: rise in price = rise in TR eg. 20% rise in price might cause quantity demanded to contract by only 5% (PED = -0.25) ➡️ more than proportional
• elastic demand: fall in price = rise in TR eg. 10% fall in price might cause quantity demanded to expand by a much larger 25% (PED = +2.5)
• perfectly inelastic demand (0): a price change = same revenue change eg. 5% increase in a firm’s prices results in a 5% increase in its TR
• unit elastic demand (-1): a change in the price = no change at all in the revenue

Question 10

Examples of the relationship between PED and total revenue ?

Answer 10

Ped is inelastic (<1) and a firm raises its price. Total revenue increases
Ped is elastic (>1) and a firm lowers its price. Total revenue increases
Ped is elastic (>1) and a firm raises price Total revenue decreases
Ped is unit elastic (=1) and a firm raises price Total revenue remains the same
Ped is -1.5 (elastic) and the firm raises price by 4% Total revenue decreases
Ped is -0.4 (inelastic) and the firm raises price by 30% Total revenue increases
Ped is -0.2 (inelastic) and the firm lowers price by 20% Total revenue decreases
Ped is -4.0 (elastic) and the firm lowers price by 15% Total revenue increases

Question 11

What is income elasticity of demand ?

Answer 11

YED measures how responsive quantity demanded is to changes in income

Question 12

What is the formula for YED ?

Answer 12

% change in quantity demanded/ % change in income

Question 13

What are the rules for YED ?

Answer 13

• perfectly income inelastic: =0 (income doesn’t affect demand)
• YED >1 ➡️ elastic
• YED between 0-1 ➡️ inelastic
• unitary elastic: = 1

🔔 the higher the number the more income elastic demand is

Question 14

What is a normal good ?

Answer 14

🔔 have a positive YED (as consumers’ income rises, more is demanded at each price)

• YED of between 0 and +1: eg. if income increases by 10% and demand for fresh fruit increases by 4%, income elasticity is+0.4 (income inelastic)
• income inelastic

Question 15

What is an inferior good ?

Answer 15

🔔 have a negative YED (demand falls as income rises etc) as consumers are switching to higher quality alternatives eg. bus transport, own label food, cigarettes

• income elasticity of < 0 (YED is -ve)
• can be either elastic or inelastic ➡️ eg. YED= -0.6 (inelastic), YED= -5.5 (elastic)

Question 16

What are luxury goods ?

Answer 16

🔔 have an income elasticity of demand > +1 i.e. demand rises more than proportionately to a change in income

• eg. 8% increase in income leads to a 10% rise in demand for new kitchens. YED= +1.25 (demand is income elastic)
• income elastic

Question 17

What does the sign tell you for YED ?

Answer 17

• normal good: +
• inferior good: -

Question 18

What does the size tell you for YED ?

Answer 18

tells you how elastic demand is:
- inelastic <1
- elastic >1

Question 19

How can you tell whether a good is a normal/luxury or inferior ?

Answer 19

• normal & luxury goods have + answer (as income rises, demand rises vice versa)
• normal: 0-1
• luxury good: >1
• inferior goods have a negative answer (as income rise, demand falls vice versa) ie. < 0

Question 20

What is the relationship between income and demand of goods ?

Answer 20

🔔 better off = can afford to increase our spending on different goods/services
🔔 YED will also affect the pattern of demand over time:

• luxury goods: YED > +1 (as incomes rise, the proportion of a consumer’s income spent on that product will go up)
• normal necessities: YED between 0 and 1 (as incomes rise, demand will also increase however not significantly as people already buying these goods)
• inferior goods: YED is negative (as income rises, demand declines and so too will the share of income spent eg. tobacco products)

Question 21

What are the uses of YED ?

Answer 21

helps firms:

• sales forcasting: predict the effect of change in consumer income on the demand for their products eg. the effect of a recession
• spread risk by offering products at different price points (appeal to differing income levels)
• product switching ➡️ business may be able to switch the kinds of products it makes in relation to rising/falling incomes
• pricing policy: helps the firm decide whether to raise or lower price following a change in consumer incomes eg. if incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand.
• luxury products w/high income elasticity see greater sales volatility over the business/trade/economic cycle than necessities where demand from consumers is less sensitive to changes in the cycle

Question 22

What are the limitations of YED ?

Answer 22

• values are based on estimates
• forecasting changes in demand is very difficult
• info used to calculate YED may become outdated
• other factors may shift the demand curve cancelling the QD effect
• the elasticity is likely to change over time so the calculation is only useful in the short term

Question 23

What is cross price elasticity of demand ?

Answer 23

• XED measures how responsive the quantity demanded of one good is to the changes in price of a different good

Question 24

What is the formula for XED ?

Answer 24

% change in quantity demanded of X / % change in price of Y

Question 25

What are the rules for XED ?

Answer 25

• perfectly inelastic: =0 (price change of one good doesn’t affect the demand for the other good)
• cross price inelastic: <1
• cross price elastic: >1
• unitary elastic: =1

🔔 the higher the number the more cross price elastic the demand is

Question 26

What does the sign tell you for XED ?

Answer 26

• substitute: +
• complementary: -

Question 27

What does the size tell you for XED ?

Answer 27

• tells you how cross price elastic demand for that good is to changes in price

Question 28

What are substitute goods ?

Answer 28

• have a positive XED (>0)
• an increase in the price of one product will lead to a rise in demand for its substitute ➡️ consumers swap away from the more expensive good

Question 29

What are complementary goods ?

Answer 29

• have a negative XED (<0)
• an increase in the price of one good will lead to a decrease in demand for another good
• when there is a strong complementary relationship cross elasticity will be negative

Question 30

What are unrelated goods ?

Answer 30

• have a XED of zero
  eg. a rise in the price of cars will have little to no effect on the demand for TIPP-EX

Question 31

How can you tell whether goods are close or weak substitutes ?

Answer 31

🔔 all substitutes have a positive XED, however:

• a high value suggests both products are close substitutes
• close substitutes: elastic ( >1) ➡️ small rise in price of X causes a large rise in demand for Y eg. XED= 5
• weak substitutes: inelastic (0-1) ➡️ a large rise in price of S leads to a small increase in demand for T eg. XED= 0.5

Question 32

How can you tell whether goods are close or weak complements ?

Answer 32

🔔 all complements have a negitive XED, however:

• close complements: elastic ( >1) ➡️ a small fall in price of A causes a large rise rise in demand for B eg. XED= -5
• weak complements: inelastic (0-1) ➡️ a large drop in price of E causes only a small rise for B eg. XED= -0.5

Question 33

How can business use XED ?

Answer 33

Complementary goods:

• consider supplying goods together in a ‘bundle’ OR ensure they are positioned close to each other in shops to increase sales
• take advantage of the ‘razor and blades’ model ➡️ razors are generally available to buy quite cheaply, but the accompanying blades (sold separately) are expensive

Substitute goods:

• often find that different brands are owned by the same company ie. ‘brand proliferation’ eg. Unilever, and Procter and Gamble, own many different cleaning product and toiletries products each

Question 34

What are the uses of XED ?

Answer 34

• helps classify goods as complementary or substitutes
• helps to determine pricy policy

substitute goods:

• helps a business work out the effect of a competitor cutting their prices on the demand for our goods
• when customers become very loyal to a brand and keep buying its products over and over then demand will become less sensitive to price (XED will be very low) ➡️ the firm should be able to charge higher

complementary goods:

• if a firm sells two products eg. cinema tickets and popcorn it can estimate the effect of a change in price, say a two for one ticket offer on the demand of popcorn- if the ticket price reduction attracts many more customer who then go on to buy popcorn (which has a high mark up) then it might be worth doing

Question 35

What are the limitations to XED ?

Answer 35

• values are based on estimates
• forecasting changes in demand is very difficult
• info used to calculate XED may become outdated
• other factors may shift the demand curve cancelling the QD effect
• the elasticity is likely to change overtime so the calculation is only useful in the short term

Question 36

What is price elasticity of supply ?

Answer 36

• PES measures how responsive quantity supplied is to changes in price
• 🔔 if supply is price elastic, producers can increase their output without a rise in cost or a time delay
• 🔔 if supply is price inelastic, firms find it hard to change their production in a given time period

Question 37

What is the formula for PES ?

Answer 37

% change in the quantity supplied/ % change in price

Question 38

What are the rules for PES ?

Answer 38

• perfectly inelastic: =0 (price doesn’t affect supply)
• price inelastic: <1
• price elastic: >1
• perfectly elastic: = infinity (the supply curve is drawn horizontally)

🔔 the higher the number the more price elastic the supply is
🔔 the answer will always be positive, this represents the positive relationship between price and supply

Question 39

What is PES affected by ?

Answer 39

• availability of producer substitutes: many substitutes = high elasticity (businesses can easily alter its pattern of production if its price rises/falls), few substitutes = inelastic
• time based factors: shorter the time period the more difficult producers find it to switch from making one product to another because:
  *some items take longer to make: longer it takes to make = more inelastic supply will be, the shorter it takes = more elastic
  *how expensive it is to store stock until they are demanded: easy to store eg. wheat = price elastic, hard to store eg. electricity = more price inelastic
• capacity levels: no spare capacity to make more of a product then it will be difficult to increase supply even in prices rise sharply ➡️ supply of goods/services most elastic in recessions as plenty of spare labour + capital resources) high capacity eg. no storage (will have to increase resources available to them) = inelastic supply, low capacity (less constraint) = elastic supply
• complexity factors + laws: more complex to make = more inelastic
• mobility of the four factors of production: PES will be higher the easier it is for firms to switch between production of one product to another or for firms to enter the market to make the product

Question 40

What is the significance of short run and long run for PES ?

Answer 40

🔔 supply is more price elastic the longer the time that a firm is allowed to adjust its production levels

• SR refers to the period of time in which at least one factor of production is fixed, PES will be relatively inelastic
• LR refers to the period of time in which all factors of production are variable; PES will be relatively elastic

Question 41

What are the uses of PES ?

Answer 41

• firms want to respond quickly to changes in price and demand ➡️ must make their supply as elastic (responsive to price change) as possible
• they will then take measures to improve the elasticity of their supply

eg. train flexible staff, update technology, have some spare capacity etc

Question 42

What are the limitations of PES ?

Answer 42

• values are based on estimates
• info used to calculate PES may become outdated
• other factors may shift supply curve cancelling the QS affect
• PES ignores any cost data
• the elasticity is likely to change over time so the calculation is only useful in the short term