1.2.3 Elasticities of Demand Flashcards
Price Elasticity of Demand (+ formula)
> The responsiveness of demand to a change in the price of a product.
PED = % change in quantity demanded / % change in price.
Income elasticity of demand (+ formula)
> The responsiveness of demand to a change in income.
> YED = % change in quantity demanded / % change income.
Cross elasticity of demand (+ formula)
> The responsiveness of demand for one product (A) to the change in price of another product (B).
XED = % change in quantity demanded of A / % change in price of B
Numerical Values of PED
> Unitary elastic PED (1) - quantity demanded changes by exactly the same percentage as price. Shown by a reciprocal curve.
Relatively elastic PED (>1) - quantity demanded changes by a larger percentage than price so demand is more responsive to price.
Relatively inelastic PED (<1) - quantity demanded changes by a smaller percentage than price so demand is less responsive to price.
Perfectly elastic PED (infinity) - a change in price means that demand falls to 0. Very responsive to price. Shown by horizontal line.
Perfectly inelastic PED (0) - a change in price has no effect on demand. Demand is completely unresponsive to price. Shown by vertical line.
Factors that influence PED
> Availability of substitutes - A good with several substitutes will be more price elastic because consumers will switch to them if the price goes up. If there are no substitutes then demand will be inelastic because even if prices rise consumers will still have to buy the good as there are no alternatives.
Necessity - necessary goods will have a relatively inelastic demand curve because even if the price goes up, consumers will still demand the product because they need it. Luxury goods will be more elastic because they are not essential.
Time - In the long run, consumers have time to respond to a change in price and find a substitute, so demand becomes more price elastic. However in the short run consumers don’t have this time so demand is relatively inelastic.
Addictiveness - if goods are addictive then demand will be more inelastic because even if the price rises consumers will buy the product to fulfil their wants.
Proportion of income spent on the good - if the good only takes up a small proportion of income, a price increase won’t have a major impact, so the good will be more inelastic. A good that takes up a significant proportion will be far more elastic.
Elasticity of demand and the imposition of indirect taxes:
The incidence of an indirect tax on firms/consumers will be different depending on the elasticity of demand.
>Firms selling a good with inelastic demand will put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly.
> (diagram sheet 1) An increase in tax will cause supply to shift from s1 to s2, which increases price from p1 to p2, and therefore demand contracts from q1 to q2. It is most effective for raising government revenue. The more inelastic the more tax revenue.
> If a firm sells an elastic good, they’re likely to receive most of the tax burden, because if the price of the good rises, demand is likely to fall, lowering overall revenue.
> (diagram sheet 1) The tax will only lead to a small increase in price and the supplier will cover the majority of the cost. This isn’t as effective more making government revenue, but it is effective at reducing demand for a good, because demand falls significantly from q1 to q2.
Elasticity of demand and the imposition of subsidies:
> With a subsidy, elastic demand means that the consumer sees a small fall in price whilst the producer gains a lot in extra revenue. The more inelastic demand, the more the price falls.
Elastic demand also means there is a larger change in output. However subsidies on inelastic products will not be very effective at increasing output, unlike on goods with elastic demand. They are therefore cheaper to impose though, due to the lower increase in output.
(diagram sheet 1) First diagram, small rise in output, large fall in price, with little producer gain. Second diagram, large rise in output, small fall in price. Government has to spend more on elastic goods.
PED and total revenue:
Total revenue is the amount sellers receive from selling the product. It is the average price of the product x the quantity sold.
> For an elastic demand curve, an increase in price leads to a decrease in total revenue, because quantity sold falls by so much. For this reason a decrease in price will increase total revenue.
> For an inelastic demand curve, an increase in price leads to an increase in total revenue because the quantity sold will not fall significantly. For this reason a decrease in price will not result in a big enough increase in quantity demanded for total revenue to increase, and it will fall instead.
> For a unitary elastic curve, a change in price does not affect total revenue.
PED = -0.5 . The firm currently sells 10,000 products at a price of £5. What will happen to total revenue if the price falls to £4?
Original total revenue -> £50,000 % change in price -> 20% So -0.5 = Q / -20% So Q = 10% New output is therefore 11,000 New total revenue is £44,000 So total revenue has decreased by £6,000
Numerical values of YED:
> An inferior good is when YED < 0 - a rise in income will lead to a fall in demand for the good. Consumers will switch to more expensive goods when incomes rise.
A normal good is when YED > 0 - a rise in income will lead to a rise in demand for the good.
A luxury good is when YED > 1 - it is a normal good with income elastic demand.
Can still be elastic or inelastic, they are inelastic when -1 < YED < 1
Significance of YED:
> It’s important for firms to know how sales will be affected by changes in income.
It may have an impact on the type of goods a firm produces. During times of prosperity when incomes are rising, firms may produce fewer inferior goods and more luxury goods, because demand for them is rising.
Numerical values of XED
> Substitutes are where XED > 0, an increase in the price of good B will increase demand for good A.
Complementary goods are where XED < 0, an increase in the price of good B will decrease demand for good A.
Unrelated goods are where XED = 0, a change in price of good B has no impact on good A.
The size of the integer represents the strength of the relationship. The larger the number, the stronger the relationship.
Significance of XED
Firms need to be aware of their competition and those producing complementary goods.
They have to know how price changes by other firms will impact them so they can respond appropriately.
