1.2.3 Price, Income and Cross Elasticities of Demand Flashcards
Price elasticity of demand
a way for economists to sense how sensitive the quantity (of a good/service) is to a change in price
Price elasticity of demand equation
percentage change in quantity/percentage change in
price %△Q/%△P
Price elastic
- the quantity changes a lot for a given price change (is relatively responsive to price change)
- has a shallow demand curve
- PED>1
- percentage change in quantity is more than price change
Price inelastic
- the quantity doesn’t change much for a given price change (is relatively unresponsive to price change)
- has a steep demand curve
- PED<1
- percentage change in quantity is less than price change
What is unitary is PED?
PED = 1
Factors that affect PED
- brand loyalty
- price of good itself (absolute price)
- ability to postpone consumption (necessity)
- width of the market definition
How does the width of the market definition affect PED
the more the substitute, the higher the PED
How does brand loyalty affect PED?
Brand loyalty = low PED
How does the ability to postpone consumption (necessity) affect PED?
If it is a necessity, it’s low PED
What should PED for a normal good be?
Negative
Importance of PED for a firm
helps firms decide whether to raise or lower price
Importance of PED for indirect tax/subsidy
- It’s important to consider PED when imposing a tax
- Govt can impose higher taxes on goods with inelastic demand vice versa
- If they don’t and the prices rise, but there’s no change in real income consumers won’t be willing to pay
Relationship between PED and total revenue
- Demand elastic
- Price decline = total revenue increase
- Demand inelastic = elasticity is the same
Total revenue equation
total amount of goods x price
Ceteris Paribus
the assumption that all other factors remaining constant
Income elasticity of demand (YED)
a measure of the responsiveness of demand following a change in income
Income elasticity of demand (YED) equation
%△Q/%△ income
Income elastic
- the change in demand is more responsive than the change in income
- YED>1
- luxury goods
Luxury goods (in terms of income elasticity of demand)
Goods with higher positive value
Inferior goods (in terms of income elasticity of demand)
Goods with negative YED values
- an increase in income will lead to a fall in demand
Income inelastic
- the change in demand is less responsive than the change in income
- YED<1 (but positive e.g decimals )
- normal good
Example of an income inelastic good
necessities e.g water
Cross price elasticity of demand (XED)
a measure of the responsiveness of demand for one good following the change in price of another good
Cross price elasticity of demand (xed) equation
%△QD of good Y/%△P of good X
Complementary goods (XED)
- negative XED (downwards slope)
- if good X becomes more expensive, the quantity demanded for both good Y and X will fall
Close complements (XED)
a small fall in the price of good X, leads to a large increase in the quantity demanded of good Y
Weak complements (XED)
a large fall in the price of good X leads to only a small increase in the quantity demanded of good Y
Substitutes (XED)
- positive XED (upwards slope)
- if good X becomes more expensive, consumers will switch to a different brand
Close substitutes
a small increase in the price of good X leads to a large increase in the quantity demanded of Y
Weak substitutes
a large increase in the price of good X leads to a smaller increase in the quantity demanded of good Y
Unrelated goods (XED)
XED is 0 (nothing changes)
Negative XED
- Complementary goods
- if good X becomes more expensive, the quantity demanded for both good Y and X will fall
Positive XED
- Substitutes (XED)
- if good X becomes more expensive, consumers will switch to a different brand
Why are firms interested in XED?
- It allows them to see how many competitors they have
- So they’re less likely to be affected by price changes of other firms, if they are selling complementary goods
Advantages of brand loyalty
Brand loyalty makes demand for a firm’s products more price inelastic = allows a business to set prices higher & extract consumer surplus turning it into producer surplus.
Consumer inertia
the tendency of some customers to buy or continue buying a product, even when superior options exist
