1.2.3 Price, income and cross elasticities of demand Flashcards
Price Elasticity of Demand (PED)
The sensitivity of demand to changes in price
Price elastic demand
Demand is more sensitive to changes in price
Price inelastic demand
Demand is less sensitive to changes in price
PED calculation
% change calculation
Elastic demand
If PED (ignoring any minus signs) is greater than 1, demand for the good is elastic.
This means a percentage change in price will cause a larger percentage change in quantity demanded.
The higher the value of PED, the more elastic demand is for the good.
Perfectly price elastic demand
Perfectly elastic demand has a PED of infinity and any increase in price means that demand will fall to zero. Consumers are willing to buy all they can obtain at price level, but none at a higher price.
Graph showing perfectly price elastic demand
Inelastic demand
If PED (ignoring any minus signs) is between 0 and 1, demand for the good is inelastic. This means a percentage change in price will cause a smaller percentage change in quantity demanded.
The smaller the value of PED, the more inelastic demand is for the good.
Perfectly price inelastic demand
Perfectly inelastic demand has a PED of 0 and any change in price will have no effect on the quantity demanded. At any price, the quantity demanded will be the same.
Graph showing perfectly price inelastic demand
Unit elasticity of demand
A good has unit elasticity (PED = +/- 1) if the size of the percentage change in price is equal to the size of the percentage change in quantity demanded.
For example, a 20% decrease in price will lead to a 20% increase in quantity demanded:
Key PED values
Price elastic: PED > 1
Unit price elastic: PED = 1
Price inelastic: PED < 1
Perfectly price elastic: ∞
Perfectly price inelastic: 0
Income Elasticity of Demand (YED)
The sensitivity of demand to changes in income.
What is an inferior good?
A good which demand decreases when income increases.
- Negative YED.
What is an normal good?
A good which demand increases when income increases.
- Positive YED.
Examples of normal goods
- Ordinary broadband
- Ford focus
- Holiday to Spain
- Streaming subscriptions
^ When income rises, demand for these goods increase.
Examples of inferior goods
- ‘Supermarket own brand’ goods.
- Tinned meat/spam, corned beef.
- Instant coffee.
- Bus travel.
- Butlin family holidays in Skegness.
^ When income rises, demand for these goods decrease as people buy alternatives.
What are the two types of normal goods?
- Necessity
- Luxury
Necessity good
A good which demand increases less than proportionately as income increases.
Example: Food, water, housing, electricity, etc.
Luxury good
A good which demand increases more than proportionately as income increases.
Example: Netflix TV, Organic luxury coffee, superfast broadband.
YED calculation
Veblen goods
Where demand rises as price rises. An increase in price encourages people to buy more of it. This is because they think more expensive goods are better.
- Demand rises as price rises
Examples of veblen goods
- Designer clothes
- Modern art
- Vintage wine
Demerit goods
Goods with negative externalities.
E.g. Smoking, drugs
Merit goods
Goods with positive externalities.
E.g. Education, health care
Cross Price Elasticity of Demand (XED)
The sensitivity of demand of one good to changes in the price of another good.
Substitutes (XED)
Alternative products.
They have positive XEDs. A fall in the price of one substitute (e.g. rice) will reduce the demand for another (e.g. pasta), The closer the substitute, the higher the positive XED.
What are goods if they have an XED of 0?
Independent - Unreleated goods don’t directly affect the demadn of each other - for example, bananas and iPhones.
Complements (XED)
Products which are components of a product.
They have negative XEDs. An increase in the price of a good will lead to a reduction in demand for its complements.
Calculation for XED
Determinants of elasticity
[Think SPLAT!]
Substitutes – If there are lots of alternative products, the product would likely be elastic.
Proportion of income – If a product costs a higher proportion of income, it would be elastic.
Luxury – If goods are a necessity, they will be more inelastic.
Addictiveness – If goods are addictive, they are more likely to be inelastic as people rely on it.
Time period - Over a long period of time, goods will become more elastic.
Demand for purchases that cannot be postponed (e.g. emergency plumbing services) tend to be…
Price inelastic.
Demand for products with several different uses (e.g. water) tends to be…
Price inelastic.
