1.2.3 - price, income and cross elasticities of demand

Question 1

How do you calculate PED?

Answer 1

% change in quantity demanded / % change in price

Question 2

What is PED?

Answer 2

A measure of the responsiveness of quantity demanded to a change in price.

Question 3

Why is PED almost always negative?

Answer 3

The Law of Demand says there is an inverse relationship between price and quantity demanded.

Question 4

How do economists determine the elasticity from the value of PED?

Answer 4

E > 1 elastic
E < 1 inelastic
E = 1 unit elastic

Question 5

What does perfectly elastic mean?

Answer 5

The percentage change in quantity demanded is infinite.
Value - infinity
Graph - horizontal line from the y axis

Question 6

What does elastic mean?

Answer 6

The percentage change in quantity demanded is greater than the percentage change in price.
Value > 1
Graph - Downwards sloping from the y axis

Question 7

What does unit elastic mean?

Answer 7

The percentage change in quantity demanded is equal to the percentage change in price
Value = 1
Graph - Reciprocal graph

Question 8

What does inelastic mean?

Answer 8

The percentage change in quantity demanded is less than the percentage change in price
Value < 1
Graph - Sloping downwards from x axis

Question 9

What does perfectly inelastic mean?

Answer 9

There is no change in quantity demanded
Value = 0
Graph - Vertical line from the x axis

Question 10

What factors determine the PED?

Answer 10

TWIST
T - type of good
W - width of definition
I - income
S - substitutes
T - time

Question 11

How does type of good affect the PED?

Answer 11

Habit forming goods eg. cigs have inelastic PEDs, the buyer is de-sensitised to changes in price
Necessities have inelastic PED as price rises only marginally reduce consumption of basic items
Luxuries have elastic PED as consumers are more likely to react to price changes of non-essential items

Question 12

How does width of definition affect PED?

Answer 12

The broader the definition (more substitutes), the more inelastic the PED.

Question 13

How does income affect PED?

Answer 13

The smaller the proportion of income spent on a good/service the more inelastic the PED.

Question 14

How do substitutes affect PED?

Answer 14

The number, closeness and availability of substitutes influence PED. A large number of substitutes make the PED more elastic but a lack of substitutes make the PED more inelastic.

Question 15

How does time affect PED?

Answer 15

PED tends to be more elastic in the long run as it takes time for consumers to adjust spending habits and find alternatives. PED is inelastic in the short run. Also, more substitutes can be developed over time.

Question 16

How does changing the price affect the total revenue of an inelastic good?

Answer 16

Increasing price = increased total revenue
Decreasing price = decreased total revenue

Question 17

How does changing the price affect the total revenue of an elastic good?

Answer 17

Increasing price = decreased total revenue
Decreasing price = increased total revenue

Question 18

What is XED?

Answer 18

Measures the responsiveness of quantity demanded of one good to a change in price of another.

Question 19

How do you calculate XED?

Answer 19

% change in quantity demanded of A / % change in price of B

Question 20

What type of XED do complements and substitutes have?

Answer 20

Substitutes have a positive XED, complements have a negative XED.

Question 21

What is joint demand?

Answer 21

Complements are jointly demanded. A change in the price of one will cause a change in demand of the other.

Question 22

What is competitive demand?

Answer 22

Close substitutes are in competitive demand. Demand for one varies directly with price of the other. eg. a decrease in the price of margarine causes a fall in the demand for butter

Question 23

What is composite demand?

Answer 23

A good/service is said to be in composite demand when its required for different uses. eg. increased demand for blankets (wool) will impact the price of wool socks.

Question 24

What is joint supply?

Answer 24

Production of one good automatically leads to production of another. eg. production of lamb leads to supply of wool. An increase in demand for one causes a fall in price of the other

Question 25

What is YED?

Answer 25

Measures the responsiveness of quantity demanded to a change in income.

Question 26

How do you calculate YED?

Answer 26

% change in quantity demanded / % change in income

Question 27

How do you find the income elasticity from the value?

Answer 27

Normal goods have a positive YED: E > 1 elastic or a luxury E < 1 inelastic or a necessity Inferior or giffen goods have a negative YED

Question 28

What is the significance of PED for firms and governments in relation to indirect taxation and subsidies?

Answer 28

PED helps governments to understand the burden of tax on producers and consumers. For price inelastic goods, a greater proportion of tax is paid by the consumer than the producer and for subsidies, there is a greater fall in price for consumers than producers for inelastic goods.

Question 29

What is the significance of PED for firms and governments in relation to changes in real income?

Answer 29

If real income levels fall, more elastic goods are likely to be demanded less as inelastic goods are usually necessities for consumers.

Question 30

What is the significance of PED for firms and governments in relation to changes in prices of substitutes and complements?

Answer 30

For more elastic goods, a fall in the price of substitutes will increase quantity demanded massively, whereas for inelastic goods, quantity demanded will be less affected by price changes. An increase in the price of complements will reduce quantity demanded hugely for elastic goods, however inelastic goods may have a smaller reduction in quantity demanded.

Question 31

How is total revenue calculated?

Answer 31

TR = price x quantity