1.2.3 Price, income and cross elasticities of demand

Question 1

Elasticity of demand

Answer 1

Elasticity of demand is an attempt to measure the responsiveness of quantity demanded to changes in other variables: its own price, the price of other goods and real income. If a good is elastic, it is relatively responsive and if it is inelastic, it is relatively unresponsive.

Question 2

Price elasticity of demand (PED) and calculation

Answer 2

This is the responsiveness of demand to a change in the price of the good.
% change in quantity demanded / % change in price

e.g. If the original price was £5 and 100 were sold and the new price is £3 and 120 are sold, what is the PED?
%change in quantity demanded: (20/100)×100=20%
%change in price: (-2/5)×100=-40%
PED= 20%/-40%= -1/2

Question 3

If the original price was £5 and 100 were sold and the new price is £3 and 120 are sold, what is the PED?

Answer 3

%change in quantity demanded: (20/100)×100= 20%
%change in price: (-2/5)×100= -40%
PED= 20%/-40%= -1/2

Question 4

Numerical value: PED

Answer 4

Most values of PED are negative, since a rise in price leads to a fall in output. Therefore, we look at the integer alone, disregarding the negative sign.
- Unitary elastic PED
- Relatively elastic PED
- Relatively inelastic PED
- Perfectly elastic PED
- Perfectly inelastic PED

Question 5

Unitary elastic PED

Answer 5

Where PED = 1
- quantity demanded changes by exactly the same percentage as price. This would be shown as a reciprocal curve

Question 6

Relatively elastic PED (>1)

Answer 6

Where PED>1
- quantity demanded changes by a larger percentage than price so demand is relatively responsive to price. The curve will be more sloping.

Question 7

Relatively inelastic PED (<1)

Answer 7

Where PED<1
- quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price. The curve will be steep.

Question 8

Perfectly elastic PED

Answer 8

Where PED=infinity
- a change in price has no effect on output so demand is completely unresponsive to price. This would be shown by a vertical line.

Question 9

Factors influencing PED

Answer 9

Availability of substitutes
Time
Necessity
How large of a % of total expenditure
Addictiveness

Question 10

Availability of substitutes - factors influencing PED

Answer 10

If a product has lots of substitutes (for example instead of buying Coke you could buy Pepsi), people will switch to other products when prices go up. Therefore, PED will be elastic. If there are no substitutes, then the demand curve will be inelastic since even if prices go up, people will have to buy that good if they want it as there are no alternatives.

Question 11

Time - factors influencing PED

Answer 11

The longer the time, the easier it will be for a person to find an alternative product/supplier of the product so the more elastic the good is. In the short term, many goods are inelastic as people may not even notice the price difference.

Question 12

Necessity - factors influencing PED

Answer 12

If you need something, the demand curve will be inelastic because even if the price goes up, you still need to buy it.

Question 13

How large of a % a total expenditure - factors influencing PED

Answer 13

If a good/service represents a very small percentage of a person’s expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic e.g. matches.

Question 14

Addictiveness - factors influencing PED

Answer 14

If a product is addictive, then the demand curve will be inelastic. No matter how high prices are, people will still buy the good to fulfill their addiction.

Question 15

Significance of PED to firms and the government

Answer 15

The price elasticity of demand, along with the price elasticity of supply, determine the effects of the imposition of indirect taxes and subsidies.

Question 16

Significance of PED to firms and the government: indirect taxes

Answer 16

Elastic: The more elastic the demand curve, the lower the incidence of tax on the consumer.
This means that when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax.
On diagram: With elastic demand, the demand curve is sloping. Output falls significantly and the producer burden is high.

Inelastic: When demand is inelastic, the tax will be mainly passed onto the consumer. Since consumers are relatively unresponsive to the price of this good, quantity demanded will not fall by a large amount. This means that the tax will be ineffective at reducing output. However, it also means that there is higher tax revenue for the government. The more inelastic the demand curve, the higher the tax revenue for the government.
On diagram: With inelastic demand, the demand curve is steep. The tax leads to a small fall in output but a large increase in price, with a large consumer burden. Revenue generated is higher when demand is inelastic.

Question 17

Significance of PED to firms and the government: subsidies

Answer 17

Elastic: With a subsidy, elastic demand means that the consumer sees a small fall in price whilst the producer gains a lot in extra revenue. There is a large change in output following a subsidy,
On diagram: There is a large rise in output but a small fall in price. The government has to spend more for subsidies on elastic goods.

Inelastic: The more inelastic demand, the more the price falls. There is little change in output. Therefore, subsidies on goods with inelastic demand are ineffective at increasing output. They are cheaper for the government to impose since output increases by less and so the government have to pay the subsidy on less goods.
Diagram: There is a small rise in output but large fall in price, with little producer gain.

Question 18

Relationship between PED and TR

Answer 18

• For an elastic demand curve: A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue.
• For an inelastic demand curve: A decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue.
• For a unitary elastic curve, a change in price does not affect total revenue.
Calculation:
PED= -0.5. The firm currently sells 10,000 at a price of £5. What will happen to total revenue if the price falls to £4?
Original total revenue: 10,000x£5= £50,000
%change in price: (-1/5)x100=-20%
Change in output: -0.5=Q/-20%
-0.5×20%=Q=10% (by rearranging the PED formula)
New output: 10% of 10,000=1000 10,000+1000= 11,000 (using the fact that output increases by 10%)
New total revenue: 11,000x4=44,000
Difference in revenue: 44,000-50,000 = -6,000.
Revenue will fall by £6,000.

Question 19

Relationship between PED and TR calculation

Answer 19

Q: PED= -0.5. The firm currently sells 10,000 at a price of £5. What will happen to total revenue if the price falls to £4?
Original total revenue: 10,000x£5= £50,000
%change in price: (-1/5)x100=-20%
Change in output: -0.5=Q/-20%
-0.5×20%=Q=10% (by rearranging the PED formula)
New output: 10% of 10,000=1000 10,000+1000= 11,000 (using the fact that output increases by 10%)
New total revenue: 11,000x4=44,000
Difference in revenue: 44,000-50,000 = -6,000.
A: Revenue will fall by £6,000.

Question 20

Income elasticity of demand YED

Answer 20

The responsiveness of demand to a change in income.
Calculation:
% change in quantity demanded / % change in income

Question 21

YED numerical values

Answer 21

• An inferior good is when YED<0: a rise in income will lead to a fall in demand for the good. For example, Tesco Value goods are inferior goods.
• 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 a type of normal good, when YED>1.
- Goods can also be as elastic or inelastic in income. If the integer is bigger than one, the good is elastic. If the integer is smaller than one, the good is inelastic and this tends to be necessities.

Question 22

Inferior vs Normal vs Luxury goods

Answer 22

Inferior goods - generic goods e.g. used cars, pizza, discount clothing, canned foods
Normal goods - wine, roses, cars, clothing
Luxury goods - luxury cars, watches, jewellery, designer clothing, yachts, private jets, corporate helicopters, urban mansions, country houses

Question 23

Significance of YED to firms: changes in real income

Answer 23

• It is important for businesses to know how their sales will be affected by changes in the income of the population. If the economy is improving and people’s incomes are rising it is vital that a business knows whether this is likely to increase their sales or not.
• It may have an impact on the type of goods that a firm produces. During times of prosperity, firms might produce more luxury goods and less inferior goods.

Question 24

Cross elasticity of demand XED

Answer 24

The responsiveness of demand for one product (A) to the change in price of another product (B).
Calculation:
% change in quantity demanded of A / % change in price of B

Question 25

XED numerical values

Answer 25

• Substitutes are where XED>0: an increase in the price of good B will increase demand for good A. For example, Coca Cola and Pepsi are substitutes.
• Complementary goods are where XED<0: an increase in the price of good B will decrease demand for good A. One example is DVDs and DVD players.
• Unrelated goods are where XED=0: a change in the 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 between the two.

Question 26

Significance of XED to firms: price changes

Answer 26

• Firms need to be aware of their competition and those producing complementary goods. They need to know how price changes by other firms will impact them so they can take appropriate action.