1.2.3 Price, income and cross elasticities of demand Flashcards
Understanding of price, income and cross elasticities of demand
PED - how responsive demand is to a change in price
YED - how responsive demand is to a change in income
XED - the responsiveness of demand for one product to the change in price of another product
Use formulae to calculate price, income and cross elasticities of demand
PED = %change in quantity demanded / %change in price
YED = %change in quantity demanded / %change in income
XED = %change in quantity demanded of A / %change in price of product B
Interpret numerical values of price elasticity of demand: unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic
PED = 0 - perfectly inelastic
PED < 1 - relatively inelastic
PED = 1 - unit elastic
PED > 1 - relatively elastic
PED = infinity - perfectly elastic
Interpret numerical values of income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic
YED < 0 - inferior good
YED > 0 - normal good
YED > 1 - luxury good
elastic YED < 1 < inelastic YED
Interpret numerical values of cross elasticity of demand: substitutes, complementary and unrelated goods
XED = 0 - unrelated good
XED < 0 - complementary goods
XED > 0 - substitutes
The factors influencing elasticities of demand
- availability of substitutes
- time
- necessity
- how large of a % of total expenditure
- habitual consumption
The significance of elasticities of demand to firms and government in terms of:
the imposition of indirect taxes and subsidies
indirect taxes:
more elastic demand means that there is a lower consumer incidence and higher producer incidence of indirect tax as consumers will be very sensitive to changes in price
more inelastic demand means that there will be a higher consumer incidence and lower producer incidence as consumers will be insensitive to changes in price
however as the goal of a tax is to reduce output to reduce externalities, inelastic demand means quantity demanded will only fall by a small amount, this will make the tax ineffective
however the greater demand that normal with a tax will mean increased tax revenue for the government
subsidies:
more elastic demand means that there is a small fall in price but a large increase in quantity demanded this means the producer gains a lot extra revenue, producer gain is higher and consumer gain is lower
more inelastic demand means price falls more to see any change in quantity demanded, consumer gain is higher and producer gain is lower. this makes subsidies ineffective at increasing output
they are cheaper for the government to implement since output increases by less and so the government has to subsidise less goods
The significance of elasticities of demand to firms and government in terms of:
changes in real income
- important for businesses to know how their sales will be affected by changes in income of the population, if an economy is improving and peoples real incomes are rising it is important for a firm to know whether this will increase their sales or not
it may have an impact on the type of goods a firm produces, during times of prosperity firms may decide to produce more luxury goods and less inferior goods
The significance of elasticities of demand to firms and government in terms of:
changes in the prices of substitute and complementary goods
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
The relationship between price elasticity of demand and total revenue (including calculation)
elastic demand
- a DECREASE in PRICE leads to MORE revenue
- an INCREASE in PRICE leads to LESS revenue
inelastic demand
- a DECREASE in PRICE leads to LESS revenue
- an INCREASE in PRICE leads to MORE revenue
unitary elastic
- a change in PRICE DOES NOT AFFECT total revenue
