1.2.3 Price, income and cross elasticities of demand Flashcards
What is PED?
Price elasticity of demand (PED) measures responsiveness of quantity demanded after a change in the good’s own price.
The formula is Percentage change in quantity demanded/Percentage change in price
Explain how to interpret the coefficient of PED
- If Ped = 0, demand is perfectly inelastic – quantity demanded does not change at all when the price
changes – the demand curve will be vertical. - If Ped is between 0 and -1 (the % change in quantity demanded is smaller than the percentage change
in price), demand is price inelastic i.e. quantity demanded is not particularly responsive / sensitive to
price changes. - If Ped = -1 (the % change in quantity demanded is exactly the same as the % change in price), demand
is unit price elastic. A 15% rise in price would lead to a 15% contraction in quantity demanded leaving
total spending on the good exactly the same. - If Ped is between -1 and -∞, quantity demanded responds more than proportionately to a change in
price i.e. demand is price elastic. For example, if a 10% increase in the price of a good leads to a 30%
drop in quantity demanded, the price elasticity of demand for this price change is –3 - If Ped = -∞ then demand is perfectly elastic – quantity demanded will fall to zero if the price rises –
the demand curve will be horizontal
Explain the 4 factors affecting PED
- Number of close substitutes – the more substitutes there are in the market, the more elastic is demand
because consumers find it easy to switch. For example, air travel and train travel are weak substitutes
for inter-continental flights but closer substitutes for journeys of 200-400km between major cities. - Cost of switching between products – there may be costs involved in switching. In this case, demand
tends to be inelastic. For example, mobile phone service providers may require a contract which has
the effect of locking-in some consumers once a choice has been made. - Degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand
whereas luxuries tend to have a more elastic demand. An example of a necessity is rare-earth metals
that are an essential raw material in the manufacture of solar cells, batteries. Another example might
be essential medicines such as insulin for people with diabetes. - Whether the product is subject to habitual consumption – consumers become less sensitive to the
price of the good when they buy something out of habit (it has become the “default choice”).
What happens to revenue when demand is price inelastic?
When demand is price inelastic, a rise in price leads to a rise in total revenue – for example, 20% rise
in price might cause quantity demanded to contract by only 5% (PED = -0.25). So, the rise in price is
more than proportional to the fall in quantity demanded, and so total revenue will rise.
What happens to revenue when demand is price elastic?
When demand is price elastic, a fall in price leads to a rise in total revenue - for example, a 10% fall
in price might cause quantity demanded to expand by a much larger 25% (PED = +2.5). The rise in
quantity demanded is proportionately greater than the fall in price, and so total revenue will rise.
What happens to revenue when demand is perfectly inelastic?
a given price change will result in the same
revenue change, for example, a 5% increase in a firm’s prices results in a 5% increase in its total
revenue
What happens to revenue when demand is perfectly inelastic?
When demand is unit elastic (i.e. PED = -1) a change in the price leads to no change at all in the
revenue
What does inelastic demand look like?
What does elastic demand look like?
How can firms use PED estimates?
Firms can use PED estimates to predict:
* Effect of a change in price on total revenue of sellers
* Price volatility in a market following changes in supply – this is important for commodity producers who
suffer big price and revenue shifts from one time period to another.
* Effect of a change in an indirect tax on price and quantity demanded and also whether the business is
able to pass on some or all of the tax onto the consumer.
- Usually a business will aim to charge a higher price to consumers whose demand is price inelastic (Ped<1)
- Arguably, businesses are keen to make demand for their goods and services more price inelastic
What is income elasticity of demand?
Income elasticity of demand (YED) measures the responsiveness of demand following a change in real income. The formula used for calculating income elasticity of demand is: Percentage change in demand divided by the percentage change in income
What are normal goods?
Normal goods have a positive income elasticity of demand so as consumers’ income rises, more is demanded at each price i.e. there is an outward shift of the demand curve
What are normal necessities?
Economists usually describe normal necessities as having an income elasticity of demand of between 0 and
+1 for example, if income increases by 10% and demand for fresh fruit increases by 4%, income elasticity is
+0.4. Demand is rising less than proportionately to income – demand is income inelastic
What are luxury goods and services?
Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionately to a change in income – for example an 8% increase in income might lead to a 10% rise in
demand for new kitchens. Income elasticity of demand in this example is +1.25. Demand is income elastic.
Explain what inferior goods are
Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises.
Typically, inferior goods or services exist where superior goods are available if a consumer has money to be
able to buy it. Examples include own label foods in supermarkets and
demand for council-owned rented properties.
