1.2.3 - price, income and cross elasticities of demand Flashcards
What does price elasticity of demand (PED) measure?
It measures the responsiveness of the quantity demand of a good or service to a change in its price.
What does PED help us understand in simpler terms?
It helps us understand how sensitive consumer demand is to changes in price.
What is the formula for calculating PED?
PED = (%∆QD)/(%∆P), where %∆ = (difference/original) * 100.
Why is PED always negative?
PED is negative because quantity demanded is inversely related to price.
What is the range of values for PED?
The values of PED range from 0 to -∞, with a mid-value of -1.
What is the effect of a large number of close substitutes on PED?
A large number of close substitutes increases the price elasticity of demand.
How does the cost of switching between products affect PED?
Higher switching costs tend to reduce the elasticity of demand.
What is the impact of necessity or luxury on PED?
Necessities have inelastic demand, while luxury goods tend to have more elastic demand.
How does the proportion of income allocated to a good affect its PED?
Goods that take up a large proportion of income tend to have more elastic demand.
How does the time period allowed for consumers to respond affect PED?
The longer the time period, the more elastic the demand.
What effect does habitual consumption have on PED?
Habitual consumption tends to make demand more inelastic.
How does brand loyalty affect PED?
Brand loyalty makes demand more inelastic.
What is the effect of peak and off-peak demand on PED?
Demand tends to be more elastic during off-peak times and more inelastic during peak times.
How does the breadth of definition of a good or service affect its PED?
A broadly defined good or service tends to have more inelastic demand.
How does the method of payment (cash vs. digital) affect PED?
Different payment methods can affect consumer perception of cost and influence demand elasticity.
What is elastic demand?
Elastic demand is when quantity demanded is very responsive to price changes.
What is the PED value for elastic demand?
The % change in QD is greater than the % change in P; the value is between -1 and -∞.
What is perfectly elastic demand?
PED = -∞, meaning a small price change will lead to an infinite change in quantity demanded as a change in supply will not lead to any change in equilibrium market price (highly competitive markets where supplier has no pricing power, charge same to buyers)
A change in price causes output to fall to zero
What is inelastic demand?
Inelastic demand is when quantity demanded is not very responsive to price changes.
What is the PED value for inelastic demand?
The % change in QD is less than the % change in P; the value is between 0 and -1.
Why do necessities like food and medicine have inelastic demand?
Because consumers are less likely to change their purchasing behavior even if prices change significantly.
What is perfectly inelastic demand?
PED = 0, meaning consumers are willing to pay any price for the product, a change in price has no affect on output so demand is completely unresponsive to price
What does unitary or unit demand signify?
Unitary demand occurs when PED = -1, meaning the % change in QD is the same as the % change in P.
Why does PED change along a demand curve?
PED changes along a demand curve because it is calculated using proportionate changes, not absolute changes.
What happens to PED at the top half of a demand curve?
The % change in QD is greater than the % change in P, showing elastic figures at high prices.
What happens to PED at the bottom half of a demand curve?
The % change in QD is less than the % change in P, showing inelastic figures at low prices.
Where is PED = -1 on the demand curve?
PED = -1 at the midpoint of the demand curve.
How does PED impact total revenue (TR) when demand is elastic?
A rise in P leads to a more than proportionate fall in QD, so TR falls. A fall in P leads to a more than proportionate rise in QD, so TR rises.
How does PED impact total revenue (TR) when demand is inelastic?
A rise in P leads to a less than proportionate fall in QD, so TR rises. A fall in P leads to a less than proportionate rise in QD, so TR falls.
What are the factors which make PED change overtime?
- Changes in addictivity (alcohol): as people become more addicted, demand becomes less sensitive to price changes.
- Availability of substitutes: if more substitutes are available, demand becomes more responsive to price changes.
- Accessibility/feasibility of complements: easier access to complementary goods can increase demand, making it more sensitive to price changes.
- Cost of switching (tied to contracts): higher switching costs make demand less responsive to price changes because people are locked in.
- Lack of rationality: when people make irrational decisions, demand may not respond logically to price changes.
What does income elasticity of demand measure?
The responsiveness of quantity demanded to a change in income
What is the formula for income elasticity of demand?
YED = (%∆QD)/(%∆Y), where %∆ = (difference/original) * 100.
What are inferior goods?
When quantity demanded decreases as incomes rises (e.g. own-brand products, boxed and canned food, low quality clothing)
What is the YED value of inferior goods?
YED between -∞ and 0, all inferior goods have negative YED
What happens to YED during a recession?
Demand for inferior goods increases
What is the YED value for normal goods?
YED between 0 and +∞, all normal goods have positive YED
What are normal goods?
When quantity demanded increases as incomes rise
What is a necessity?
When quantity demanded is not very responsive to changes in income, as the quantity needed is the same regardless of income
What is the YED value for normal goods?
YED between 0 and +1, demand is income inelastic
What is a luxury good?
When quantity demanded responds greatly to income changes as people are likely to want more as their incomes rise and easily avoid purchasing if incomes decrease
What is the YED value for a luxury good?
YED between +1 and +∞, demand is income elastic
When is demand for goods perfectly income inelastic?
When YED = 0
What does cross elasticity of demand measure?
The responsiveness of quantity demanded of good x to a change in price of good y, where the integer represents the strength of the relationship
What is the formula for cross elasticity of demand?
XED = (%∆QD of good x)/(%∆P of good y), where %∆ = (difference/original) * 100.
What are complementary goods?
Goods which go hand-in-hand
What is the XED value for complementary goods?
XED is negative and between -∞ and 0, as an increase in price leads to a decrease in price for its complement
What do different XED values represent for complementary goods?
- Higher the coefficient of XED (ignoring the negative sign), the closer/stronger complements as consumers are likely to change consumption of a good due to change in price of another good
- Strong complementary goods have XED between -∞ and -1, demand between goods is price elastic
- Weak complementary goods have XED between -1 and 0, demand between goods is price inelastic
What are substitute goods?
Goods which are in direct competition with each other
What is the XED value for substitute goods?
XED is positive and between 0 and +∞, as an increase in price leads to increase in demand for substitute
What do different XED values represent for substitute goods?
- Higher the coefficient of XED, closer/stronger substitutes as consumers are more likely to switch to a substitute when there is a change in price
- Strong substitute goods have XED between +1 and +∞, price between goods is price elastic
- Weak substitute goods have XED between 0 and +1, price between goods is price inelastic
What is the XED value for goods which are unrelated?
XED = 0, demand between goods is perfectly price inelastic
