1.2.3 - Price, income and cross elasticities of demand

Question 1

What is the equation for PED?

Answer 1

PED = % change in quantity demanded/ % change in price

Question 2

What is the definition of PED?

Answer 2

PED measures responsiveness of change in price i.e how much does demand change when change the price

Question 3

How is percentage change calculated?

Answer 3

Old - New / Old x 100

Question 4

How is revenue calculated?

Answer 4

Price x Quantity = Revenue

Question 5

What affect does changes in prices have on revenue if the demand is elastic?

Answer 5

Price increase = less revenue
Price decrease = More revenue

Question 6

What affect does changes in prices have on revenue if the demand is inelastic?

Answer 6

Price increase = More revenue
Price decrease = Less revenue

Question 7

What are the rules for elasticity of demand and what can affect it?

Answer 7

=0 = Perfectly inelastic (price doesn’t affect demand) - Quantity demanded does not change at all as price changes
>1 = Price elastic - Quantity demanded changes by a larger % than does price
=1 = Unitary elastic - Quantity demanded changes by exactly the same % as does price
<1 = Price inelastic - Quantity demanded changes by a small % than does price
infinity = Perfectly elastic - Buyers are prepared to purchase all they can obtain at some given price but not at all at a higher price.

High the number the more price inelastic the product is. Answer will always be negative

Question 8

What does the elasticity graphs look like?

Answer 8

Question 9

What affects the price elasticity of demand?

Answer 9

Number of substitutes for a product: The more substitutes there are for a product, the easier it is for customers to purchase another product when price changes occur.

Time: The longer the period of time the more elastic the demand product become.

Whether the product is a necessity or a luxury, necessities are price inelastic, luxuries are price elastic.

The % of a consumers income allocated to spending the good. The higher the % the more elastic demand is likely to be.

The cost of switching between products, the lower the cost of switching the more elastic demand will be

Unique selling points and brand loyalty

Question 10

What are the uses of price elasticity of demand?

Answer 10

Helps firms determine the optimum price to charge

Helps firms decide if it should increase or decrease price

Can be used to calculate the impact of a change of price on sales revenue

Helps a firm decide on a non-price strategies for increasing demand. e.g. if PED is elastic the firm cannot increase revenue by increasing price. But what if it can’t lower it either due to cost levels ? Then it knows it will need to use other strategies to increase demand and shift the curve to the right to increase revenue

Question 11

What are the limitations of price elasticity of demand?

Answer 11

Values are based on estimates.

Information used to calculate PED may become outdated

Other factors may shift the demand curve cancelling the QD affect

Whilst helpful in determining revenue. It does not necessarily follow that an increase in revenue leads to more profit. PED ignores any cost data.

The elasticity is likely to change over time so the calculation is only useful in the short term.

Question 12

What does inelastic and elastic demand mean for pricing?

Answer 12

Inelastic = The business can set as high as price as possible. Also its definitely not worth considering lowering your price.

Elastic = as demand changes by more than price the business should consider lowering its prices. Increasing prices will be a bad idea.

Question 13

What is the equation for YED?

Answer 13

(Income elasticity of demand)

%change in QD/ %change in income

Question 14

What is the definition of YED?

Answer 14

YED measures how responsive quantity demanded is to changes in income i.e how much does demand change when income rise or fall.

Question 15

What are the rules for YED?

Answer 15

=0 = Perfectly income inelastic (does not affect demand)
>1 = Income inelastic
=1 = Unitary Elastic
<1 = Income inelastic
The higher the number the more income elastic the demand is

Question 16

What are normal goods?

Answer 16

Normal goods such as electricity have a +positive income elasticity less than 1. When incomes rise demand for these goods rise, When incomes fall demand for these goods fall (Income elasticity less than

Question 17

What are inferior goods?

Answer 17

Inferior goods such as own brand supermarket goods have a negative income elasticity. When incomes rise demand for these goods falls (as consumers buy higher quality alternatives) When incomes fall demand for these goods rises (consumers switch from buying higher quality alternatives) (Negative YED values are inferior)

Question 18

What are luxury goods?

Answer 18

Income elasticity is greater than 1. Demand for these increase when incomes rise and decreases when incomes fall. They are also income elastic as demand changes by a greater amount than income value over 1

Question 19

What do the sign and size say when determining what a good is?

Answer 19

Sign tells you if the product is a normal good or an inferior good.
Size tells you how elastic demand is for that product

Question 20

What do the 3 types of goods look like on a graph?

Answer 20

Question 21

What are the Uses of income elasticity?

Answer 21

Knowledge of income elasticity of demand helps firms to predict the effect of a change in consumers income on the demand for their product like an effect of a recession on demand for their goods.

Helps businesses plan ahead if recessions are expected firms might cut output.

Luxury products with high income elasticity see greater sales volatility over businesses trade and economic cycle than necessities where demand from consumers is less sensitive to changes in the cycle

Products switching. The business may be able to switch the kind of products it makes in relation to rising and falling incomes

Question 22

What are the limitations of income elasticity?

Answer 22

Values are based on estimates
Forecasting changes in demand is very difficult
Information used to calculate YED may be outdated.
Other factors may shift the demand curve cancelling the QD affect
The elasticity is likely to change over time so the calculation is only useful in the short term.

Question 23

What is the calculation for cross price elasticity?

Answer 23

XED =% change in quantity demanded of X/ % change in price of Y

Question 24

What is the definition for cross price elasticity?

Answer 24

XED measures how responsive the Quantity demanded of one good is to changes in the price of a different good

Question 25

What are the rules for cross price elasticity?

Answer 25

=0 = Perfectly cross price inelastic (a price change in one good doesn’t affect demand for the other group)
>1 = Cross price elastic
=1 = Unitary elastic
<1 = Cross price inelastic
The higher the number the more cross price elastic the demand is.

Question 26

What does the sign and size of the value tell you about the different types of goods for cross price elasticity?

Answer 26

Sign tells you if the product is a substitute good or a complementary good
Size tells you how cross price elastic demand for that good is to changes in income

Question 27

What characteristics do substitute goods posses in XED value?

Answer 27

2 goods that are substitutes will have a +positive cross elasticity/
An increase in the price of Good A will lead to an increase in the QD of Good B. A decrease in the price of good A will lead to a decrease in the QD for good B, linear relationship. Always + value

Question 28

What characteristics do complementary goods posses in XED value?

Answer 28

2 goods that are complementary will have a -negative cross elasticity
An increase in the Price of good A will lead to a decrease in the QD for good B. A decrease in the Price of good a will lead to an increase in the QD for good be. Always negative value.

Question 29

What are unrelated goods?

Answer 29

These goods will have a cross elasticity of 0. Do not affect the price or QD of each other

Question 30

What do the XED graphs look like for substitutes?

Answer 30

Question 31

What do the XED graphs look like for complementary goods?

Answer 31

Question 32

What are the uses of XED?

Answer 32

Helps to classify goods (complementary or substitutes)

Helps to determine pricing policy

Substitutes goods help businesses work out the effect of competitor cutting their prices on the demand for their goods.

Complementary goods. If firms sell 2 products it can estimate the effect of a change in price. Say 2 for 1 ticket offer in demand for popcorn ticket prices fall attracts more customers

Substitutes goods, When customers become very loyal to brand and keep buying its product again then demand will become less sensitive to price. XED will be very low. Therefore the firm should be able to charge higher prices to increase their revenue and profit.

Question 33

What are the limitations of XED?

Answer 33

Values based on estimates
Forecasting changes in demand is very difficult
Information used to calculate XED may become outdated
Other factors may shift the demand curve cancelling the QD affect
Elasticity is likely to change over time so the calculation is only useful in the short term