1.2.3 Price, Income & Cross Elasticities of Demand

Question 1

What is income elasticity of demand (YED) ?

Answer 1

Income elasticity of demand (YED) measures the responsiveness of demand to a change in income

Question 2

How is YED calculated? What is the formula?

Answer 2

YED = percentage change in quantity demanded / percentage change in income

Question 3

What is a normal good? Does it have a positive or negative YED?

Answer 3

A normal good is a good which has a positive income elasticity. Demand for normal goods increases as incomes increase

Question 4

What are the two types of normal goods that they can be split into?

Answer 4

Normal goods can be split into luxury goods or necessity goods

Question 5

What YED does a normal necessity good have?

Answer 5

Normal necessity goods have a YED of 0 to 1. Demand increases when income increases. They are income inelastic which means that it is relatively unresponsive to a change in income.

Question 6

What YED does a normal luxury good have?

Answer 6

Normal luxury goods have a YED of greater than 1. Demand increases when income increases. They are income elastic which means that is is relatively responsive to a change in income.

Question 7

What is an inferior good? Does it have a positive or a negative YED and why?

Answer 7

An inferior good is one which has a negative income elasticity (less than 0). This is because they are goods which have higher quality substitutes. Demand decreases when income increases.

Question 8

What factors influence the YED of goods/services?

Answer 8

YED is influenced by any factors in an economy which change the wages of workers.
- During a recession wages usually fall and demand for inferior goods rises and luxury goods falls
- During a period of economic growth and rising wages, demand for luxury goods increases and demand for inferior goods decreases
- Other influences on incomes include minimum wage legalisation, taxation, and increased international trade.

Question 9

What is Cross Price Elasticity of Demand? (XED)

Answer 9

Cross price elasticity of demand (XED) measures the responsiveness of demand for good A to a change in price of good B

Question 10

How is XED calculated? What is the formula?

Answer 10

XED = percentage change in quantity demanded of good A / percentage change in price of good B

Question 11

What are complementary goods? Do they have positive or negative XED?

Answer 11

A complementary good is a good which adds value to another good when they are consumed together. They have a negative XED (less than 0). A rise in price leads to a fall in demand for a complementary good.

Question 12

What are substitutes? Do they have positive or negative XED?

Answer 12

Substitutes are two alternative goods that could be used for the same purpose. They have a positive XED (greater than 0). A rise in price leads to a rise in demand for a substitute.

Question 13

What are unrelated goods? What XED do they have?

Answer 13

Unrelated goods are ones which have no relationship to each other (e.g. mushrooms and cars). They have a XED of close to zero (0).

Question 14

How can we tell the strength of the relationship between two goods?

Answer 14

• For substitutes the more positive the value, the stronger the relationship.
• For complements the more negative the value , the stronger the relationship
• For unrelated goods, the closer to 0, the weaker the relationship

Question 15

What could businesses do if their good is a complement?

Answer 15

• They could ‘bundle’ them together and sell them as a package, eg meal deals
• They could take over businesses that sell the complements or work more closely with them

Question 16

What could businesses do if their good is a substitute?

Answer 16

• They could use brand proliferation to weaken the degree of substitutability
• They could engage in heavy advertising or price wars

Question 17

How is knowledge of PED important to firms seeking to maximise their revenue?

Answer 17

• If their product is price inelastic in demand, they should raise prices
• If their product is price elastic in demand, then they should lower their prices

Question 18

How is knowledge of PED important to governments with regard to taxation and subsidies?

Answer 18

• If govs tax price inelastic in demand products, they can raise tax revenue without harming firms too much - Consumers are less responsive to price changed to firms will pass on the tax to the consumer
• If they subsidise price elastic in demand products, there can be a greater than proportional increase in demand

Question 19

How is knowledge of XED important to firms who aim to maximise revenue?

Answer 19

• It can help them adjust pricing strategies for substitutes and complements
• It can help them understand the likely impact of competitors’ pricing strategies on their sales

Question 20

How is knowledge of YED important to firms as they seek to maintain sales and maximise profits through periods of recession or economic growth?

Answer 20

• Firms should consider providing more inferior goods in a recessionary environment as households will have less to spend due to falling incomes
• Firms should consider providing more luxury goods during periods of economic growth as households will have more to spend due to rising incomes