2.5: Price and income Elasticity Of Demand Flashcards
Elasticity of demand
Responsiveness of quantity demanded for a good due to a change in factor that affects demand
Demain is price/income elasticity if…
A small change in price or income leads to a large change in demand
Price elastic demand
- relatively small change in prices causes a larger percentage change in the quantity demanded
- customers are highly sensitive to price changes
- more incentive to switch to substitutes
Price inelastic demand
Small change in price causes a smaller proportionate change in quantity demanded
Price elasticity of demand (PED)
- measures degree of responsiveness of quantity demanded following a change in the price of a product
- percentage change in quantity demanded /divided/ percentage change in price
Percentage change formula
(New figure - old figure) x 100
Divided by old figure
PED > 1
Demand is price elastic
PED <1
Demand is price inelastic
Degrees of PED
1) PED = 0 (perfectly inelastic)
2) PED = infinite (perfectly elastic)
3) PED = 1 (unitary price elastic demand)
Perfectly inelastic
- demand curve is vertical
- change in price has no impact on quantity demanded
- theoretical extreme
- the product has no substitutes
Perfectly price elastic
- demand curve is horizontal
- demand exists at one price only
- theoretical extreme
- customers switch to substitutes that are perfect and accessible
Unitary elasticity of demand
- curve is directly proportional
- given price change leads to the same percentage change in quantity demanded
- changing price leads to no change in revenue
PED along a regular demand curve
- value of PED increases as price rises as demand is pore responsive when price accounts for a larger potion of income
- at the midpoint PED = 1
- above the midpoint the PED = >1
- below the midpoint PED = <1
Determinants of PED
- acronym = TINS
- T time period
- I income portion spent
- N degree of necessity
- S number and closeness of substitutes
Time period as a PED determinant
- over time a good becomes more elastic
- consumers have time to find substitues, firms have time to develop substitutes
- increased durability = decreased elasticity (they last, you dont need to buy a new one)
Portion of income as a determinant of demand
- Ceteris paribus, the greater the proportion os the consumers real income spent on a product, the more price elastic it will be
Degree of Necessity and PED
- essential products tend to be more inelastic
- luxury goods are more elastic
- degree of necessity can be subjective ( trends, staples and preferences, addiction)
Substitutes and PED
- the greater the number and availability of close substitutes, the higher the PED value
- some companies use trademarks and non-compete clauses to restrict number of substitutes + innovation
Relationship between PED and total revenue
- Value of PED shows how a firms revenue will change if they change the price of a product
- elastic demand = increased revenue by decreasing price
- inelastic demand = increased revenue by increasing price
Elasticity of demand and decision makers
- PED informs decision makers on effect of price changes on sales revenue
- firms can employ price discrimination or dynamic/ surge pricing to capitalize off of fluctuating elasticity
- government used PED to determine taxation policies
Sales revenue formula
Price x quantity traded
PED and taxation
- heavy taxes on demerit good that are often inelastic (alcohol, gambling, cigs)
- dissuade use + high tax revenue
Primary goods and PED
- raw materials
- inelastic
- lack close substitutes
- necessity is high
- small proportion of income vs labour and capital
Manufactured goods PED
- relatively elastic
- degree of necessity is lower
- large proportion of income
- more durable, dont need frequent replacement
Income elasticity of demand
Measures the degree of responsiveness of demand following a change in income
YED formula
Percentage change in quantity demanded /divided by/ percentage change in income
Income elastic demand
- responsive to income change
- YED > 1
- percentage change in quantity demanded is greater than percentage change in income
- luxury goods and services
Income inelastic demand
- demand not responsive to income change
- percentage change in quantity demanded is greater than percentage change in income
- necessities + staple goods
YED negative value
- inferior good
- demand increases when income decreases
YED positive value
- normal goods
- necessities and luxuries
- demand increases as income increases
YED and sectoral change in economy
- primary sector not impacted by income fluctuations
- as country income increases, economy will move towards manufactured sector
