3.2 Price, Income And Cross Elasticities Of Demand

Question 1

What is the price elasticity of demand?
Give the formula

Answer 1

• The price elasticity of demand is the responsiveness of a change in demand to a
  change in price.
• The formula for this is: percentage change in quantity demanded/ percentage change in price
• %∆QD / %∆P

Question 2

How responsive is a price elastic good to a change in price?

Answer 2

• A price elastic good is very responsive to a change in price.
• In other words, the change in price leads to an even bigger change in demand.
• The numerical value for PED is >1- a good with this value is price elastic

Question 3

How responsive in an inelastic good to a change in price?

Answer 3

• A price inelastic good has a demand that is relatively unresponsive to a change in price.
• PED is <1- a good with this value is price inelastic

Question 4

What is a unitary elastic good?

Answer 4

• A unitary elastic good has a change in demand which is equal to the change in price.
• PED = 1.

Question 5

What is a perfectly inelastic good?

Answer 5

• A perfectly inelastic good has a demand which does not change when price changes.
• PED = 0.

Question 6

What is a perfectly elastic good?

Answer 6

• A perfectly elastic good has a demand which falls to zero when price changes.
• PED = infinity.

Question 7

What factors influence PED?

Answer 7

• Necessity
• Substitutes
• Addictiveness or habitual consumption
• Proportion of income spent on the good
• Durability of the good
• Peak and off-peak demand

Question 8

Factors influencing PED- necessity

Answer 8

• A necessary good, such as bread or electricity, will have a relatively inelastic demand.
• In other words, even if the price increases significantly, consumers will still demand bread and electricity, because they need it.
• Luxury goods, such as holidays, are more elastic.
• If the price of flights increases, the demand is likely to fall significantly.

Question 9

Factors influencing PED- substitutes

Answer 9

• If the good has several substitutes, such as Android phones instead of iPhones, then the demand is more price elastic.
• The elasticity can also change within markets.
• The closer and more available the substitutes are, the more price elastic the demand.
• Elasticity also changes in the long and short run.
• In the long run, consumers have time to respond and find a substitute, so demand becomes more price elastic.
• In the short run, consumers do not have this time, so demand is more inelastic.

Question 10

Factors influencing PED-Addictiveness or habitual consumption

Answer 10

• The demand for goods such as cigarettes is not sensitive to a change in price because consumers become addicted to them, and therefore continue demanding the cigarettes, even if the price increases.

Question 11

Factors influencing PED-Proportion of income spent on the good

Answer 11

• If the good only takes up a small proportion of income, such as a magazine which
  increases in price from £1.50 to £2, demand is likely to be relatively price inelastic.
• If
  the good takes up a significant proportion of income, such as a car which increases in
  price from £15,000 to £20,000, the demand is likely to be more price elastic.

Question 12

Factors influencing PED- durability of the good

Answer 12

• A good which lasts a long time, such a washing machine, has a more elastic demand because consumers wait to buy another one.

Question 13

Factors influencing PED- peak and off-peak demand

Answer 13

• During peak times, such as 9am and 5pm for trains, the demand for tickets is more
  price inelastic.

Question 14

Elasticity of demand and tax revenue

Answer 14

• The burden of an indirect tax will fall differently on consumers and firms,
  depending on if the good has an elastic or inelastic demand.
• If a firm sells a good with an inelastic demand, they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause
  demand to fall significantly.
• If a firm sells a good with an elastic demand, they are likely to take most of the tax burden upon themselves.
• This is because they know if the price of the good increases, demand is likely to fall, which will lower their overall revenue.

-This is not as effective for raising government revenue, but if a government wants to reduce the demand of a particular good, it is effective.
- Demand will fall significantly

Question 15

Elasticity of demand and subsidies:

Answer 15

• A subsidy is a payment from the government to firms to encourage the production of a good and to lower their average costs.
• It has the opposite effect of a tax because it increases supply.
• The benefit of the subsidy can go to both the producer, in the form of increased revenue or to the consumer, in the form of lower prices

Question 16

What is the relationship between PED and total revenue?

Answer 16

• Total revenue is equal to average price times quantity sold.
• TR= P x Q
• If a good has an inelastic demand, the firm can raise its price, and quantity sold will not fall significantly
• This will increase total revenue

-If a good has an elastic demand and the firm raises its price, quantity sold will fall.
-This will reduce total revenue.

Question 17

What is income elasticity of demand?

Answer 17

• Income elasticity of demand is the responsiveness of a change in demand to a
  change in income.
• The formula for this is:
• %∆Qd / %∆income

Question 18

What are inferior goods?

Answer 18

• Inferior goods are those which see a fall in demand as income increases.
• For example, the ‘value’ options at supermarkets could be seen as inferior.
• As income increases, consumers switch to branded goods. YED < 0.

Question 19

What are normal goods?

Answer 19

• With normal goods, demand increases as income increases.
• YED >0.

Question 20

What are luxury goods?

Answer 20

• With luxury goods, an increase in income causes an even bigger increase in demand.
• YED > 1
• For example, a holiday is a luxury good.
• Luxury goods are also normal goods, and they have an elastic income.

Question 21

Why might people switch between inferior, normal, luxury goods?

Answer 21

• During periods of prosperity, such as economic growth when real incomes are rising, firms might switch to producing more luxury goods and fewer inferior goods, because demand for luxury goods will be increasing.

Question 22

What is cross elasticity of demand?

Answer 22

• Cross elasticity of demand is the responsiveness of a change in demand of one good, X, to a change in price of another good, Y
• The formula for this is:
• %∆Qd of good x / %∆ of good Y

Question 23

What are complements?

Answer 23

• Complementary goods have a negative XED.
• If one good becomes more expensive, the quantity demanded for both goods will fall.
• Close complements: a small fall in the price of good X leads to a large increase in QD of Y.
• Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y.

Question 24

What are substitutes?

Answer 24

• Substitutes can replace another good, so the XED is positive and the demand curve is upward sloping.
• If the price of one brand of TV increases, consumers might switch to another brand.
• Close substitutes: a small increase in the price of good X leads to a large
  increase in QD of Y
• Weak substitutes: a large increase in the price of good X leads to a smaller
  increase in QD of Y

Question 25

What are unrelated goods?

Answer 25

• Unrelated goods have a XED equal to zero.
• For example, the price of a bus journey has no effect on the demand for tables.

Question 26

Why are firms interested in XED?

Answer 26

• Firms are interested in XED because it allows them to see how many competitors
  they have.
• Therefore, they are less likely to be affected by price changes by other firms, if they are selling complementary goods or substitutes.