4.1.2.2 Price, income and cross elasticities of demand Flashcards
What is price elasticity of demand (PED)?
PED measures the responsiveness of quantity demanded to a change in price. The formula is:
PED = % change in quantity demanded / % change in price
What does a PED > 1 indicate?
A PED > 1 indicates that the good is price elastic, meaning demand is highly responsive to price changes.
What does a PED < 1 indicate?
A PED < 1 indicates that the good is price inelastic, meaning demand is relatively unresponsive to price changes.
What does a PED = 1 indicate?
A PED = 1 indicates unitary elasticity, where the percentage change in quantity demanded equals the percentage change in price.
What does a PED = 0 indicate?
A PED = 0 indicates perfectly inelastic demand, where quantity demanded does not change regardless of price changes.
What does a PED = infinity indicate?
A PED = infinity indicates perfectly elastic demand, where demand falls to zero if the price changes even slightly.
How is PED calculated?
PED is calculated using the formula:
PED = % change in quantity demanded / % change in price
For example, if the price of bread increases by 15% and demand falls by 20%, PED = -20% / 15% = -1.33 (price inelastic).
What factors influence PED?
Factors influencing PED include:
- Necessity (necessities are inelastic, luxuries are elastic).
- Availability of substitutes (more substitutes = more elastic).
- Addictiveness or habitual consumption (addictive goods are inelastic).
- Proportion of income spent on the good (small proportion = inelastic).
- Durability of the good (durable goods are more elastic).
- Peak and off-peak demand (peak demand is inelastic).
How does PED affect total revenue?
Inelastic demand (PED < 1): Increasing price raises total revenue.
Elastic demand (PED > 1): Increasing price reduces total revenue.
Unitary elasticity (PED = 1): Total revenue remains unchanged.
What is income elasticity of demand (YED)?
YED measures the responsiveness of demand to a change in income. The formula is:
YED = % change in quantity demanded / % change in income
What does YED > 0 indicate?
YED > 0 indicates a normal good, where demand increases as income rises.
What does YED < 0 indicate?
YED < 0 indicates an inferior good, where demand decreases as income rises.
(e.g., value-brand goods).
What does YED > 1 indicate?
YED > 1 indicates a luxury good, where demand increases more than proportionally as income rises.
(e.g., holidays).
What is cross elasticity of demand (XED)?
XED measures the responsiveness of demand for one good (X) to a change in the price of another good (Y). The formula is:
XED = % change in quantity demanded of X / % change in price of Y
What does XED > 0 indicate?
XED > 0 indicates substitute goods, where an increase in the price of Y leads to an increase in demand for X.
(e.g., iPhones and Android phones).
What does XED < 0 indicate?
XED < 0 indicates complementary goods, where an increase in the price of Y leads to a decrease in demand for X.
(e.g., strawberries and cream).
What does XED = 0 indicate?
XED = 0 indicates unrelated goods, where the price of Y has no effect on the demand for X.
(e.g., bus journeys and tables).
How does PED affect the burden of indirect taxes?
Inelastic demand: Most of the tax burden falls on consumers, as demand does not fall significantly when prices rise.
Elastic demand: Most of the tax burden falls on producers, as demand falls significantly when prices rise.
How do subsidies affect supply and demand?
Subsidies increase supply, lowering prices for consumers and increasing revenue for producers. The benefit is shared between producers and consumers.
Why are firms interested in XED?
Firms use XED to understand competition and the impact of price changes by other firms. It helps them identify substitutes and complements in the market.
What is the relationship between YED and economic growth?
During economic growth (rising incomes), demand for luxury goods (YED > 1) increases, while demand for inferior goods (YED < 0) decreases.
What is the difference between close and weak substitutes?
Close substitutes: A small price increase for X leads to a large increase in demand for Y.
Weak substitutes: A large price increase for X leads to a small increase in demand for Y.
What is the difference between close and weak complements?
Close complements: A small price decrease for X leads to a large increase in demand for Y.
Weak complements: A large price decrease for X leads to a small increase in demand for Y.
How does PED influence government tax revenue?
Goods with inelastic demand are more effective for raising tax revenue, as demand does not fall significantly when prices rise. Goods with elastic demand are less effective for raising revenue but can reduce consumption.
