LS 15 And 16 Flashcards
What is cross elasticity of demand(XED)?
Measures the responsiveness of demand for one good to a change in the price of another good
XED = % change in demand for good A
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%change in price for good B
Which goods have which XED’s?
Substitute goods have a positive XED
Complement goods have negative XED
Unrelated goods have 0 XED
Define income elasticity of demand(YED)
Measures the responsiveness of demand for a good to a change in real income
YED = %change in demand
%change in income
Which goods have which YED’s?
Income in elastic goods like necessities had a YED between 0 and 1
Elastic goods have a YED above 1 (normal goods)
Inferior goods have a negative YED
What is a normal good?
If income rises, demand for it rises so it has a positive YED
What is an inferior good?
As income rises, demand for it falls so rising income leads to inferior goods being replaced by normal goods
They have a negative YED
What are the uses of YED?
1) can be used for sales forecasting if YED and change in income is known, demand changes can be predicted
2) pricing: price of normal goods can be reduced if income is expected to fall
3) during a boom demand for a product with high YED will rise but would fall during a recession so firms may choose to supply products with a low YED so demand doesn’t fall
4) if firms know the XED, they know how to react to changes in price of complements and substitutes so they can maximise profit
5) governments can use when setting policies, eg if incomes fall demand for buses may rise
What is price?
The value of goods and services exchanged
What is price mechanism?
The means by which decisions of consumers and producers interact to determine the allocation of resources
Price changes until equilibrium is met
What are the 3 functions of price mechanism?
Signalling: changes in price show changes in supply and demand which signals to producers and consumers that the market is changing
Incentive: when there is an increase in demand, it leads to a price rise which encourages firms to produce more to maximise profit
Rationing: if there is high demand causing excess demand or a shortage, price will rise to deter customers and reduce demand
Answer for when there is excess supply
Signal sent to producers that life is too high(excess stock)
Incentive to lower price so that excess supply is liquidated so profits can be made
There is a contraction in supply and an extension in demand until the excess supply has been rationed away
A new equilibrium is reached with perfect allocation
What happens to revenue if there is a decrease in price?
For an elastic good, revenue increases (as demand rises)
For an inelastic good, revenue decreases (as demand doesn’t rise as much)
What happens to revenue if there is an increase in price?
If demand is price elastic, revenue falls
If demand is price inelastic, revenue rises
Answer for signalling function:
If there is excess supply, equilibrium price has to fall. The excess supply signals to producers that there is lower demand than supply so they have to reduce price to liquidate their stock
The lower price decreases the incentive for producers to produce more so they will reduce supply
How does price elasticity vary along the demand curve?
The top half is elastic, the bottom half is inelastic, the middle has unit elasticity
