price elasticity, income elasticity and cross elasticity of demand chapter 8

Question 1

elasticity

Answer 1

numerical measure of responsiveness of one variable following a change in another variable, ceteris paribus or other things equal.

Question 2

elastic

Answer 2

where the relative change in the quantity demanded is greater than the change in price, income or the prices of substitutes and complements.

Question 3

inelastic

Answer 3

where the relative change in the quantity demanded is less than the change in price, income or the prices of substitutes and complements.

Question 4

why is the distinction between elastic and inelastic important

Answer 4

The distinction is important as it can be used to explain how firms respond to a range of changing circumstances in their markets. These circumstances include understanding how much the quantity demanded for a good or product responds not only to a change in its price but also to a change in the income of consumers or the prices of substitutes and complements.

Question 5

Price elasticity of demand

Answer 5

measures of the responsiveness of the quantity demanded for a product following a change in the price of the product. PED=%change in demand/%change in price. negative figure is because of the negative (or inverse) relationship between price and quantity demanded; as the price goes up, the quantity demanded goes down and as the price decreases, the quantity demanded increases. (Economists usually refer to PED in absolute terms by ignoring the negative sign)..

Question 6

price elastic

Answer 6

when the relative change in the quantity demanded is greater than the change in price of the product.

Question 7

price inelastic

Answer 7

when the relative change in quantity demanded is less than the change in price of the product.

Question 8

perfectly inelastic

Answer 8

where a change in price has no effect on the quantity demanded. when the PED =0, demand is perfectly inelastic.

Question 9

perfectly elastic

Answer 9

where all that is produced is sold at a given price. the relative change in quantity demanded is infinite, since the original demand was zero.

Question 10

unit elasticity

Answer 10

where the change in price is relatively the same as the change in quantity demanded. demand is said to be perfectly inelastic when the ped= -1.

Question 11

factors affecting price elasticity of demand

Answer 11

the availability and attractiveness of substitutes
the relative expense of the product
the time period such as short run or long run

Question 12

how the availability and attractiveness of substitutes affects elasticity of demand

Answer 12

The greater the number of substitute products and the more closely substitutable those products are, the more it can be expected that consumers will switch away from a particular product when its price goes up (or towards that product if its price falls). As we classify products into groupings demand will start to become more price inelastic. So, the narrower the definition of the market, the likelihood is that the PED will be greater.

Question 13

how the relative expense of the product affects elasticity of demand

Answer 13

A rise in price reduces the purchasing power of a person’s income and their ability to pay for products. The larger the proportion of income that price represents, the larger the impact is on the consumer’s income as a result of a change in the product’s price. So, the greater the relative proportion of income accounted for by the product, the higher the PED.

Question 14

how the time period such as short run or long run affects elasticity of demand

Answer 14

In the short run, perhaps weeks or months, people may find it hard to change their spending patterns. In the longer run, if the price of a product goes up and stays up, then over time people will find ways of adapting and adjusting, so the PED of a product is likely to increase over time. In other words, it changes from being price inelastic to price elastic as consumers look at what else is available in the market.

Question 15

substitutability issues

Answer 15

The quality and extent to which information is available about products that consumers need so as to be able to satisfy their particular wants and needs.
The extent to which people consider the product to be a necessity or a luxury. Necessity goods are essential for everyday living and are price inelastic. Luxury goods are price elastic as consumers can do without them.
The addictive properties of the product (whether the product is habit-forming). Their demand is likely to be price inelastic.
The brand image of the product. Such products are likely to be price inelastic.

Question 16

PED and downward sloping linear demand curve

Answer 16

PED is not the same throughout the entire length of the demand curve. PED is calculated using percentages. When prices are high and the quantity demanded is low, a large change in price will not be a large percentage change; the percentage change in quantity demanded will be higher and significant in percentage terms. This results in demand being price elastic. on the upper part of the demand curve. The reverse applies and explains why PED is inelastic in the lower portion of the demand curve.

Question 17

income elasticity of demand (YED)

Answer 17

measures the responsiveness of the quantity demanded for a product following a change in income. YED= %change in quantity demanded/%change in income. measures how the quantity demanded is affected by a change in a consumer’s income.

Question 18

change in income elasticity of demand

Answer 18

If demand is responsive to an income change, the percentage change in quantity demanded will be greater than the percentage change in income. This produces an income elastic outcome and a YED which is greater than 1. Where demand is not responsive to an income change, then the quantity demanded is income inelastic and has a value of less than 1.

Question 19

the classification of goods in relation to income

Answer 19

this classification is based on the size(in numerical terms) and the sign(positive or negative). the four
The classification of goods in relation to income depends on the level of income of consumers or households.
types of goods that can be identified using YED-
normal goods
inferior goods
necessity good
superior or luxury good

Question 20

how are normal goods identified using YED

Answer 20

A normal good is one where the quantity demanded increases as income increases. For normal goods, the YED is positive and expected to be between 0 and 1.

Question 21

how are inferior goods identified using YED

Answer 21

An inferior good is one where the quantity demanded decreases as income increases or increases as income falls. In the case of a rise in income, consumers use their increased incomes to buy better quality goods to replace inferior substitutes. The YED is negative; its size indicates the strength of the relationship between a change in income and the quantity demanded.

Question 22

how are necessity goods identified using YED

Answer 22

A necessity good is a type of normal good for which the quantity demanded is unlikely to change when income changes. The YED is positive but is likely to be close to zero. A low value for the YED indicates that there is a limit to the quantity of these goods that households purchase even when the change in income might seem to be substantial.

Question 23

how are superior goods identified using YED

Answer 23

A superior or luxury good has a positive YED that is greater than 1 and is a normal good where the quantity demanded is responsive to changes in income. The higher the size of the YED, the greater the change in quantity demanded.

Question 24

necessity good

Answer 24

a type of normal good with a YED that is close to zero.

Question 25

superior good

Answer 25

a good with a YED greater than 1.

Question 26

cross elasticity of demand (XED)

Answer 26

measures the responsiveness of the quantity demanded for one product following a change in the price of another product. measures how the quantity demanded is affected by a change in price of a related product. it can be both elastic and inelastic. XED=%change in quantity demanded of product A/ %change in price of product B.

Question 27

cross elastic

Answer 27

when the quantity demanded for one product responds more than proportionately (to a greater degree) to a change in the price of another product. This leads to an XED that is greater than 1.

Question 28

cross inelastic

Answer 28

When the quantity demanded for one product responds less than proportionately to a change in the price of another product, demand is said to be cross inelastic. The XED value is less than 1

Question 29

how does is XED important in indicating the relationship between the two goods

Answer 29

Where the XED is positive, the two goods are substitutes. This is because an increase in the price of one good causes an increase in the quantity demanded of the other good. XED is negative when the two products are complements or jointly demanded. An increase in the price of one product causes a decrease in the demand for another product (whose price has remained unchanged).

Question 30

how PED affects decision making

Answer 30

PED can be used to explain: price variations in a market the impact of changing prices on consumer expenditure and sales revenue the effects of changes in indirect taxes on government income.

Question 31

relationship between PED and price variations in a market

Answer 31

businesses use price variations to increase their revenue. They are aware of variations in PED in their markets and try to use the opportunities presented to them to increase sales and revenue.

Question 32

relationship between PED and total expenditure on a product

Answer 32

the total revenue of a firm=Price x Quantity. Making a product more price elastic is more difficult. It can be done if a product is one of many products in a market where demand is particularly price sensitive. Retailers often use special sales promotions to increase sales by reducing the price of the product with the intention that consumers continue to purchase the product when the promotion has ended. Such a policy is risky since competitors are likely to make the same price reduction, in which case all producers will probably lose out.

Question 33

what does a business keep in mind while making price changes.

Answer 33

When demand is price inelastic, a business is able to increase price in order to increase its revenue. Reducing price is not a sensible option as revenue will fall. When demand is price elastic, the business should decrease price to increase the quantity demanded and therefore revenue. Increasing price would only decrease sales and revenue.

Question 34

how does YED help decision making

Answer 34

It is potentially of great importance for firms and for governments in forecasting the future demand for a whole range of consumer goods and services. If the YED for a normal good is greater than 1, then demand will be expected to grow more quickly than consumer incomes. usually the case in times of sustained economic growth, firms producing these types of product suffered reduced demand during a recession. If YED is negative, in the case of inferior goods, firms that produce these can expect their sales to decline when the economy is doing well; at a time of recession, though, demand for their product is likely to increase.

Question 35

how does XED help decision making

Answer 35

Many firms are concerned about the impact that competitors' pricing strategies will have on the demand for their own products. Firms are increasingly concerned with trying to get consumers to buy not just one of their products but a whole range of complementary ones.

Question 36

problems in calculating elasticity values

Answer 36

In practice, there are many practical problems, which mean that elasticity values are best seen as reasonable estimates. This is because in all three cases we are trying to measure change in the market and this is by no means easy, as data for two points in time are required. The data available are likely to be unreliable the longer the time span involved. Over time, the products available in the market are subject to change, particularly in technological terms.