Price, Income And Cross Elasticities Of Demand Flashcards
Price elasticity of demand
The price elasticity of demand in the responsiveness of a change in demand to a change in price.
Formula for price elasticity of demand
Percentage change in quantity demanded/ percentage change in price
Price elastic good
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
Price inelastic
A price inelastic good has a demand that is relatively unresponsive to a change in price. <1
Unitary elastic good
Has a change in demand which is equal to the change in price. PED=1. The demand curve for a good with a PED of 1 is a curve because for a 1% decrease in the price there is a 1% increase in the quantity demanded.
Perfectly inelastic good
Has a demand which doesn’t change when price changes
Perfectly elastic good
Has a demand which falls to 0 if price change PED=infinity
Factors influencing PED
1) Necessity- A necessary good like bread or electricity will have a relatively inelastic demand. Luxury goods are more elastic, if the price of a flight increases, the demand is likely to fall significantly.
2) Substitutes- If the good has several substitutes, then the demand is more price elastic.
-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 don’t have this time, so demand is more inelastic.
3) Addictiveness or habitual consumption- 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 changes.
4) Proportion of income spent on the good. If the good only takes up a small proportion of income, like magazines which increases in price from 1.50 to 2 it’s likely to be more price inelastic. If the good takes up a significant proportion of income, like cars which increases in price from 15,000 to 20,000 the demand is likely to be more price elastic
5)Durability of the good- A good which lasts a long time like washing machines has a more elastic demand because consumers wait to buy another one.
6) Peak and off peak demand- during peak times, such as 9-5 for trains the demand for tickets is more price inelastic.
Elasticity of demand and tax revenue
-The burden, or incidence, of an indirect tax will fall differently on consumers and firms, depending on if the good has an elastic or inelastic demand. Taxes shift supply curve not demand curve.
-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. An increase in tax will decrease supply from S1 to S2, which increases price from P1 to P2, and therefore demand contracts from Q1 to Q2. This is most effective for raising government revenue.
-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 the overall revenue.
This is not as effective for easing government revenue, but if a government wants to reduce the demand of a particular good, it is effective. Demand will fall significantly, from Q1 to Q2.
https://www.ezyeducation.co.uk/ezyeconomicsdetails/ezylexicon-economic-glossary/696-producer-tax-burden.html
Elasticity of demand and subsidies
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.
https://www.ezyeducation.co.uk/ezyeconomicsdetails/ezylexicon-economic-glossary/703-subsidy.html
PED and total revenue
-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.
Income elasticity of demand
-The responsiveness of a change in demand to a change in income. The formula for this is:
YED= percentage change in quantity demanded/ percentage change in income
Inferior, normal and luxury goods
-Inferior goods are those which see a fall in demand as income increases. Eg value options at supermarkets. YED<0
-With normal goods, demand increases as income increases.
-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.
-During periods of prosperity, like 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.
Cross elasticity of demand
Responsiveness of a change in demand for one good to a change in price of another good
XED= %change in quantity demanded of good x/ %change in price of good y
Complements, substitutes and unrelated goods
-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 price of goods x leads to a large increase in QD of Y.- shown as elastic
-weak complements-a large fall in price of good x leads to only a small increase in QD of Y
-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 goods x leads to a large increase in QD of Y. Curve upward and elastic
-weak substitutes: a large increase in the price of good x leads to a smaller increase in QD of Y. Curve upward and inelastic.
Unrelated goods have a XED equal to 0. For example the price of a bus journey has no effect on the demand for tables.
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.
