Price, Income and Cross Elasticities of Demand Flashcards
What is the theory?
Elasticity theory looks at the sensitivity of one variable in relationship to another
How do we work out percentage change?
Change/Original x 100
What is an elasticity coefficient?
The measure of the response of one variable to changes in another variable e.g If price increases by 5% demand might decrease by 15%
-The elasticity coefficient is given by -15%/+5% = -3
What does Price Elasticity of Demand (PED) measure?
The responsiveness of demand to a change in price
How is PED calculated?
rice elasticity of demand = %age change in qd/%age change in price
qd= Quantity demand
What does a perfectly inelastic product have a coefficient of?
0
What happens to the quantity demanded if price changes, with a perfectly inelastic product?
If price was to change the quantity demanded would not be affected
What coefficient does a price inelastic product have?
A price inelastic product will have a PED coefficient between 0 and -1
What happens to demand if the price changes with a price inelastic product?
If price was to change the quantity demanded would change by a lesser amount
What does a price elastic product have a coefficient of?
A price elastic product will have a PED coefficient between -1 and ∞
What happens to demand if price changes with a price elastic product?
If price was to change the quantity demanded would change by a greater amount
What does a perfectly elastic have a coefficient of?
A perfectly elastic product will have a PED coefficient of ∞
What happens to quantity demanded when the price of a perfectly elastic product changes?
If price was to change the quantity demanded would be infinite
What are changes in total expenditure influenced by?
PED
- If PED is elastic i.e. >1 a rise in price will cause total expenditure to fall and vice versa
- If PED is inelastic i.e. <1 a rise in price will cause total expenditure to rise and vice versa
What is price elasticity determined by?
Substitutes- The number and closeness of available substitutes will help to determine PED
-If there are no close or lack of available substitutes the product is likely to be very price inelastic and vice versa
What is the definition of a market?
As we widen the market so PED becomes more inelastic
- For example, cigarettes are very price inelastic as there are no close substitutes
- However, the demand for specific brands of cigarette will have a higher PED
What is income elasticity of demand?
Income elasticity of demand (YED) is a measure of the responsiveness of demand to a change in income
How do we work out income elasticity of demand?
Income elasticity of demand = %age change in qd/%age change in income
What is YED determined by?
Whether the good is a necessity or a luxury
-At higher standards of living increased consumer incomes see additional demand tend towards luxury goods as demand for necessities is satiated
Are wealthier countries likely to have higher or lower standards of living?
Higher
What is cross-elasticity of demand?
Cross-elasticity of demand (XED) is a measure of the responsiveness of demand for one good x to a change in price of nother good y.
How so we work out XED?
Cross elasticity of demand = %age change in quantity of A/%age change in price of B
What is XED determined by?
Whether the product is a: Substitute
- Substitutes will have a positive cross-elasticity of demand
- As the price of good Y increases (positive) the demand for good X will increase (positive)
- Close substitutes will have a higher XED as consumer demand for good X will be more sensitive to a change in price of good Y
What is a complement?
- Complements will have a negative cross-elasticity of demand
- As the price of good Y increases (positive) the demand for good X will decrease (negative)
- Close complements will have a higher XED as consumer demand for good X will be more sensitive to a change in price of good Y
What will firms do?
Attempt to change the cross-elasticity of their products
How will firms attempt to change XED?
Substitutes
Firms will try to differentiate their products from the competition
Complements
Firms will produce a range of complements to accompany their core products
What factors determine PED?
Substitutability Percentage of income Type of good The width of the market definition Time
What is Substitutability?
The most important determinant of PED.
-When a substitute exists for a product consumers, respond to a price rise by switching spending away from the good and buying a substitute whose price has not risen
What is Percentage of Income?
The demand for goods or services on which households spend a large proportion of their income tend to be more elastic than those small items that account for only a small fraction of income
What are necessities or luxuries?
It is sometimes said that demand for necessities are price inelastic whereas luxury goods are elastic. However if no substitute exists then demand for a luxury good may be inelastic and if there are available substitutes for necessities then they would be elastic
What is the width of the market?
The lower the PED. The demand for bread produced by a certain baker is likely to be more elastic than the demand for bread produced by all bakers. Other bakeries are providing a number of close substitutes. This can be stretched further
What is time?
For many goods and service demand is more elastic in the LR than the SR because it takes time to respond to a price change
What are the rules of PED elasticity?
- If total consumer spending increases in response to a price fall, demand is elastic
- If total consumer spending decreases in response to a price fall, demand is inelastic
- If consumer spending remains constant to a price fall then it is neither elastic or inelastic - unit elastic
