Topic 3.2 Price, income and cross elasticities of Demand

Question 1

Price elasticity of Demand

Answer 1

The price elasticity of demand is the responsiveness of a change in demand given a change in price

Question 2

PED formula

Answer 2

PED = %Change in Demand / %Change in Price

Question 3

PED result and why

Answer 3

This is always negative (unless anomalies) due to the Law of Demand - either the numerator or denominator of PED will be negative

Question 4

PED > 1

Answer 4

Demand is price elastic. This means that a small change in price results in a great change in demand.
E.g Luxuries or lots of competition

Question 5

PED < 1

Answer 5

Demand is price inelastic. This means that demand doesn’t change much even if there is a big change in price

Question 6

PED = 0

Answer 6

Demand is perfectly price inelastic. This means that the numerator is 0 therefore demand doesn’t change at all even with a change in price (a vertical line)

Question 7

PED = ∞

Answer 7

Demand is perfectly price elastic. This means that the denominator is 0 therefore the demand changes whilst price remains the same (a horizontal line)

Question 8

PED = 1

Answer 8

Demand is unitary price elastic. This means the numerator was the same as the denominator. Reverse of an exponential curve.

Question 9

Factors influencing PED

Answer 9

1. Substitutes (if the good has several substitutes, then it would be more price elastic).
2. Degree of necessity (necessities tend to have lots of demand therefore price inelastic wheras luxuries would be price elastic).
3. Habit (consumers less sensitive to price changes if they are used to buying out of habit therefore price inelastic).
4. Peak and off-peak demand (demand is price inelastic at peak times and vice versa for off-peak times).
5. Proportion of income spent on good (if high proportion, then price inelastic as people are less sensitive to price and vice versa).

Question 10

Income Elasticity of Demand

Answer 10

Income elasticity of demand (YED) is the responsiveness of a change in demand to a change in income

Question 11

YED formula

Answer 11

% change in quantity demanded / % change in income

Question 12

Inferior goods

Answer 12

This is when income increases but demand decreases. This is for cheap goods as now people have more money to spend on more expensive/branded goods. Therefore YED < 0

Question 13

Normal and Luxury goods

Answer 13

When income increases, demand increases.
Necessities have a YED of 0 < YED < 1
Luxuries have a YED > 1

Question 14

Determinants of YED

Answer 14

1. The type of good: inferior, normal (necessity) or normal (luxury)
2. Level of Income of a consumer

Question 15

Firms decisions when incomes increase

Answer 15

During economic growth when incomes are rising, firms may decide to switch to produce more luxury goods.

Question 16

Cross Elasticity of Demand

Answer 16

Cross elasticity of demand is the responsiveness of a change in demand of one good to a change in price of another good.

Question 17

XED Formula

Answer 17

% change in quantity demanded of Good X / % change in price of Good Y

Question 18

XED Good

Answer 18

The type of related good
Substitutes: Positive value (+). If price increases for X then quantity demanded for Y also increases. Vice Versa.
Complements: Negative value (-). If price increases for X then Quantity demanded for Y decreases. Vice Versa

Question 19

XED Coefficient

Answer 19

Tells the type of elasticity.
XED > 1: Demand between the goods are price elastic.
XED < 1: Demand between the goods are price inelastic.
XED = 0: Demand between the goods are perfectly price inelastin (no relationship)