Uses of Elasticities of Demand

Question 1

Many factors influence the price elasticity of demand

Answer 1

1. Substitutes
   - The more substitutes a good has, the more price elastic demand is - if there are many substitutes available then consumers can easily switch to something else if price rises
   - Number of substitutes a good has depends on how closely it is defined
2. Type of good (or service)
   - Demand for essential items is price inelastic but demand for non-essential items tends to be price elastic
   - Demand for goods that are habit-forming tends to be price inelastic
   - Demand for purchases that cannot be postponed tends to be price inelastic
   - Demand for products with several different uses tends to be price inelastic
3. Percentage of income spent on good
   - Demand for products that need a large proportion of the consumer’s income is more price elastic than demand for products that only need a small proportion of income. Consumers are more likely to shop around for the best price for an expensive good
4. Time
   - In the long run demand becomes more price elastic as it becomes easier to change alternatives because consumers have had the time to shop around. Also, in the long run, habits and loyalties can change

Question 2

Total Revenue and Price Elasticity of Demand

Answer 2

1. Its important for firms to understand the relationship between total revenue (price per unit x quantity sold) and a product’s price elasticity of demand.
2. Elasticity changes along a straight-line demand curve:
   - PED changes alond the demand curve from minus infinity at high price/zero demand, through an elasticity of minus one at the midpoint, to an elasticity of zero at zero price/ high quantity demanded
   - The n-shaped graph underneath shows how the total revenue changes as the point moves along the demand curve - i.e. as the price and quantity demanded change
   - Total revenue is maximised when PED = =+_ 1 - the nearer a firm sets a product’s price to the mid-point of the demand curve, the higher its total revenue will be.
3. If a good has elastic demand, then:
   - A reduction in price will increase the firm’s total revenue.
   - An increase in price will reduce the firms total revenue
   * Look at example in textbook*
4. However, if a good has inelastic demand, then:
   - A reduction i price will reduce the firm’s total revenue
   - An increase in price will increase the firm’s total revenue
   * LOOK AT DIAGRAM IN TEXTBOOK*

Question 3

Income Elasticity of Demand is different for Normal and Inferior goods

Answer 3

Normal goods (most common type of good):
- These goods have a positive YED. As income rise, demand increases. The size of the demand increase is dependent on the product's elasticity. If the YED of a product is elastic (YED > 1) then its a luxury or superior good.

Inferior goods:
- These goods have a negative YED (YED < 0). As income rise, demand falls. A rise in income will lead to the inferior good being replaced with one considered to be of higher quality.

Question 4

Cross Elasticity of Demand shows if goods are Substitutes or Complements

Answer 4

1. Substitutes have positive cross elasticities of demand (XED’s). A fall in the price of one substitute will reduce the demand for another. The closer the substitutes, the higher the positive XED. E.g. ballpoint pends and fountain pens will have have a higher XED than ballpoint pens and pencils.
2. Goods that are complements have negative XEDs. An increase in the price of a good will => reduction in demand for its complement.
3. Goods which have a XED of zero are independent (or unrelated) goods and don’t directly affect the demand of each other e.g. bananas and slippers.