4.1.2.2 Price, income and elasticity of demand

How are changes in TE 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

• Therefore, the total expenditure of buyers depends on the PED of the good or service.

What are the determinants of PED?

Substitutes:(number of)

• More substitutes there are more PE demand is likely to be and vice versa

Percentage of Income:

• greater the POI, that a price change takes more PE demand is likely to be & vice versa

Luxury/Necessity:

• Luxuries have more PE

• Necessities have more PIE

Time

• In the short run products are likely to be more price inelastic as consumers find it difficult to change their shopping habits

• In the long run products are likely to be more price elastic as consumers adjust to changing market conditions

What does the term Income elasticity of demand mean (YED)?

• measure of the responsiveness of demand to a change in income

What is the formula for YED?

%🔼QD/%🔼y

What is a normal good?

• When demand for a product increases when incomes increase

• Normal goods will always have a positive income elasticity of demand i.e. a + sign.

What is an inferior good?

• When demand for a product decreases when incomes increase we call this an inferior good.

• Inferior goods will always have a negative income elasticity of demand i.e. a – sign.

Example: Incomes increase by 15%. This leads to an increase in the demand for iPads of 20%.

The income elasticity of demand is:

What are the 2 types of normal goods?

• Necessities are product(s) and services that consumers will buy regardless of the changes in their income levels, they have a positive YED that is between 0 and 1.

• Luxuries are products for which demand increases more than proportionally as income rises, they have a positive YED that is greater than 1.

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

  The level of income of a consumer

• Poorer consumers tend to spend their income on necessities

• As they become wealthier the YED for necessities moves towards zero as consumers are satisfied with the amount of the product e.g. staple foods that they can buy

• Normal goods that are necessities will have lower positive YED coefficients

• As consumer incomes increase they are likely to spend some of their income on luxuries

• These products e.g. cars and foreign holidays will have higher positive YED coefficients

  Standards of living

• Wealthier countries are likely to have consumers with higher disposable incomes

• This means that they have greater spending power and are likely to use some of this greater income to buy luxury goods and services

• Therefore, firms will produce superior products that meet the needs of these consumers e.g. high technology goods and complex financial services

  The economic cycle

  o When the economy is in recovery mode and leading into boom disposable incomes increase and consumers spend a greater proportion of this increase in income firstly on necessities and then on luxury goods

• When the economy is in decline and leading into slump disposable incomes decrease and consumers spend a lesser proportion of their incomes on luxury goods, moving to necessities and then inferior good

What is cross elasticity of demand (XED)?

• measure of the responsiveness of demand for one good, x to a change in price of another good, y

What is the formula for XED?

What do the YED coefficient mean?

The price of good Y (Mars Bars) increases by 10%. This leads to an increase in the demand for good X (Snickers) of 5%.

The cross-elasticity of demand is:

What are the determinants of XED?

Substitute

o Substitutes = positive cross-elasticity of demand

o As the price of good Y increases (positive) the demand for good X will increase (positive)

o Close substitutes have a higher XED

Complementary goods

o Complements will have a negative cross-elasticity of demand

o As the price of good Y increases (positive) the demand for good X will decrease

(negative)

o 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

Has no relationship

oThe change in the price of good X will have no impact on the demand for good Y

oXED will be 0

How will Firms attempt to change the cross-elasticity of their products?

Substitutes

o Firms will try to differentiate their products from the competition

o This can be done through advertising and branding of the product so that consumers are less likely to switch to competitor’s products

o A firm with plenty of close substitutes will be less able to increase its prices

Complements

o Firms will produce a range of complements to accompany their core products

o For example, Apple produce accessories, such as cases and docks, that consumers are likely to buy alongside their core products, such as the iPhone

o A firm that sells a range of complements is likely to increase total revenue