4. Elasticities

price elasticity of demand (PED)

percentage change in quantity demanded divided by percentage change in price

when is demand elastic?

when elasticity is less than -1

when demand is elastic, what effect do price cuts have on total spending?

increases total spending

when is demand inelastic?

when elasticity is between -1 and 0

when demand is inelastic, what effect do price cuts have on total spending?

reduces total spending

when is demand unit-elastic?

when elasticity is -1

when demand is unit elastic, what effect do price changes have on total spending?

none

example of price inelastic demand

demand for oil is price inelastic - price changes have small effect on quantity demanded

example of price elastic demand

demand for foreign holidays is price elastic - price changes have big effect on quantity demanded

which has a higher PED - good with many substitutes or good with few substitutes?

good with many substitutes

the more narrowly defined a commodity is…

the higher the PED

what is PED useful for?

calculating price rise needed to eliminate shortage or price fall to eliminate surplus

price effect

after price cut each unit is now sold at lower price - tends to decrease total spending

quantity effect

after price cut more units sold - tends to raise total spending

fallacy of composition

what is true for an individual may not be true for everyone, what is true for everyone may not hold for an individual

is the PED in the short run elastic or inelastic?

inelastic

is the PED in the long run elastic or inelastic?

elastic

why is the PED lower in the short run than the long run?

there is more scope to substitute other goods in the long run

cross-price elasticity of demand

holds constant own-price of the good and examines the price change of related goods

what does a positive cross-price elasticity imply about goods?

they are substitutes

what does a negative cross-price elasticity imply about good?

they are complements

if cross price elasticity is close to or equal to zero, what are the goods considered to be?

independent

budget share

price of good multiplied by quantity demanded divided by total consumer spending or income

income elasticity of demand

percentage change in quantity demanded divided by corresponding percentage change in income

do inferior goods have positive or negative income elasticities of demand?

negative

what effect do higher incomes have on quantity demanded and therefore on the budget share of inferior goods?

higher incomes reduce the quantity demanded and the budget share of inferior goods

what income elasticities of demand do luxury goods have?

luxury goods have income elasticities larger than 1

what effect do higher incomes have on quantity demanded and therefore on the budget of luxury goods?

higher incomes raise quantity demanded and the budget share of luxury goods

do normal goods have positive or negative income elasticities of demand?

positive

what income elasticities of demand do necessities have?

necessities have income elasticities less than 1

what is income elasticities of demand useful for?

helps forecast pattern of consumer demand as economy grows which affects decisions of suppliers

elasticity of supply

percentage change in quantity supplied divided by percentage change in price

unless otherwise specified, what does the elasticity of demand refer to?

own-price elasticity

what effect does doubling all nominal variables have on demand?

no effect since it neither alters real value of incomes nor the relative prices of goods

real value of income aka…

purchasing power of income