1.2.3 Price, income and cross elasticities of demand

ELASTICITY OF DEMAND

• attempt to measure the responsiveness of quantity demanded to changes in other variables: its own price, the price of other goods and real income

• If a good is elastic, it is relatively responsive and if it is inelastic, it is relatively unresponsive

PED

• PRICE ELASTICITY OF DEMAND is the responsiveness of quantity demanded to a change in the price of the good

• %change in quantity demanded/%change in price

NUMERICAL VALUES OF PED

Most values of PED are negative, since a rise in price leads to a fall in output- look at the integer alone, disregarding the negative sign

• Unitary elastic PED is where PED=1: quantity demanded changes =% as price-This would be shown as a reciprocal curve

• Relatively elastic PED is where PED>1: quantity demanded changes by a larger % than price so demand is relatively responsive to price-The curve will be more sloping

• Relatively inelastic PED is where PED<1: quantity demanded changes by a smaller % than price so demand is relatively unresponsive to price-The curve will

  be steep

• Perfectly elastic PED is where PED=infinity: a change in price means that quantity falls to 0 and demand is very responsive to price- horizontal line

• Perfectly inelastic PED is where PED=0: a change in price has no effect on output so demand is completely unresponsive to price- vertical line

FACTORS INFLUENCING PED

• Availability of substitutes

• Time

• Necessity

• How large of a % of total expenditure

• Addictive

AVAILABILITY OF SUBSTITUTES

• If a product has lots of substitutes (for example instead of buying Coke you could buy Pepsi), people will switch to other products when prices go up- so PED will be elastic

• If there are no substitutes, people will buy that good even if prices go up- so PED will be inelastic

TIME

• The longer the time, the easier it will be for a person to find an alternative product/supplier of the product so the more elastic the good is

• In the short term, many goods are inelastic as people may not even notice the price difference

NECESSITY

• A good that is essential for basic living, leading to inelastic demand as consumers will purchase it regardless of price changes.

HOW LARGE OF A % OF TOTAL EXPEDINTURE

• If a good/service represents a very small % of a person's expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic e.g. matches.

ADDICTIVE

• If a product is addictive, then the demand curve will be inelastic- No matter how high prices are, people will still buy the good to fulfill their addiction.

SIGNIFICANCE OF PED

• The PED, along with the PES, determine the effects of the imposition of indirect taxes and subsidies

SIGNIFICANCE OF PED- ELASTIC TAX

• The more elastic the demand curve, the lower the incidence of tax on the consumer.

• This means that when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax.

SIGNIFICANCE OF PED- INELASTIC TAX

• When demand is inelastic, the tax will be mainly passed onto the consumer.

• Since consumers are relatively unresponsive to the price of this good, quantity demanded will not fall by a large amount.

• This means that the tax will be ineffective at reducing output-but it also means that there is higher tax revenue for the government (the more inelastic the demand curve, the higher the tax revenue for the government)

SIGNIFICANCE OF PED- ELASTIC SUBSIDY

• With a subsidy, elastic demand means that the consumer sees a small fall in price whilst the producer gains a lot in extra revenue

• also means there is a large change in output following a subsidy

• gov has to spend more for subsidies on elastic goods.

SIGNIFICANCE OF PED- INELASTIC SUBSIDY

• The more inelastic demand, the more the price falls

• little change in output

• subsidies on goods with inelastic demand are ineffective at increasing output- cheaper for the gov to impose since output increases by less and so the gov have to pay the subsidy on less goods

PED AND REVENUE

• elastic demand curve: A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue

• inelastic demand curve: A decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue

• unitary elastic curve: a change in price does not affect total revenue

YED

• INCOME ELASTICITY OF DEMAND is the responsiveness of quantity demanded to a change in income

• % change in quantity demand/% change in income

NUMERICAL VALUE OF YED

• An inferior good is when YED<0: a rise in income will lead to a fall in demand for the good. For example, Tesco Value goods are inferior goods.

• A normal good is when YED>0: a rise in income will lead to a rise in demand for the good.

• A luxury good is a type of normal good, when YED>1.

  Goods can also be as elastic or inelastic in income.

• If the integer is >1, the good is elastic

• If the integer is <1, the good is inelastic and this tends to be necessities.

SIGNIFICANCE OF YED

• It is important for businesses to know how their sales will be affected by changes in the income of the population- if the economy is improving and people's incomes are rising it is vital that a business knows whether this is likely to increase their sales or not

• It may have an impact on the type of goods that a firm produces- during times of prosperity, firms might produce more luxury goods and less inferior good

XED

• CROSS ELASTICITY OF DEMAND is the responsiveness of demand for one product (A) to the change in price of another product (B)

• %change in quantity demanded of A'/%change in price of B

NUMERICAL VALUES OF XED

• Substitutes are where XED>0: an increase in the price of good B will increase demand for good A. For example, Coca Cola and Pepsi are substitutes

• Complementary goods are where XED<0: an increase in the price of good B will decrease demand for good A. One example is DVDs and DVD players

• Unrelated goods are where XED=0: a change in the price of good B has no impact on good A

• The size of the integer represents the strength of the relationship: the larger the number, the stronger the relationship between the two

SIGNIFICANCE OF XED

• Firms need to be aware of their competition and those producing complementary goods- they need to know how price changes by other firms will impact them so they can take appropriate action