Price, Income & Cross elasticities of Demand (3)

What does the law of demand state ?

• The law of demand states that when there is an increase in price, there will be a fall in quantity demanded

  • Economists are interested by how much the quantity demanded will fall

What is Price elasticity of demand ?

• Price elasticity of demand reveals how responsive the change in quantity demanded is to a change in price

  • The responsiveness is different for different types of products

How to calculate PED

• PED can be calculated using the following formula:

  • PED = % change in quantity demanded / % change in price

• To calculate a % change, use the following formula:

  • % Change = (new value - old value / old value) x 100

 

Interpreting PED values - The Size of PED Varies From 0 to Infinity (∞) and Is Classified As Follows

Value	Name	Explanation
0	Perfectly Inelastic	The QD is completely unresponsive to a change in P (very theoretical value e.g. heart transplant is extremely inelastic but possibly not perfectly)
0→1	Relatively Inelastic	The %∆ in QD is less than proportional to the %∆ in P (e.g. addictive products)
1	Unitary Elasticity	The %∆ in QD is exactly equal to the %∆ in P
1→ ∞	Relatively Elastic	The %∆ in QD is more than proportional to the %∆ in P (e.g. luxury products)
∞	Perfectly Elastic	The %∆ in QD will fall to zero with any %∆ in P (highly theoretical elasticity)

Factors that influence the PED ? (Determinants of PED)

• Some products are more responsive to changes in prices than other products

• The factors that determine the responsiveness are called the determinants of PED and include:

1. Availability of substitutes: high availability of substitutes results in a higher value of PED (relatively price elastic)

2. Addictiveness of the product: addictiveness turns products into necessities and habitual consumption, resulting in a low value of PED (relatively price inelastic)

3. Price of product as a proportion of income: the lower the proportion of income the price represents, the lower the PED value will be. Consumers are less responsive to price changes on cheaper products (relatively price inelastic)

4. Time period: In the short term, consumers are less responsive to price increases, resulting in a low value of PED (relatively price inelastic). Over a longer time period, consumers may feel the price increase more and so look for substitutes, resulting in a higher value of PED (relatively price elastic)

Income Elasticity of Demand (YED)

• Changes in income result in changes to the demand for goods/services

  • Economists are interested in how much the quantity demanded will change for different products

• Income elasticity of demand (YED) reveals how responsive the change in quantity demanded is to a change in income

YED Calculation

• YED can be calculated using the following formula:

  • YED = %change in quantity demanded/% change in income

Interpreting YED values - The YED value can be positive or negative and the value is important in determining the type of good

The Value of YED Determines the Type of Good and Response to Changes in Income

VALUE	Type of good	Explanation
0→1	Normal necessity	Demand increases proportionately less when income increases. Income inelastic, which means that demand is relatively less responsive to a change in income
YED > 1	Normal luxury	Demand increases proportionately more when income increases. Income elastic, which means demand is relatively more responsive to a change in income
YED < 0	Inferior Good	Demand decreases when income increases or vice versa so YED is negative

Factors that influence YED

• YED is influenced by any factors in an economy which change the wages or salaries of workers

  • During a recession (two quarters of negative economic growth), , incomes usually fall so the demand for inferior goods rises and the demand for normal goods fall

  • During a period of economic growth and rising incomes, demand for normal goods rises and the demand for inferior goods fall

  • Other influences on income include minimum wage legislation, taxation, and increased international trade

What shows the relationship ?

• The sign + or - shows the relationship: Normal good or inferior good

• The number shows the strength of the relationship. For example, YED = +2.5 means there is a strong relationship between a change in income and demand

Cross Price Elasticity of Demand (XED)

• Changes in the prices of complementary goods (Two products that the consumer uses together) and substitutes affect the demand for related products

• Cross price elasticity of demand (XED) reveals how responsive the change in quantity demanded for good A is to a change in price of good B

  • The responsiveness is different for different types of products

Calculation of XED

• XED can be calculated using the following formula:

  • XED = %change in quantity demanded of good A/ %change in price of good B

Interpreting XED Values - Using XED Values To Identify if Goods Are Complements, Substitutes, or Unrelated

Value	Name	Explanation
XED < 0	Complementary goods	The negative value indicates the two goods are complements. The higher the value, the stronger the relationship
XED > 0	Substitutes	The positive value indicates the two goods are substitutes. The higher the value, the stronger the relationship
XED = 0	Unrelated goods	A value of zero indicates that there is no relationship between the two goods. The closer to zero, the weaker the relationship is

Why is knowledge of PED important to firms ?

• Knowledge of PED is important to firms seeking to maximise their revenue

  • If their product is price inelastic in demand, they should raise their prices

  • If price elastic in demand, then they should lower their prices

Why is knowledge of PED important to governments ?

• Knowledge of PED is important to Governments with regard to taxation and subsidies

  • If they tax price inelastic in demand products, they can raise tax revenue without harming firms too much

  • Consumers are less responsive to price changes so firms will pass on the tax to the consumer

  • If they subsidies price elastic in demand products, there can be a greater than proportional increase in demand

Why is knowledge of XED important to firms ?

• Knowledge of XED is important to firms as they seek to maximise their revenue

  • It can help them adjust pricing strategies for substitute and complementary products

  • It can help them understand the likely impact of competitors' pricing strategies on their sales

Why is knowledge of YED important to firms ?

• Knowledge of YED is important to firms as they seek to maintain sales and maximise profits through periods of recssion or economic growth

  • Firms should consider providing more inferior goods in a recessionary environment

  • Firms should consider providing more income elastic normal goods/ luxury products during periods of economic growth

The Revenue Rule of PED

• The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are price inelastic in demand and decrease prices on products that are price elastic in demand