1.2.3 Price, income and cross elasticities

price elasticity of demand

the responsiveness of a change in demand to a change in price

formula for PED

PED = %change in Qdx / %change in Px

formula for percentage change

%change = (new - original) / original x100

price elasticity - numerical values

• perfectly elastic: infinity

• elastic: > 1

• unitary elastic: 1

• inelastic: < 1

• perfectly inelastic: 0

price elasticity - definitions

• perfectly elastic: extreme response in %Qdx to almost no change in %Px

• elastic: bigger change in %Qdx than change in %Px

• unitary elastic: equal change in %Qdx compared to %Px

• inelastic: smaller change in %Qdx compared to %Px

• perfectly inelastic: no response %Qdx compared to change in %Px

price elasticity - graphs

factors of price elasticity of demand

1. nature of commodity: necessity=inelastic, comfort=elastic, luxury=more elastic

2. substitutes: more substitutes=elastic, less substitutes=inelastic

3. number of uses(durability): single use=inelastic, multi use=elastic

4. habits(addictiveness): addictive=inelastic

5. time period: short period=inelastic, long period=elastic (more substitutes available)

6. urgency of needs: urgent=inelastic

7. level of income: higher income=inelastic

8. proportion of total expenditure spent: higher proportion=elastic

significance of PED - indirect taxes

• determines the effects of the imposition of indirect taxes and subsidies

• if 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

• if PED is inelastic: tax will mainly be passed onto the consumer, tax will be ineffective at reducing output but there will be a higher tax revenue for the gov.

significance of PED - subsidies

SHIFT FROM S2 TO S1: subsidy

• if PED is elastic: consumer sees small fall in price, producer gains lots more revenue, large change in output following a subsidy

• if PED is inelastic: bigger fall in price but ineffective at increasing output - cheaper for gov to impose as output increases by less so the gov have to pay subsidies on less goods

expenditure

money paid by consumer

revenue

money earned by worker

price inelastic vs revenue

total revenue PROPORTIONAL to change in price

• increase in price = increase in revenue

• decrease in price = decrease in revenue

unitary price elastic vs revenue

NO CHANGE in revenue even if price changes

• increase in price = no change in revenue

• decrease in price = no change in revenue

elastic price vs revenue

total revenue INVERSE to change in price (proportional to Qdx)

• increase in price = decrease in total revenue

• decrease in price = increase in total revenue

income elasticity of demand - definition

responsiveness of a change in demand to a change in income

income elasticity of demand - formula

YED = %change in Qdx / %change in income

income elasticity of demand - numerical values

- inferior good: YED

income elasticity of demand - relationships and graphs

INCREASE IN INCOME:

• inferior: negative relationship, leftward shift

• normal: =necessity: inelastic goods, positive relationship, small rightward shift =luxury: elastic goods, positive relationship, big rightward shift

uses of YED

-investment planning: boom in economy=invest in luxuries, recession in economy, invest in inferiors
-production planning: if income increases: increase capacity of luxuries=increase in sales, if income decreases: increase capacity of inferior goods=increase in sales
-product switching: some firms switch products, in a recessions=switch to inferior goods

cross elasticity of demand - definition

the responsiveness of quantity demanded of one good when the price of a related good changes

cross elasticity of demand - formula

XED = %change in demand of good X / %change in price of good Y

cross elasticity of demand - numerical values and graphs

- complementary goods (negative relationship):
STRONG= XED>1, flatter curve, elastic
WEAK= XED

uses of cross elasticity of demand

• allows firms to see competition = less likely to be affected by price changes by other firms if they are selling complementary/substitute goods

• if there are no close substitutes, firm can increase prices

• loss leaders: firms can use knowledge of complementary products to increase overall revenue (e.g. sell one product cheaply to profit from a more expensive product)