1.2.3 Price, income and cross elasticities
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23 Terms
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price elasticity of demand
the responsiveness of a change in demand to a change in price
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formula for PED
PED = %change in Qdx / %change in Px
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formula for percentage change
%change = (new - original) / original x100
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price elasticity - numerical values
- perfectly elastic: infinity
- elastic: > 1
- unitary elastic: 1
- inelastic: < 1
- perfectly inelastic: 0
- elastic: > 1
- unitary elastic: 1
- inelastic: < 1
- perfectly inelastic: 0
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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
- 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
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price elasticity - graphs
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factors of price elasticity of demand
nature of commodity: necessity=inelastic, comfort=elastic, luxury=more elastic
substitutes: more substitutes=elastic, less substitutes=inelastic
number of uses(durability): single use=inelastic, multi use=elastic
habits(addictiveness): addictive=inelastic
time period: short period=inelastic, long period=elastic (more substitutes available)
urgency of needs: urgent=inelastic
level of income: higher income=inelastic
proportion of total expenditure spent: higher proportion=elastic
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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.
- 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.
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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
- 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
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expenditure
money paid by consumer
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revenue
money earned by worker
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price inelastic vs revenue
total revenue PROPORTIONAL to change in price
- increase in price = increase in revenue
- decrease in price = decrease in revenue
- increase in price = increase in revenue
- decrease in price = decrease in revenue
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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
- increase in price = no change in revenue
- decrease in price = no change in revenue
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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
- increase in price = decrease in total revenue
- decrease in price = increase in total revenue
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income elasticity of demand - definition
responsiveness of a change in demand to a change in income
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income elasticity of demand - formula
YED = %change in Qdx / %change in income
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income elasticity of demand - numerical values
- inferior good: YED
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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
- inferior: negative relationship, leftward shift
- normal:
=necessity: inelastic goods, positive relationship, small rightward shift
=luxury: elastic goods, positive relationship, big rightward shift
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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
-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
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cross elasticity of demand - definition
the responsiveness of quantity demanded of one good when the price of a related good changes
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cross elasticity of demand - formula
XED = %change in demand of good X / %change in price of good Y
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cross elasticity of demand - numerical values and graphs
- complementary goods (negative relationship):
STRONG= XED>1, flatter curve, elastic
WEAK= XED
STRONG= XED>1, flatter curve, elastic
WEAK= XED
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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)
- 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)
Note 
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