Chapter 8: Price elasticity, income elasticity and cross elasticity of demand

Elasticity

A measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.

Elastic (Demand curve diagram)

Change in quantity is greater than the change in price

Inelastic (Demand curve diagram)

Change in price is greater than the change in quantity.

Price elasticity of demand (PED)

The responsiveness of demand to changes in price.

%Change in quantity demanded
/
%Change in price

Perfectly inelastic (Demand curve diagram)

Completely unresponsive to a change in price

PED = 0

Perfectly elastic (Demand curve diagram)

All of the product is sold at a given price and consumers are not willing to pay anything above it.

PED = INFINITY

Unite elastic demand

The change in quantity is relatively the same as a change in price.

PED = (-1)

Factors affecting PED

Availability and attractiveness of substitutes

- The greater the number of substitutes and the easier to substitute the more elastic.

The relative expense of the product

- The more expensive it is for a consumer's income, the more elastic

The time period

- If in the short run more inelastic as it becomes more difficult to alter spending patterns.

Brand image/loyalty

Addictiveness

Necessity

Downward sloping demand curve (Demand curve diagram)

The upper part of the demand curve will be more elastic than the lower due to high prices.

Therefore, the lower part will be more inelastic.

This is because at the higher part, there are higher prices and there are lots of substitutes therefore consumers will quickly shift and at the lower part there are usually fewer substitutes.

Income elasticity of demand (YED)

a measure of the responsiveness of quantity demanded following a change in income.

%Change in QD
/
% Change in income

Different goods

Normal good: Demand increases as income increases. Smartphones, Tv's

Inferior good: Demand decreases as income increases. Noodles, public transport

Necessity good: Normal good where QD does not change when income changes. Gas, healthcare

Superior good/Luxury good:

Demand increases at a higher rate than income rises.

- Luxury cars, designer clothing etc.

What does YED represent

- Income elasticity of demand

YED: % change in quantity demanded / % change in price

What does YED measure

- Measures the responsiveness of the quantity demanded to a change in income, ceteris paribus

If demand is responsive to an income change, what is the condition for YED

- If demand is responsive to an income change YED >1

If demand is not responsive to an income change, what is the condition for YED?

- If demand is not responsive to an income change YED < 1

How are goods classified in relation to changes in income based on the sign and size of YED?

- The classification of goods in relation to changes in income of consumers is

based on the size and the sign

: +Ve (positive) or –Ve (Negative) of the YED

Different goods relationship: YED

- A normal good, Quantity demanded increases as Income increases. YED is between 0 and 1.

Define an inferior good and YED

- An inferior good, Quantity demanded decreases as Income increases. YED < 0.

Define a necessity good and YED

- A necessity good is a normal good where quantity demanded does not change when income changes. YED > 0

Define a superior or luxury good and YED

- A superior or luxury good, YED > 1. Is a normal good that is responsive to changes in income. E.g., jewelry. In low-income economies, a motorcycle can be a superior good compared to using the bus or a bicycle

What does XED represent?

Cross elasticity of demand

XED:

Measures the responsiveness of QD of one good to a change in price of another good.

How is XED measured?

%change in QD of product A
/
% Change in price of good B

Different elasticities of XED and what they represent? 8.4

XED > 1 indicates cross elasticity, where quantity demanded responds more than proportionally to the price change.

XED < 1 indicates cross inelasticity, where quantity demanded responds less than proportionally to the price change.

XED = 1 indicates unitary elasticity, where the percentage change in quantity demanded equals the percentage change in price.

Why is the sign of XED important? What do they indicate?

- The sign of XED (+ve or –Ve or 0) indicates the relationship between the two goods.

- Where positive (+ve): means the two goods are substitutes.

i.e an increase in price of one good leads to an increase in quantity demanded of the other. E.g. Coke and Pepsi.

- Where negative (-ve) it means the two products are compliments.

i.e. An increase in price of golf green fees may lead to a drop in the demand for golf clubs. Or when fast-food meals price drops the quantity of Coke sold will increase.

- An XED of (0) suggests no relationship between products.

E.g. the change in price of McDonald’s burger leads to no change in demand for clothes.

How does PED impact firm/business decision making?

- PED helps businesses understand how consumers will react to price changes thus influencing pricing strategies.

Uses of PED?

- PED explains price variations in a market.

- Predicts the impact of changing prices on consumer expenditure and sales

- Assesses the effects of changes in indirect taxes on government income.

How does PED impact price variations in a market?

- In markets with more elastic demand, price changes have a significant impact on quantity demanded.

What are Price variations?

Firms view or expectation of what price should be.

Give an example of PED's impact on price variations?

- For example, in a sports event, finals tickets may be priced higher due to higher demand, leading to a more inelastic demand curve.

What factors contribute to variations in PED?

- Advance purchase discounts: like airlines
- Seasonal demand fluctuations.

Total expenditure

Price x Quantity

What action should a business take if demand is price elastic?

- When demand is price elastic, a business should decrease price to increase revenue.

What action should a business take if demand is price inelastic?

- When demand is price inelastic, a business can increase price to make more revenue.

What is the objective of a firm regarding Price Elasticity of Demand (PED)

- The objective is to make PED more inelastic to increase revenue.

Methods for firms to make products more inelastic?

Persuasive advertising: Highlighting health benefits compared to substitutes shifts the demand curve right without changing price.

Creating a strong brand image: Establishing the brand as superior to competitors.

Mergers or takeovers: Increasing control over the market.

Creating a monopoly: Utilizing patents or regulations to establish dominance.

Using price for more price elastic products: Running price promotions to attract consumers, although this may lead to price wars.

What is the risk associated with using price promotions?

Using price promotions may result in a price war as competitors react and implement similar strategies.

How does YED help with Forecasting Future Demand?

Crucial for predicting future demand as it helps allocate resources efficiently based on changes in consumer's income.

such as planning for road infrastructure with an increase in car demand

How does YED indicate demand for goods?

YED > 1 for normal goods indicates demand grows quicker than consumer incomes during economic growth and vice versa during a recession.

YED < 0 for inferior goods suggests sales decline during economic growth and increase during a recession

Importance of XED for Producers

XED helps producers understand the impact of pricing changes in other products on their own demand

What XED do substitutes have?

Substitutes have a positive XED, indicating higher interdependence between products.

A competitor's price cut has a higher impact as XED increases

Effect of XED on Quantity Demanded?

A higher XED suggests a greater impact on quantity demanded

For substitutes, a positive XED of 1.5 means a 10% price decrease in a competitor's product results in a 15% decrease in quantity demanded for their own product.

What XED do complimentary goods have?

Complementary goods have a negative XED, resulting in a shift in demand curve when the demand for one product changes

Firms adjust pricing structures to maximize sales and profit, considering XED effects

Limitation of PED, YED and XED?

They are only as good as the reliability of the data.