1.2.3 Unit content

Students should be able to:• Explain price, income and cross elasticities of demand• Use formulae to calculate and interpret numerical values of: o price elasticity of demand: unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic

o income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic

o cross elasticity of demand: substitutes, complementary and unrelated goods• Analyse factors that influence elasticities and their

significance to firms and government in terms of:

o the imposition of indirect taxes and subsidies (topic 1.2.9)

o changes in real income

o changes in the prices of substitute and complementary goods• Evaluate the relationship between PED and total revenue

(including calculations)

Elasticity definition

Elasticity tries to identify the impact of changes that one variable (e.g. price) has on another variable (usually quantity demanded).

If prices are lowered we would expect demand to _________ and elasticity measures this.

Price elasticity of demand formula

Price elasticity of demand refers to how much demand changes when there is a change in price. The formula is:

Price elasticity = % change in quantity demanded

% change in price

Price elastic

So the demand for the chocolate is relatively price elastic as:

a small percentage change in price

brought about a bigger percentage change in quantity demanded.

Types of price elasticity

There are five possibilities when calculating price elasticity:1. Perfectly inelastic2. Price inelastic demand3. Unitary price elasticity of demand4. Price elastic demand5. Perfectly elastic demand

Price elastic - responsive

Sometimes people say that the price elasticity is high, this is another way of saying it is price elastic and responsive to changes in price.

Draw a diagram showing a product with a relatively price elastic demand, where a small change in price leads to a proportionately bigger rise in quantity

Price inelastic – less responsive

Similarly, if the price elasticity is low this means demand is price inelastic and less responsive to changes in price.

Price elasticity and the demand curve

Price elasticity will affect the demand curve.

A fairly elastic demand curve will mean that a change in price will cause a larger change in demand whereas an inelastic demand curve for a product such as petrol will produce a different outcome.

So for an inelastic product, a sharp increase in price will only reduce the quantity by a small amount.

What are the main determinants of price elasticity?

Income elasticity of demand

Income elasticity of demand measures the responsiveness of demand to changes in ____________

Usually demand will rise as incomes rise. This is true for ___________ goods. These have a positive income elasticity of demand.

Examples:

What is the opposite of a normal good?

Inferior goods

For other goods, known as inferior goods demand will fall as incomes rise.E.g. So in a recession, incomes will fall and hence demand will rise for inferior goods and this will shift the demand curve to the ____________(NOTE inferior goods refer to demand changing due to changes in _________ NOT changes in ___________)

Formula for income elasticity

The formula is similar to price elasticity:

Income elasticity = % change in quantity demanded % change in income

Income elastic versus income inelastic

As with price elasticity, answers above 1 mean that demand is income _______, positive answers also mean that the good is __________

Answers between 0 and 1 mean demand is relatively unresponsive to changes in income, it is income __________

Answers that are negative mean demand falls as incomes rise (_________ goods).

Income elasticity and the economy

When an economy is growing then average incomes tend to rise and so demand for income elastic products tends to rise at a faster rate than income.

Examples are luxury products e.g. _______

This also means that employment in those industries is likely to grow __________ than in other industries.

Income elasticity and types of good

________ goods are those goods for which demand rises as incomes increase.

YED > 0

________ goods are those goods for which demand rises as incomes falls

YED < 0

________ goods are those goods for which demand rises at a faster rate than income.

YED > 1

Cross price elasticity

Cross price elasticity measures the extent to which changes in the price of one good affect demand for another.

E.g. if Peugeot cut the prices of their cars then the demand for Fords might be expected to fall.

Cross price elasticity = % change in demand of good A% change in price of good B

Example of cross price elasticity

If Peugeot cut their prices by 10% and demand for Fords fell by 12% then:

% change in demand for Fords =

% change in price of Peugeots =

Cross elasticity =

So demand for Fords is relatively cross price elastic: demand changes by a greater proportion than price.

Substitutes versus complementary goods

The fact that the answer is positive shows that these goods are competing goods or __________________In general, the higher the cross price elasticity the closer they are as substitutes. If the answer was negative it would show that these goods are ______________ goods. This means that they are consumed together.