1.2.3 Price, income and cross elaasticties of demand

• Price elasticity of demand

  The responsiveness of a change in demand to a change in price
• Formula for price elasticity of demand


  Percentage change in quantity demanded divided by Percentage change in price
• Price elastic good


  • Very responsive to a change in price
  • Change in price leads to an even bigger change in demand
  • Numerical value for PED is >1
• Price inelastic good


  • Demand is relatively unresponsive to a change in price
  • PED is <1
• Unitary elastic good


  • Change in demand is equal to the change in price
  • PED = 1
• Perfectly inelastic good


  • Demand does not change when price changes
  • PED = 0
• Perfectly elastic good


  • Demand falls to zero when price changes
  • PED = infinity
• Factors influencing price elasticity of demand

  • Necessity
  • Substitutes
  • Addictiveness or habitual consumption
  • Proportion of income spent on the good
  • Durability of the good
  • Peak and off-peak demand
• Necessity of a good

  Necessary goods have relatively inelastic demand, luxury goods have more elastic demand
• Availability of substitutes


  More substitutes = more price elastic demand
• Time period


  Demand is more price elastic in the long run than the short run
• Addictiveness or habitual consumption


  Demand is not sensitive to price changes
• Proportion of income spent on the good


  Goods taking up a small proportion of income have more inelastic demand
• Durability of the good

  Durable goods have more elastic demand
• Peak and off-peak demand

  Demand is more price inelastic during peak times
• Indirect tax on a good

  Firms with inelastic demand can pass more of the tax burden to consumers
• Indirect tax on a good

  Firms with elastic demand have to absorb more of the tax burden themselves
• Subsidy


  Payment from government to firms to encourage production and lower average costs
• Price elasticity of demand and total revenue

  • Inelastic demand allows firms to raise prices and increase total revenue
  • Elastic demand means raising prices reduces total revenue
• Income elasticity of demand

  Responsiveness of a change in demand to a change in income
• Formula for income elasticity of demand


  Percentage change in quantity demanded divided by Percentage change in income
• Inferior goods


  • Demand falls as income increases
  • YED < 0
• Normal goods


  • Demand increases as income increases
  • YED >0
• Luxury goods


  • Increase in income causes an even bigger increase in demand
  • YED > 1
  • Also normal goods with elastic income
• Economic growth and prosperity

  Firms may switch to producing more luxury goods and fewer inferior goods
• Cross elasticity of demand

  Responsiveness of a change in demand of one good to a change in price of another good
• Formula for cross elasticity of demand


  Percentage change in quantity demanded of good X divided by Percentage change in price of good Y
• Complementary goods


  • Have a negative XED
  • If one good becomes more expensive, quantity demanded for both goods falls
• Close complements


  • Small fall in price of good X leads to large increase in quantity demanded of good Y
• Weak complements


  • Large fall in price of good X leads to only small increase in quantity demanded of good Y
• Substitute goods


  • Have a positive XED and upward sloping demand curve
  • Consumers switch to another brand if price of one brand increases
• Weak substitutes


  • Large increase in price of good X leads to smaller increase in quantity demanded of good Y
• Unrelated goods


  • XED is zero, price of one good has no effect on demand for the other
• Firms are interested in cross elasticity of demand to see how many competitors they have and how price changes by other firms will affect them