1.2.3
Price, income and cross elasticities of demand
a) Price elasticity of demand (PED)
PED - the responsiveness of demand to a change in price (KEY DEFINITION).
% change in quantity demanded
% change in price
So, if quantity demanded rises from 2 to 4, and price falls from £8 to £6, PED = 100% / -25% = -4.
(when calculating, ALWAYS remember to queue before you pee, or Q before you P!!).
Numerical values
Due to the law of diminishing marginal returns (1.2.2), as prices rise, quantity demanded falls. This means that most of the time, PED will be a negative number. It is important that WHEN CALCULATING you show the use of the negative sign for PED, however WHEN INTERPRETING, this negative sign should be disregarded (ie a value of -3 should be written as 3).
Unitary elastic PED - This is when the % change in quantity demanded and price is the same, and the subsequent value is PED = 1. It looks like the curve D1 (above).
Relatively elastic PED - The % change in quantity demanded is larger than that of price, so PED > 1. This can be seen above depicted as the curve D2.
Perfectly elastic PED - There is no % change in price no matter how much of a % change in quantity demanded, so PED = ∞. This would look like a horizontal line.
Relatively inelastic PED - The % change in quantity demanded is smaller than that of price, so PED < 1. This can be seen above depicted as the curve D3.
Perfectly elastic PED - There is no % change in quantity demanded no matter how much of a % change in price, so PED = 0. This would look like a vertical line.
Factors influencing PED
Substitute availability - If there are many substitutes for a good, people will be happy to switch to an alternative when the price of one rises, as the goods are almost identical but one is now cheaper. This makes PED elastic, as when price rises by a small amount, quantity demanded will fall by a large amount.
Time - In the long-run, people are more likely to find better alternatives to a good they are currently purchasing, therefore making the good more elastic as if price rises, quantity demanded falls by a higher amount. In the short-run, goods are often inelastic as many don't know about better alternatives.
Addictiveness - The more addictive a good is, the less likely people are to switch if price rises, making the good more inelastic.
Necessity - If a good that is necessary, such as petrol, has a price rise, few are likely to stop buying it as they need it to run their cars. This makes the good more inelastic.
Use the word STAN as a mnemonic device for remembering the factors influencing PED!
Significance of PED
The PED for a good or service can help determine the effects of imposing an indirect tax or subsidy on/for producers.
The diagram here shows a tax on a good with elastic PED. The tax has caused supply to shift in from S1 to S2. When there is a tax on an elastic good, the consumer burden is lower and the producer burden is higher. This is because there is a more significant loss of revenue for firms, as when price rises from P1 to P2, quantity demanded falls by a higher amount, and the firm loses customers. The customers who switch to another good or service don't face the burden of higher prices, but those who don't switch do face this burden. Because more people stop buying the good than those who continue to buy it, the consumer burden is lower. This shows that the tax has been effective at reducing output, as fewer are buying it, so less is produced.
The diagram here shows a tax on a good with inelastic PED. The tax has caused supply to shift in from S1 to S2. When there is a tax on an inelastic good, the consumer burden is higher and the producer burden is lower. This is because there is a less significant loss of revenue for firms, as when price rises from P1 to P2, quantity demanded falls by a smaller amount, and the firm only loses a few customers. This makes the producer burden low. Because most customers keep buying this good and don't switch, they start paying the higher price at P2, making the consumer burden high. This shows that the tax has been ineffective at reducing output, as quantity demanded is still similar, so there is little change to production. Also, the government gains more tax revenue than if demand were elastic.
On the diagram we can see the effects of a subsidy imposed on a good with elastic PED. The subsidy causes supply to shift out from S1 to S2. The producer gain is higher as the drop in price from P1 to P2 has led to a higher increase in quantity demanded, so more customers want their product, so revenue increases. The consumer gain is still positive, but less significant than the producer gain, as prices have only fallen slightly for them whilst producer revenues have massively increased. The subsidy for this elastic good has increased output more significantly than it would on an inelastic good, and therefore the government has to pay more per unit.
On the diagram we can see the effects of a subsidy imposed on a good with inelastic PED. The subsidy causes supply to shift out from S1 to S2. The producer gain is lower as the drop in price from P1 to P2 has led to a small increase in quantity demanded, so few extra customers want their product, so revenue don't increase significantly. The consumer gain is much larger as prices have dropped significantly for them. For inelastic goods, subsidies are fairly ineffective at increasing output, and the government pays a lower subsidy per unit as less in produced.
Relationship between PED and revenue
When ELASTIC, a rise in price leads to a fall in revenue (inverse relationship).
When INELASTIC, a rise in price leads to an increase in revenue (direct relationship).
When UNITARY, a change in price does not have an effect on total revenue.
b) Income elasticity of demand (YED)
YED - the responsiveness of demand to a change in income (KEY DEFINITION).
% change in quantity demanded
% change in income
Numerical values
Relatively elastic YED - When the % change in quantity demanded is greater than the % change in income, so YED > 1.
Relatively inelastic YED - When the % change in quantity demanded is less than the % change in income, so YED < 1.
Inferior goods - When a rise in income leads to a fall in demand for the good (looks like the standard demand curve), so YED < 0.
Normal goods - When a rise in income leads to a rise in demand for the good (looks like the standard supply curve, or the curve on the graph here), so YED > 0.
Luxury goods - A type of normal good with YED > 1.
Significance of YED
It is important for firms to know roughly what the YED for the product they sell is, as if incomes are rising in the economy they can respond accordingly by increasing or decreasing production. Also, if incomes are rising, firms may decide to produce more luxury goods, as they will be in higher demand and this way they can maximise their revenues.
c) Cross elasticity of demand (XED)
XED - The responsiveness of demand for good or service A, to the change of price for good or service B (KEY DEFINITION).
% change in quantity demanded for A
% change in price for B
Numerical values
Substitutes - An increase in the price of good or service B will increase demand for good or service A, so XED > 0. A weak substitute can be seen on the first graph as D1, which is more elastic, whereas a strong substitute would be D2, which is more inelastic.
Complements - An increase in the price of good or service B will decrease demand for good or service A, so XED < 0. On the second graph, the weak complement is the more elastic curve D1, and the strong complement is the more inelastic curve D2.
Unrelated goods - Where XED = 0, so the goods have no impact on one another.
The size of the number corresponds the the strength of the correlation between price and quantity.
EXAM TIP: Using PED to evaluate a question on taxes/subsidies, revenue or almost anything is essential for getting the A*. It's such an easy but elegant way to evaluate as well.
Significance of XED
Firms need to know their XED to adjust production/output to changes in competitor's prices (so substitute prices), and adjust production/output to changes in complement prices too.
To help revise this, click the button for my condensed flashcards!