Download Topic 1.2.3 Elasticity student version

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 inelastic
2. Price inelastic demand
3. Unitary price elasticity of demand
4. Price elastic demand
5. 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.