1.2.3 Price, income and cross elasticities of demand

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a) Understanding of price, income and cross elasticities of demand
Price Elasticity of Demand
PED is a measure of the responsiveness of demand following a change in the price of a good or service
A measure of how much demand changes when there is a change in the price of a good or service
We characterise goods and services under two types of elasticity
• Price Inelastic: Changes in price of a good will have less than proportional change in demand • Price Elastic: Changes in price of a good will have more than proportional change in demand
Curves:

Extreme values of PE :

What is income elasticity of demand?
Income elasticity of demand is a measure of the responsiveness in demand for a good or service following a change in income
A measure of how much demand changes following a change in individuals’ income

Worked Examples
The Price of a Freddo Chocolate Bar increases from 17p. Following this price change, demand for the product at the local store falls from 142 units to 107 units.
• Freddo percentage change in price = 2/15 = 13% • Freddo percentage change in demand = 35/142 = 25% • PED (Freddo) = 25%/13% = 1.92 Price Elastic
The Price of a calculator increases from £2 to £2.20. Following this price change, demand for the product falls from 74 to 73 units.
• Calculator percentage change in price = 0.2/2 = 0.1% • Calculator percentage change in demand = 1/74 = 0.014% • PED (Calculator) = 0.014%/0.1% = 0.14 Price inelastic
The Price of a packet of crisps increases from 57p to 64p. Following this price change, demand for the product falls from 80 units to 10 units.
• Crisps percentage change in price = 7/57 = 0.12%

• Crisps percentage change in demand = 70/80 = 0.88%

• PED (Crisps) = 0.88%/0.12% = 7.3 Price elastic
3) The Price of a pencil increases from 10p to 20p, following this price change, the demand for the
product falls from 5 units to 4 units.
• Pencil percentage change in price = 10/10 = 1%

• Pencil percentage change in demand = 1/5 = 0.20%

• PED (Pencil) 0.20/1 = 0.2 Price inelastic

Worked Examples
Income increases from £18000 to £19650, demand increases from 3000 to 3950

• 1650/ 18000 = 0.092%

• 950/ 3000 = 0.32%

• 0.32%/0.092% = 3.48 Normal and Luxury

Income decreases from £23000 to £22450, demand increases from 245 to 283
• -550/23000 = -0.24%

• 38/245 = 0.16%

• -0.24%/ 0.16% = -0.67 Inferior and Necessity

Worked Examples
The price of a DVD player falls from £120 to £107. Following this, the demand for DVDs rises from 160 units to 175 units

• 15/160 = 0.93%

• -13/120 = -0.11%

• 0.93%/ -0.11% = -0.87 Weak Complementary Good

2) The Price of IKEA chairs increases from £35 to £38. Following this, the demand for chairs from John Lewis increases from 560 units to 590 units

• 30/560 = 0.053%

• 3/35 = 0.086%

• 0.053%/0.086% = 0.625 Weak Substitute Good

c) Interpret numerical values of
Price elasticity of demand: unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic
Price inelastic – between 0 and 1 (perfectly inelastic = 0)
Price elastic – between 1 and infinity (perfectly elastic is infinity)
Unit elastic – 1
Income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic
Normal Goods (Positive YED) – An increase in income results in an increase in demand for these goods
• Luxury Goods (holidays)

• Necessity Goods (food)
Inferior Goods (Negative YED) – An increase in income results in a decrease in demand for these goods
• Luxury Goods

• Necessity Goods
Luxury goods are between 1 and infinity
Necessity goods are between 0 and 1
Cross elasticity of demand: substitutes, complementary and unrelated goods

e) The significance of elasticities of demand to firms and government in terms of:
The imposition of indirect taxes and subsidies
Changes in real income
Changes in the prices of substitute and complementary goods
Burden of indirect tax falls differently on consumers and firms – depends on if the good has an elastic or inelastic demand
Indirect taxes:
Very effective at raising (government) revenue when demand is price inelastic
• But the more price inelastic demand is – less effective an indirect tax will be in reducing use of the good
Not effective at raising (government) revenue when demand is price elastic
• But the more price elastic demand is – more effective an indirect tax will be in reducing use of the good
Important – taxes shift the supply curve, not the demand curve
If a firm sells an inelastic good they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly
• True of goods with few or no substitutes – habitual goods (addictive drugs) and where the good forms a relatively small proportion of overall spending
If a firm sells elastic good they are likely to take on most of the tax burden, because they know a price increase will cause demand to fall significantly
• True of goods with a lot of substitutes

Reduces supply of the good

Most of the burden of an indirect tax is paid by the consumer (top bit):

An increase in tax will decrease supply from S to ST. Price increases from P1 to P2 and quantity falls from q1 to q2.
The fall is much smaller when demand is price inelastic but the tax revenue generated is greater when demand is price inelastic

Most of the burden of an indirect tax is paid by the producer (bottom bit):

A firm selling a good with an elastic demand are more likely to take most of the tax burden on themselves
Because they know if the price of the good increases, demand is likely to fall significantly – will lower their overall revenue
An increase in tax will decrease supply from S to ST. Price increases from P1 to P2 and quantity falls from q1 to q2.
The tax revenue generated is greater when demand is price inelastic – because the firm is able to pass on far more of the tax to the consumer without seeing a large drop in sales.
Not as effective for raising government revenue, but if a government wants to reduce the demand of a particular good, it is effective. Demand will fall significantly, from Q1 to Q2
Taxation: Point of Evaluation
PED determines how much the consumer or producer pays
More price elastic goods – taxes are less effective at reducing demand as the producer takes up most of the cost
More price inelastic goods – taxes are more effective as the producer reducing demand as the producer can pass on cost to consumer
Perfectly elastic demand – burden of indirect tax falls entirely on the producer
Perfectly inelastic demand – burden of tax falls entirely on the consumer
Indirect taxes are regressive and hit lowest income individuals hardest and thus income inequality

Elasticity of demand and subsidies
Subsidy – A payment (or grant) from government to firms to encourage (promote) production of a good and to lower their average costs (usually a merit good)
Has the opposite effect of a tax – increases supply

Subsidy when price is elastic
Subsidies – more effective when price is elastic but the cost of the subsidy will be greater

Subsidy when the price is inelsatic demand
Subsidies – less effective when price is inelastic but the cost of the subsidy will be smaller.
The impact of subsidies on consumers, producers and government
Cost of production reduces – they can supply more
Price decreases in product, quantity demanded increases – make more profit revenue
Consumer surplus increases
Prices are lower
Elasticity of demand and subsidies
Benefit of subsidy can go to the producer (increased revenue (C-P1)) or to the consumer (lower prices (P1-P2))
f) The relationship between price elasticity of demand and total revenue (including calculation)
Price elasticity of Demand and Firms
Revenue for a firm is identified as area under the demand curve bordered by the price and corresponding quantity demanded
It is equal to average price times quantity sold – TR = P x Q
If a firm changes price of their good this may increase, decrease or keep revenue the same
If a good has inelastic demand – the firm can raise price – quantity sold won’t fall significantly – increases total revenue
If good has elastic demand – the firm raise price – quantity sold will fall – reduces total revenue
• E.g. if a firm raises price of a good by 5% – means for every unit sold, they gain 5% higher revenue – but increase in price will reduce the willingness and ability of consumers to purchase the good • E.g. quantity demanded falls by 10% – prices rising (increases revenue) is combined with 10% fall in sales (reduces revenue) • E.g. Old price is £100 and 400 units are bought – if price rises by 5% (£105), but quantity demanded falls by 10% (360 units).Total revenue falls from (£100 x 400 = 40,000) to (£105 x 360 =£37,800)
If % increase in price is higher than % fall in demand then total revenue rises

Co-Efficient of PED along a linear demand curve
PED along a straight line demand curve will vary
High prices – a reduction in price has an elastic price response – i.e. lowering prices causes total revenue to rise
Demand is price inelastic towards the bottom of demand curve – a fall in price causes total revenue to drop

What is importance of PED for firms?
Pricing Strategy – Firms able to predict what will happen to total revenue following change in price
Price discrimination – Firms able to charge different prices for different sections of the market – most obvious example is off-peak (elastic) and peak (inelastic) rail tickets
Non – price policy – Firms influence elasticity for a product through non-price marketing such as advertisement
But…PE for a good or service changes over time (life cycle of a product)
In reality, firms find it very difficult to calculate price elasticity of demand and so the actual figure they do find is simply a prediction or estimation
Relationship between price changes, PED and total revenue