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Unit 1 Module 1

Topic 2: Theory of Consumer Demand


Mrs. C. Mohammed-Beharry

Graphs of Price Elasticity of Demand


1. Elastic Demand (% change in quantity demanded > % change in price)
Price

P0
P1
D

Quantity
Q0

Q1

2. Inelastic Demand ( % change in quantity demanded < % change in price)


Price

P0

P1

D
Q0

Q1

Quantity

3. Perfectly Inelastic Demand (% change in quantity demanded = 0)


Price
D

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Quantity
4. Perfectly Elastic ( % change in quantity demanded is infinite)
Price

Quantity
5. Unit Elastic ( % change in quantity demanded = % change in price)
Price

Quantity

Determinants of Price Elasticity of Demand

The number of substitutes. The greater the number of substitutes available, the higher the
PED tends to be. Goods which are necessities tend to have an inelastic demand as they
possess very few substitutes.

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Income. The higher the proportion of consumers income which the price of a good
represents, the higher is its PED. For example consumers can only spend a small
percentage of their income on salt and so are not very sensitive to price changes in this
product. Demand is price inelastic.

The type of good. The more addictive a product tends to be, the smaller is its PED e.g.
cigarette/drugs, newspapers and certain brands of coffee.

Price Elasticity and a Straight Line Demand Curve


Price
Price elastic ( > 1)

Unit Elastic ( = 1)

Price Inelastic ( < 1)


Quantity

Uses of Price Elasticity

Used to determine pricing policy: If demand is found to be elastic, a viable option would
be to lower prices, as this would increase consumers expenditure on the product and thus
increase the firms total revenue. If demand is price inelastic, firms will increase price to
raise revenue.

Firms can use it for planning e.g. by estimating the effect of a price change, firms can
plan the number of goods to produce, the number of people to employ and the impact of
cash flow

Used by the government to estimate the impact of an indirect tax increase in terms of
sales and tax revenue. To increase taxation revenue, taxes on goods which have an elastic
demand should be reduced, while those goods which have an inelastic demand should be
subject to higher taxes.

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

Cross Elasticity of Demand


Cross Elasticity of Demand measures the degree of responsiveness of the quantity demanded of
one good (Good A) to changes in the price of another good (Good B).
XED = percentage change in quantity demanded of good A = %QA
Percentage change in the price of good B

%PB

If the two goods are substitutes, the cross elasticity will be positive. If good B increases in price,
people will switch to good A and demand for A rises.
If the goods are complements, such as golf clubs and golf balls, the sign will be negative. As the
price of golf clubs rises, fewer people buy clubs and fewer people buy golf balls.
Categories of XED

0 < XED < , when good A and B are substitutes

XED = 0, when there is no relationship between good A and good B.

- < XED < 0, when good A and good B are complementary

Uses of Cross Elasticity

Firms can estimate the effect on their demand of a competitors price cut

Firms can estimate impact on demand for their product if they cut the price of a
complement e.g. if they cut the price of a computer, how much will demand for software
increase?

Income Elasticity of Demand


Income elasticity of demand measures the degree of responsiveness of the quantity demanded of
a product to changes in consumers income.

YED = percentage change in quantity demanded = %Q


Percentage change in income

%Y

The coefficient of YED can be negative in the case of inferior goods; positive in the case of
normal goods and even zero when income does not influence demand (i.e. when demand is fixed

Unit 1 Module 1
Topic 2: Theory of Consumer Demand
Mrs. C. Mohammed-Beharry

e.g. salt). If the good is normal, the income elasticity will be positive. As income rises, the
quantity demanded rises. If the value is greater than 1, demand is income elastic e.g. holidays
abroad, private health care (luxuries). If the value is less than 1, demand is income inelastic e.g.
demand for bread (necessities). If the good is inferior or Giffen, the income elasticity will be
negative. With more income people switch from this good to a more superior good e.g. they
switch from using buses to buying a car.
The higher the figure (ignoring the sign), the greater the relationship between demand and
income.
Categories of YED

YED < 0, negative income elasticity for inferior goods

YED = 0, zero income elasticity for constant demand

0 < YED < 1, income inelasticity

YED = 1, unitary income elasticity

1 < YED < , income elasticity

Uses of Income Elasticity

Can determine what goods to produce or stock e.g. as the economy grows i.e. as
consumers income increases, the demand for normal goods would increase. Hence,
firms might want to avoid inferior goods

Can help firms plan production and employee requirements

Can help firms estimate any potential changes in demand e.g. as overseas income grows
it may create new markets.