Price, Income and Cross Elasticity of Demand

Elasticity of Demand
The responsiveness of Demand to changes in other variables such as price, income and Price of related goods etc.

Elasticity of Supply

Elasticity
Price elasticity of demand Income elasticity of demand Cross elasticity Price elasticity of supply

Elasticity
Price Elasticity of Demand
The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Point Elasticity

Note: PEd has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity
Price
Less elastic Unitary Inelastic
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

more elastic Perfectly elastic

Quantity Demanded

Elasticity
Price
If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

(140 100) 100 PEd = (3 5) 5

= -1

Total Revenue

D
100 140 Quantity Demanded (000s)

Elasticity
Price 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

Hence, Not a good Decision

D
5 6
Quantity Demanded

Elasticity
Price

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Hence, Good Decision
D

10 7

Quantity Demanded

20

Arc Elasticity

Elasticity
If demand is more price elastic: Increasing price would reduce TR (% Qd > % P) Reducing price would increase TR (% Qd > % P) If demand is price inelastic: Increasing price would increase TR (% Qd < % P) Reducing price would reduce TR (% Qd < % P)

Determinants of Price Elasticity

Nature of Product Availability of Substitutes Postponement of expenditure Importance of the product in consumers budget Tastes, preferences and fashion

Income Elasticity
Income Elasticity of Demand:
The responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Elasticity
Income Elasticity of Demand:
A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity
For example: Yd = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yd = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yd = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yd = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Cross Elasticity
The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement.
% Qd of good X = __________________ % Price of good y

Xed

Cross Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse relationship between the two)

Goods which are substitutes:

Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price
% Quantity Supplied ____________________ % Price

Pes =

Importance of Elasticity
Relationship between changes in price and total revenue Importance in analysing time lags in production Influences the behaviour of a firm