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Price, Income and Cross Elasticity

This document discusses different types of elasticity including price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity. It provides formulas for calculating each type and explains how to interpret the results, such as whether a relationship is elastic or inelastic. The importance of understanding elasticity is that it shows how changes in factors like price and income impact total revenue.

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Eshaan Chadha
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86 views20 pages

Price, Income and Cross Elasticity

This document discusses different types of elasticity including price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity. It provides formulas for calculating each type and explains how to interpret the results, such as whether a relationship is elastic or inelastic. The importance of understanding elasticity is that it shows how changes in factors like price and income impact total revenue.

Uploaded by

Eshaan Chadha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Price, Income

and Cross Elasticity


Elasticity – the concept
• The responsiveness of one variable
to changes in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
Elasticity – the concept
• If price rises by 10% - what
happens to demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent
to which demand will change
Elasticity
• 4 basic types used:
• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity
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
Elasticity
The Formula:
% Change in Quantity Demanded
___________________________
Ped =
% Change in Price

If answer is between 0 and -1: the relationship is inelastic


If the answer is between -1 and infinity: the relationship is elastic

Note: PED has – sign in front of it; because as price rises


demand falls and vice-versa (inverse relationship between
price and demand)
Price (£)
Elasticity
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded
Elasticity
Price Total revenue is price x
The importance of elasticity
quantity sold. In this
is the information it
example, TR = £5 x 100,000
provides on the effect on
= £500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5

Total Revenue

100 Quantity Demanded (000s)


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
£5 revenue.

£3

Total Revenue
D
100 140 Quantity Demanded (000s)
Elasticity
Price (£)
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded
Elasticity
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20
Elasticity
• If demand is • If demand is
price elastic: price inelastic:
• Increasing price • Increasing price
would reduce TR would increase
(%Δ Qd > % Δ P) TR
• Reducing price (%Δ Qd < % Δ P)
would increase • Reducing price
TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
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:
• Yed = - 0.6: Good is an inferior good but inelastic –
a rise in income of 3% would lead to demand falling
by 1.8%
• Yed = + 0.4: Good is a normal good but inelastic –
a rise in incomes of 3% would lead to demand rising
by 1.2%
• Yed = + 1.6: Good is a normal good and elastic –
a rise in incomes of 3% would lead to demand rising
by 4.8%
• Yed = - 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%
Elasticity
• Cross Elasticity:
• The responsiveness of demand
of one good to changes in the price
of a related good – either
a substitute or a complement
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
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
% Δ Quantity Supplied
____________________
Pes =
% Δ Price
Determinants of Elasticity
• Time period – the longer the time under
consideration the more elastic a good is likely
to be
• Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic
• The proportion of income taken up by the
product – the smaller the proportion the more
inelastic
• Luxury or Necessity - for example,
addictive drugs
Importance of Elasticity
• Relationship between changes
in price and total revenue
• Importance in determining
what goods to tax (tax revenue)
• Importance in analysing time lags
in production
• Influences the behaviour of a firm

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