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Price, Income and Cross Elasticity

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?

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Price, Income and Cross Elasticity

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  1. Price, Income and Cross Elasticity

  2. 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?

  3. 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

  4. Elasticity • 4 basic types used: • Price elasticity of demand • Price elasticity of supply • Income elasticity of demand • Cross elasticity

  5. 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

  6. 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 (Price elasticity of demand) has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

  7. Elasticity Price (£) 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

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

  9. 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. £5 £3 TotalRevenue D 100 140 Quantity Demanded (000s)

  10. Elasticity Price (£) Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

  11. 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 20 5 Quantity Demanded

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

  13. 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

  14. Elasticity • Income Elasticity of Demand: • A positive sign denotes a normal good • A negative sign denotes an inferior good • Yed= % change in quantity demanded • % change in Income

  15. Elasticity • For example: • Yed (income elasticity demanded) = - 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%

  16. 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 • Xed= cross elasticity of demand % Δ Qd of good t __________________ Xed = % Δ Price of good y

  17. 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)

  18. 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

  19. 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

  20. 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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