2.2 Price Elasticity, Income Elasticity and Cross Elasticity of Demands
Price, income, and cross elasticity of demand measure how quantity demanded responds to changes in price, consumer income, and prices of related goods, respectively. PED is calculated as the percentage change in quantity demanded over percentage change in price. YED measures the impact of income changes, classifying goods as normal or inferior. XED determines whether goods are substitutes or complements. The chapter covers how elasticity values—perfectly elastic, inelastic, or unitary—inform business decisions. It also explores factors affecting elasticity, variations along the demand curve, and the connection between elasticity and total expenditure, emphasizing strategic decision-making for firms.
Chapter 2.2: Price Elasticity, Income Elasticity and Cross Elasticity of Demand – Full Revision Notes
2.2.1 Definitions
Price Elasticity of Demand (PED)
PED measures the responsiveness of the quantity demanded of a good to a change in its price, assuming all other factors remain constant (ceteris paribus). A high PED indicates that consumers are sensitive to price changes, while a low PED suggests that consumers are relatively unresponsive.
Income Elasticity of Demand (YED)
Income Elasticity of Demand refers to the responsiveness of quantity demanded to changes in consumer income. It helps classify goods into:
– Normal goods (positive YED)
– Inferior goods (negative YED)
– Luxury goods (YED > 1)
Cross Elasticity of Demand (XED)
Cross Elasticity of Demand measures the responsiveness of the quantity demanded for one good in relation to a change in the price of another good.
– If XED is positive: the goods are substitutes.
– If XED is negative: the goods are complements.
2.2.2 Formulae and Calculation
General Elasticity Formula:
Elasticity = % Change in Quantity Demanded / % Change in Related Variable (Price, Income, Price of Other Good)
PED = %∆Q / %∆P
YED = %∆Q / %∆Income
XED = %∆Q of A / %∆P of B
Example PED Calculation:
Price rises from $9 to $10 → %∆P = (10 – 9)/9 = 11.11%
Quantity falls from 150 to 110 → %∆Q = (110 – 150)/150 = -26.67%
PED = -26.67 / 11.11 = -2.4 (Elastic demand)
2.2.3 Significance of Relative Percentage Changes and Elasticity Coefficients
Elasticity values are interpreted based on the magnitude and sign of the coefficient:
PED
– Negative sign due to inverse relationship between price and demand.
– |PED| > 1 → Elastic
– |PED| = 1 → Unitary
– |PED| < 1 → Inelastic
YED
– YED > 0 → Normal goods
– YED < 0 → Inferior goods
– YED > 1 → Luxury goods
XED
– XED > 0 → Substitutes
– XED < 0 → Complements
– XED = 0 → Unrelated goods
2.2.4 Descriptions of Elasticity Values
Perfectly Elastic (∞): Any small change in price causes demand to fall to zero.
Highly Elastic (>1): Quantity demanded changes more than proportionately with price.
Unitary Elastic (=1): Proportionate change in quantity equals change in price.
Inelastic (<1): Quantity changes less than price.
Perfectly Inelastic (=0): Demand remains constant regardless of price.
2.2.5 Variation in PED Along a Demand Curve
Along a straight-line demand curve:
– Top of the curve: Elastic (PED > 1)
– Midpoint: Unitary elasticity (PED = 1)
– Bottom of the curve: Inelastic (PED < 1)
This variation happens because the percentage change in quantity is larger relative to price at the top and smaller at the bottom.
2.2.6 Factors Affecting Elasticity
Price Elasticity of Demand (PED)
– Availability of Substitutes
– Proportion of Income Spent
– Time Period
– Necessity vs Luxury
– Addictive Nature
Income Elasticity of Demand (YED)
– Type of Good
– Income Level of Consumers
– Time Period
Cross Elasticity of Demand (XED)
– Substitutability or Complementarity
– Brand Strength and Loyalty
– Market Definition
2.2.7 Relationship Between PED and Total Expenditure
Total revenue = Price × Quantity
Elastic Demand (PED > 1):
– Price ↑ → Revenue ↓
– Price ↓ → Revenue ↑
Inelastic Demand (PED < 1):
– Price ↑ → Revenue ↑
– Price ↓ → Revenue ↓
Unitary Demand (PED = 1):
– Price changes do not affect revenue
Understanding PED helps firms set optimal prices for maximum revenue.
2.2.8 Implications for Decision-Making
Why is Elasticity Important for Firms and Policymakers?
– Pricing Strategy: Firms use PED to set prices that maximize revenue.
– Sales Forecasting: YED helps anticipate demand trends during economic changes.
– Product Portfolio: Businesses adjust offerings based on income sensitivity.
– Marketing Strategy: XED helps identify competitor threats and complementary products.
– Risk Management: Helps firms reduce exposure to market fluctuations.
– Public Policy: Governments use elasticity data when applying taxes or subsidies.
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