3.3.2 - Price, Income and Cross Elasticities of Demand Flashcards
What is elasticity?
The proportionate responsiveness of a second variable to an initial change in the first variable.
i.e. change the price of a good, and it’s level of demand will change.
Why is elasticity a useful statistic?
It is independent of the units, such as price and quantity.
What is the price elasticity of demand?
Measures the extent to which the demand for which a good changes in response to a change in the price of that good.
What do horizontal and vertical demand curves have in terms of elasticities?
They both have constant elasticities at all points on the curve.
What is a horizontal demand curve showing?
Perfectly elastic or infinitely elastic.
What is a vertical demand curve showing?
Completely inelastic or infinitely inelastic.
What does perfectly elastic mean?
Quantity demanded drops to zero at a higher price but will increase without limit at a lower price.
What does perfectly inelastic mean?
No matter what the price is, the demand always remains the same.
What factors can determine the price elasticity of demand?
Substitutability
Percentage of Income
Necessities or Luxuries
The ‘width’ of the market definition
Time
How does substitutability determine the PED?
When there is a suitable substitute, people will shift their expenditure away from one product to another of a lower price, making it a more elastic good.
If there is not a suitable substitute, it is more likely to be an inelastic good.
How does percentage of income determine the PED?
The demand curves of goods that have a high percentage of the household income spent are much more likely to be elastic, as there is a noticeable difference in the price.
Demand curves of goods that have a low percentage of household income spent are more likely to be inelastic as people are unlikely to notice a change in price.
N.B. for low percentage household income goods, the same is not true of ‘big ticket’ items such as holidays or cars.
How does necessities or luxuries determine the PED?
The PED of necessities is price inelastic. The PED of luxuries is price elastic.
However, for a necessity, if there is a suitable substitute, then it is still likely to be an elastic good. If there is no suitable substitute for a luxury, then it will still be inelastic, but not at the opposite gradient that a substitutable necessity would ever be as a luxury will eventually have a demand of 0 if the price is too high regardless of if there is no available substitute, however, the demand for a necessity will never hit 0 irrespective of substitutes.
How does the ‘width’ of the market definition determine the PED?
The PED for a particular brand of a product with other substitutes is likely to be quite elastic, as consumers can move to a substitute, but the PED for the overall product is likely to be inelastic as it is difficult to find a substitute for an overall product.
How does time determine the PED?
For most goods and services, demand is far more elastic in the long run than in the short run because it takes time to respond to price changes.
e.g. if the cost of petrol cars skyrockets and the price of electric cars plummets, it will take time for motorists to respond as they will be locked in to their existing investment in petrol-engine cars. However, it can also work in the opposite way. If the price of petrol rises, this might cause motorists to use their cars in a more economical way, but in the long run, they will get used to the price and will return to their old motoring habits.
What is the short run?
The time period in which at least one factor of production is fixed and cannot be varied.
