Topic 3: Elasticity

Question 1

Define the PRICE ELASTICITY OF DEMAND

Answer 1

A measure of the responsiveness of the quantity demanded for a good to a change in its price when all other influences on buyers’ plans remain the same.

Question 2

What is the formula for finding the price elasticity of demand?

Answer 2

% change in quantity / % change in price

Question 3

Demand is price ELASTIC if…

Answer 3

The percentage change in quantity demanded exceeds the percentage change in price

(Ed > 1)

Question 4

Demand is price INELASTIC if…

Answer 4

The percentage change in quantity demanded is less than the percentage change in price

(Ed < 1)

Question 5

Demand is price UNIT ELASTIC if…

Answer 5

The percentage change in quantity demanded equals the change in price

(Ed = 1)

Question 6

Demand is PERFECTLY PRICE ELASTIC if…

Answer 6

If the percentage change in the quantity demanded changes by a VERY LARGE PERCENTAGE compared to a small percentage change in price

(Ed = ∞)

Question 7

Demand is PERFECTLY PRICE INELASTIC if…

Answer 7

The quantity demanded remains constant as price changes

Ed = 0

Question 8

What are the influences on PED?

Answer 8

1) Availability of substitutes
2) Luxury vs. Necessity
3) Narrowness of definition
4) Duration of price change
5) Proportion of income spent

Question 9

How does “LUXURY VS. NECESSITY” influence PED?

Answer 9

• Necessities have poor substitutes, so demand for a necessity is inelastic. (E.g. medication)
• Luxury has many substitutes so the demand for luxuries is elastic (e.g. exotic vacations)

Question 10

How does “NARROWNESS OF DEFINITION” influence PED?

Answer 10

• The demand for a narrowly defined food is elastic (e.g. Nestle Hot Chocolate has substitutes like Miss Swiss Hot Chocolate)
• Broadly defined good is inelastic (E.g. salt generally can’t be substituted easily)

Question 11

How does “DURATION OF PRICE CHANGE” influence PED?

Answer 11

The more elastic the demand for a good will be when more time is allowed for customer to respond to the price change because it allows them time to find a substitute.

Question 12

How does “PROPORTION OF INCOME SPENT” influence PED?

Answer 12

• The greater the proportion of income spent on a good, the greater the impact a change in price would have on the quantity demanded.
• E.g. a bar of chocolate is a small percent of income, therefore if its price doubled, not as much of a change in proportion of income compared to doubled prices of an exotic vacation.

Question 13

Define total revenue (TR)

Answer 13

• Total revenue is the amount spent on a good and received by its seller.
• It equals the price of the food multiplied by the quantity of the good sold.

Question 14

Define total expenditure (TE)

Answer 14

• Total expenditure is the amount paid for a good by a consumer multiplied by quantity purchased.
• It can be used interchangeably with total revenue as the total revenue garnered by sellers corresponds to money spent by customers

Question 15

What is the total revenue test?

Answer 15

The total revenue test is a method of estimating the price elasticity of demand by multiplying the price of a good by the quantity of the food sold.

Question 16

How do we know demand is price ELASTIC according to the total revenue test?

Answer 16

• If demand is elastic, the price and total revenue change opposite directions.
• A percentage increase in price leads to a larger decrease in the quantity demanded.
• Total revenue decreases

Question 17

How do we know demand is price INELASTIC according to the total revenue test?

Answer 17

• If demand is inelastic, price and total revenue change in the same direction.
• A percentage increase in price brings a smaller percentage decrease in the quantity demanded
• Total revenue increases

Question 18

Define cross elasticity of demand

Answer 18

CED is the measure of the extent to which demand for a good changes when the price of a related good changes, with all other things remaining the same.

Question 19

What is the formula for the cross elasticity of demand?

Answer 19

CED = % change of Qd / % change in the price of its substitutes or complements

Eab = %🔺Qd of A product / % 🔺P of B product

Question 20

The CED for a SUBSTITUTE is positive because…

Answer 20

• The quantity demanded of the good and the price of its substitutes change in the same direction
• A fall in the price of a substitute good brings a fall in the quantity demanded of the good.

Question 21

The CED of a COMPLEMENT is negative because…

Answer 21

• The quantity demanded of the food and the price of its complements change is opposite direction
• A fall in the price of a complement of the good brings a rise in the quantity demanded of the good.

Question 22

Is the CED for a substitute good positive or negative?

Answer 22

The CED of a substitute good is POSITIVE.

Question 23

Is the CED for a complement good positive or negative?

Answer 23

The CED for a complement good is NEGATIVE.

Question 24

Define income elasticity of demand

Answer 24

A measure of the extent to which quantity demanded for a good changes in relation to a change in income, with all other things remaining the same.

Question 25

What is the formula for income elasticity of demand?

Answer 25

EID= % change in quantity demanded / % change in income

Question 26

What is a NORMAL NECESSITY good? (IED)

Answer 26

* A good is normal and a necessity if IED is positive but < 1. * Normal necessities have a positive but low IED because a change in income has little effect on the quantity demanded for it * It is income inelastic * E.g. Milk

Question 27

What is a NORMAL LUXURY good? (IED)

Answer 27

* A good is normal and a luxury if IED is positive and > 1 * Normal luxuries have a positive and high IED because quantity demanded for the good changes more than proportionate to a change in income * Income elastic * E.g. restaurant meals and exotic vacations

Question 28

What is an INFERIOR good? (IED)

Answer 28

* A good is inferior if IED is negative * This is because it quantity demanded has an inverse relationship to a change in income. * As income rises, less of the good is consumed and vice versa. * E.g. Homebrand products and public transport