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Submitted to:
1. Price Elasticity
2. Income Elasticity
3. Cross Elasticity
Price Elasticity
Price Elasticity of Demand focuses only on how the quantity demanded will be
FORMULA:
Example of PED
If the price of petrol increased from 130p to 140p and demand fell from 10,000 units to 9,900
Price elasticity is usually negative, as shown in the above example. It follows the
concept of Law of Demand, which is the price that serves as the primary determinant in the
Elastic relationship
When there is a little change in price that results in a big change in the quantity
demanded.
- Goods which are elastic tend to have some or all of the following characteristics.
- They are expensive and a big % of income e.g. sports cars and holidays
- Goods with many substitutes and a very competitive market. E.g. if Sainsbury’s put up the
price of its bread there are many alternatives, so people would be price sensitive.
Inelastic relationship
- When there is a big change in the price and the quantity demanded has a small change.
- Goods which are inelastic tend to have some or all of the following features:
- They are necessities, e.g. if you have a car, you need to keep buying petrol, even if price of
petrol increases
Possible Combination of changes in PRICE and QUANTITY DEMANDED
If PED = 0 demand is perfectly inelastic - demand does not change at all when the price
changes – the demand curve will be vertical.
PED is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic.
If PED = 1 (i.e. the % change in demand is exactly the same as the % change in price), then
demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level.
If PED > 1, then demand responds more than proportionately to a change in price i.e.
demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop
in demand. The price elasticity of demand for this price change is –3
The Determinants of Price Elasticity of Demand
3. Income level:
People with high incomes are less affected by price changes than people with low
incomes.
4. Proportion of income spent on the commodity:
When a small part of income is spent on the commodity, the price change does not affect
the demand therefore the demand is inelastic in nature.
5. Urgency of demand / postponement of purchase:
The demand for certain commodities are highly inelastic because you cannot postpone
its purchase.
For example medicines for any sickness should be purchased and consumed immediately.
6. Durability of a commodity:
If the commodity is durable then it is used it for a long period. Therefore elasticity of
demand is high. Price changes highly influences the demand for durables in the market.
7. Purchase frequency of a product/ recurrence of demand:
The demand for frequently purchased goods are highly elastic than rarely purchased
goods.
If the quantity demanded for a commodity increases with the rise in income of the
consumer and vice versa, it is said to be positive income elasticity of demand. For example:
As the income of consumer increases, they consume more of superior (luxurious) goods.
Quantity demanded for a commodity decreases with the rise in income of the consumer
and vice versa. For example: as the income of consumer increases, they either stop pr
consume less of inferior goods.
Quantity demanded for a commodity remains constant with any rise or fall in income of
the consumer. For example: in case of basic necessary goods such as salt, kerosene,
electricity, etc. there is zero income elasticity of demand.
Expression of Income Elasticity of Demand
Mathematically, it is expressed as:
YED = % Q
% Y
= change in
Q = quantity
Y = income
Ey = Elasticity of Demand
Example to explain Income Elasticity of Demand
Normal Goods (+)
As income rise, demand for normal goods increases so YED will always be positive. As
income falls, demand falls, so YED is positive.
Suppose that the initial income of an individual is P2000 and quantity demanded for the
commodity by him is 20 units. When his income increases to P3000, quantity demanded by him
also increases to 40 units. Find out the elasticity of demand.
Solution: P
Income (Y) Quantity (Q)
2000 20 = P
3000 40
Q
Q1 Q2
20 40
% Q= Q2-Q1 40-20 20
% Y Q1 = 20 = 20 = 2%
1
=
Y2-Y1 3000-2000 1000 0.5 YE
Y1 2000 2000 D
Suppose that the initial income of an individual is P4000 and quantity demanded for the
commodity by him is 40 units. When his income increases to P5000, quantity demanded by him
decreases to 30 units. Find out the elasticity of demand.
Solution: P
Income (Y) Quantity (Q)
4000 40 = P
5000 30
D
Q
Q2 Q1
30 40
The responsiveness of the quantity of one commodity demanded to a change in the price
of another good is calculated with the following formula.
Example 1: The quantity demanded or product A has increased by 12% in response to a 15%
increase in price of product B. Calculate the cross elasticity of demand and tell whether the
product pair is (a) apples and oranges, or (b) cars and gas.
Since the cross elasticity of demand is positive, product A and B are substitute goods. They are
most likely apples and oranges.
Example 2: The government of Selgina is very serious about drugs. Possession of drugs is illegal
and is severely penalized. However, a black market exists which the government has failed to
dismantle despite serious attempts. Khusenichho Chamling, the health minister, is worried about
the situation. In early 2009, a consultant working with health ministry suggested that the
government should increase the price of a pack of cigarettes from 200 Selgina dollars (S$) to
S$600. A survey conducted in December 2009 suggested that over the year, the quantity
demanded of marijuana decreased from 2,000 kgs per day to just 800 kgs. Calculate the cross
elasticity of demand and tell why has the policy proved so effective.
Cigarettes and marijuana have negative cross elasticity of demand which tells that they are
complimentary goods.
The policy has proved effective because cigarettes and marijuana are consumed together.
Increase in price of cigarettes increased the price of the whole bundle and reduced the
purchasing power of people and resulted in a drop in consumption of marijuana.