1.2.3 Price, Income and Cross Elasticities of Demand (Edexcel)

This study note for Edexcel covers Price, Income and Cross Elasticities of Demand

A) Understanding Price, Income, and Cross Elasticities of Demand

1. Price Elasticity of Demand (PED)

• PED measures the responsiveness of the quantity demanded to changes in the price of a good.
• Formula: PED = (% Change in Quantity Demanded) / (% Change in Price)

2. Income Elasticity of Demand (YED)

• YED measures the responsiveness of the quantity demanded to changes in consumer income.
• Formula: YED = (% Change in Quantity Demanded) / (% Change in Income)

3. Cross Elasticity of Demand (XED)

• XED measures the responsiveness of the quantity demanded of one good to changes in the price of another.
• Formula: XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B)

B) Using Formulas to Calculate Elasticities

• Calculate each elasticity using the respective formula and percentage changes in quantity demanded, price, or income.

C) Interpretation of Numerical Values

Price Elasticity of Demand (PED):

• Unitary Elastic (PED = 1): Percentage change in quantity demanded is exactly proportional to the percentage change in price.
• Perfectly Elastic (PED = ∞): Quantity demanded is extremely responsive to price changes, demand is perfectly elastic.
• Perfectly Inelastic (PED = 0): Quantity demanded does not respond to price changes, demand is perfectly inelastic.
• Relatively Elastic (PED > 1): Demand is responsive to price changes.
• Relatively Inelastic (0 < PED < 1): Demand is less responsive to price changes.

Income Elasticity of Demand (YED):

• Inferior Goods (YED < 0): Demand decreases as income increases (e.g., low-quality goods).
• Normal Goods (0 < YED < 1): Demand increases with income but at a decreasing rate.
• Luxury Goods (YED > 1): Demand increases significantly with income (e.g., luxury cars).

Cross Elasticity of Demand (XED):

• Substitutes (XED > 0): An increase in the price of one good leads to an increase in the quantity demanded of the other (e.g., Coke and Pepsi).
• Complementary Goods (XED < 0): An increase in the price of one good leads to a decrease in the quantity demanded of the other (e.g., cars and gasoline).
• Unrelated Goods (XED = 0): The price change of one good has no effect on the other.

D) Factors Influencing Elasticities of Demand

• Availability of substitutes, necessity vs. luxury, time horizon, and habit can influence elasticities.

E) Significance to Firms and Government

Firms:

• Firms use elasticities to set prices and predict revenue changes.
• Elastic demand means price increases reduce total revenue, while inelastic demand means price increases raise total revenue.

Government:

• Government uses elasticities to make taxation and subsidy decisions.
• Inelastic goods can bear higher taxes, while elastic goods may see reduced consumption due to taxes.
• Subsidies can encourage the consumption of essential goods.

Understanding these concepts and calculations is crucial for analyzing market dynamics, consumer behavior, and government policies in the real world. Elasticities help firms and governments make informed decisions about pricing, taxation, and subsidies.