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Significance of Price Elasticity of Demand
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Significance of Price Elasticity of Demand
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If Ed > 1, then demand is said to be elastic
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An increase in price will reduce total revenue
• A decrease in price will increase total revenue
• A decrease in price will increase total revenue
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If Ed < 1, then demand is said to be inelastic
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An increase in price will increase total revenue
• A decrease in price will decrease total revenue
• A decrease in price will decrease total revenue
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If Ed = 1, then demand is said to be unit elastic
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An increase in price will have no impact on total revenue
• A decrease in price will have no impact on total revenue
• A decrease in price will have no impact on total revenue
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Income elasticity of demand
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measures how much the quantity demanded of a good responds to a change in consumers' income. It is computed as the percentage change in the quantity demanded divided by the
percentage change in income.
percentage change in income.
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Types of Goods
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Normal Goods and Inferior Goods.
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Normal Goods
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with income elasticities that are positive
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Inferior Goods
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with income elasticities that are negative
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Income elasticity of demand
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Higher income raises the quantity demanded for normal goods but lowers the
quantity demanded for inferior goods.
quantity demanded for inferior goods.
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Formula of Income elasticity of demand
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Income elasticity of demand =
Percentage change in quantity demanded/Percentage change in income
Percentage change in quantity demanded/Percentage change in income
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Ey = - 0.6: this good is an inferior good
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a rise in income of 10% would lead to
demand falling by 6%
demand falling by 6%
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Ey = + 0.4: this good is a normal good
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a rise in income of 10% would lead to
demand rising by 4%
demand rising by 4%
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Ey = + 1.6: this good is a normal good
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a rise in income of 10% would lead to
demand rising by 16%
demand rising by 16%
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Ey = - 2.1: this good is an inferior good
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a rise in income of 10% would lead to a fall
in demand of 21%
in demand of 21%
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Cross Elasticity
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measures the responsiveness of demand for one good to changes in
the price of a related good - either a substitute or a complement
the price of a related good - either a substitute or a complement
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Goods which are complements
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Cross Elasticity will have negative sign (inverse relationship)
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Goods which are substitutes
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Cross Elasticity will have a positive sign (positive relationship)
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Example of Cross Elasticity of Demand
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% Qd of good A
__________________
% Price of good B
__________________
% Price of good B
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Price elasticity of demand measures
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how much the quantity demanded responds to
changes in the price.
changes in the price.
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Price elasticity of demand is calculated as
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the percentage change in quantity
demanded divided by the percentage change in price.
demanded divided by the percentage change in price.
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If a demand curve is elastic
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total revenue falls when the price rises
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If it is inelastic
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total revenue rises as the price rises
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The income elasticity of demand measures
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how much the quantity demanded
responds to changes in consumers' income.
responds to changes in consumers' income.
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The cross-price elasticity of demand measures
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how much the quantity demanded of
one good responds to the price of another good.
one good responds to the price of another good.
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In most markets, supply is
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more elastic in the long run than in the short run
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If profit equals revenue, then cost must equal
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zero
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If Ey = 2, then by what % must incomes of consumers rise
in order to double sales of this good?
in order to double sales of this good?
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50%
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If the price elasticity of demand for a good is unitary and price rises by 20 %,
what happens to sales of the good?
what happens to sales of the good?
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sales fall by 20%
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There are 3 goods: sneakers, boots and socks. Relating two of them will always yield
a positive cross elasticity of demand. Which two?
a positive cross elasticity of demand. Which two?
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sneakers and boots, because they are substitutes.
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IGiven: Ed = 0 a perfectly inelastic demand. if a 100$ tax was placed on production, how much of it would truly be paid by the
producer?
producer?
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none at all, since the buyer has no choice, the burden is passed
completely to him in the form of a higher market price
completely to him in the form of a higher market price
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