# Price, income and cross elasticities of demand

A) Understanding of price, income and cross elasticities of demand

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Income elasticity of measures the responsiveness of quantity demand to a change in income. Cross price elasticity of demand measures the responsiveness of quantity demanded for good A to the change in the price of good B.

B) Use formulae to calculate price, income and cross elasticities of demand

C) Interpret numerical values of

• Price elasticity of demand: unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic
• Income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic
• Cross elasticity of demand: substitutes, complementary and unrelated goods
 PED 0 Perfectly inelastic 0 to -1 Relatively inelastic -1 Unitary elastic -1 to ∞ Relatively elastic ∞ Perfectly elastic

 YED <0 (negative) Inferior good – as income rises the demand for the product will fall 0 to +1 Normal good – income inelastic demand +1 to ∞ Normal good – income elastic demand

 XED <0 (negative) Complements >0 (positive) Substitutes 0 Unrelated goods

D) Factors influencing price elasticities of demand:

The availability of substitutes – If there are lots of substitutes available to the consumer then the PED of the good is likely to be relatively elastic. This is due to the fact that if the price of the good increases then consumers can easily switch to another good that is now cheaper that preforms a similar function. For example, if the price of Coca cola increased then the percentage decrease in quantity demanded is likely to be greater than the percentage increase in price. This is because Coca Cola customers can easily switch their consumption to Pepsi as it is a similar product.

Percentage of income – The greater percentage of income that a good takes up, the more elastic demand for the good is likely to be. For example, a 10% increase in the price of bread is unlikely to have a big effect on demand. This is due to the fact that bread is a cheap product therefore although the price may have increased; the percentage of a person’s income that it takes up is still very small. However, if the price of a car increased by 10% then this is likely to have a much greater impact on demand. This is due to the fact that cars are very expensive and therefore a 10% increase in price will have a much bigger impact on the percentage of a person income that the good takes up. Overall this means that demand for cars is likely to be more inelastic.

Luxury or necessity – Luxury goods are not essential in achieving a basic standard of living for an individual. For example, designer clothes would not be considered essential. As a result of this, the price elasticity of demand for this product would be relatively elastic. Therefore if the price of the good increases then the consumer may change their consumption habits to exclude this good as they can do without it. However, this is in contrast to a necessity good such as bread/basic food which is essential for survival. As a result of this, an increase in the price of bread will have little impact on demand.

Time period – In the short run the price elasticity of demand for a good is likely to be relatively inelastic. This is due to the fact that consumers take time changing their consumption habit or do not notice the price change. However, in the long run the price elasticity for the good turns more elastic as consumers are given more time to change their consumption habits. Furthermore, they are more likely to notice the price difference in the long run and therefore are more likely to not buy the product in the future or reduce their consumption of the good.

E) The significance of elasticities of demand to firms and government in terms of:

• The imposition of indirect taxes and subsidies – The elasticity of the product is one of the main factors to consider when governments decide to implement indirect taxes and subsidies. This is due to the fact that the elasticity of the product has a massive effect on who takes the majority of the burden of the tax and the effectiveness of the tax in solving its objective. For example, taxes on de merit goods such as cigarettes are aimed at reducing the consumption of the good. As shown on the diagram, an increase in the price of cigarettes (P-P1) reduces the demand for cigarettes from Q to Q1. However, due to the fact that it is an addictive product it has a relatively price inelastic demand. Therefore, the tax isn’t as effective as it would be for a product with a more price elastic demand. In addition to this, subsidising a product in order to increase consumption would only be effective if the demand for that product was relatively price elastic. This is because the increase in quantity demanded would be more than proportionate to the decrease in price. Therefore only a small subsidy would have to be provided in order to have a big impact on consumption.