AQA Economics A-level

Microeconomics

Topic 3: Price Determination in a Competitive Market

3.2 Price, Income, and Cross Elasticities of Demand

• Price Elasticity of Demand (PED): Measures responsiveness of demand to a change in price.

  • Price Elastic Good: Responsive to price changes, PED > 1.
  • Price Inelastic Good: Unresponsive to price changes, PED < 1.
  • Unitary Elastic Good: Equal change in demand and price, PED = 1.
  • Perfectly Inelastic Good: Demand unchanged by price changes, PED = 0.
  • Perfectly Elastic Good: Demand falls to zero with price change, PED = infinity.
  • Example: Bread price increase of 15%, demand decrease of 20% results in PED = -1.33.

• Factors Influencing PED:

  1. Necessity: Necessities (e.g., bread, electricity) have inelastic demand; luxuries are more elastic.
  2. Substitutes: More substitutes increase elasticity; elasticity varies across markets and timeframes.
  3. Addictiveness/Habitual Consumption: Addictive goods have inelastic demand (e.g., cigarettes).
  4. Proportion of Income: Small proportion goods are inelastic; significant proportion goods are more elastic.
  5. Durability: Durable goods (e.g., washing machines) have elastic demand.
  6. Peak and Off-Peak Demand: Peak times (e.g., train tickets) lead to inelastic demand.

• Elasticity of Demand and Tax Revenue:

  • Indirect Tax Burden: Depends on demand elasticity; inelastic demand sees more burden on consumers.
  • Tax Impact on Supply and Demand: Tax increases reduce supply, increase price, and contract demand.
  • Elastic Demand and Government Revenue: Elastic demand leads to reduced demand and revenue.

• Elasticity of Demand and Subsidies:

  • Subsidy Impacts: Lowers costs, increases supply; benefits both consumers (lower prices) and producers (higher revenue).

• PED and Total Revenue:

  • Inelastic demand allows price increases without significantly reducing sales, increasing revenue.
  • Elastic demand means price increases reduce sales, decreasing revenue.

• Income Elasticity of Demand (YED): Responsiveness of demand change to income change.

  • Inferior Goods: Demand falls as income rises (e.g., value products), YED < 0.
  • Normal Goods: Demand rises with income, YED > 0.
  • Luxury Goods: Demand increases more than income increase, YED > 1.

• Cross Elasticity of Demand (XED): Responsiveness of demand change in one good to price change of another.

  • Complements: Negative XED; price increase in one good decreases demand in both.
  • Substitutes: Positive XED; price increase in one good increases demand in another.
  • Unrelated Goods: XED = 0, no effect on demand between goods.

• Firms and XED:

  • Understanding XED helps firms assess competitor impact and market position regarding substitutes and complements.