1.2.2 Price, Income and Cross Elasticities of Demand

1. 1.2.2 Price, Income and Cross Elasticities of Demand What do all these products have in common? What property is a common feature? AQA Econ 1: Markets and market failure

2. 1.2.2 What you need to know • Candidates should be able to calculate price, income and cross elasticities of demand and understand the factors that influence these elasticities of demand • They should understand the relationships between price elasticity of demand and firms’ total revenue (total expenditure), and between income elasticity of demand and normal and inferior goods

3. Elasticity theory • Plus or minus: • In elasticity theory we use the + and – sign to show the relationship between two variables: • A + sign stands for a positive relationship e.g. if income increases (+) demand increases (+) • A – sign stands for a negative relationship e.g. if price increases (+) demand decreases (-) • Elasticity theory looks at the sensitivity of one variable in relationship to another • To work out a percentage change we use the following formula: • An elasticity coefficient is the measure of the response of one variable to changes in another variable • If price increases by 5% demand might decrease by 15% • The elasticity coefficient is given by -15%/+5% = -3 • x 100

4. Price elasticity of demand If a product is price inelastic i.e. less than 1: an increase in P will lead to a decrease in D but an increase in Total Revenue (TR). A decrease in P will lead to an increase in D but a decrease in TR • Price elasticity of demand (PED) measures the responsiveness of demand to a change in price • Calculated by the formula: • = PED Or: = PED What does the answer mean? If a product is price elastic i.e. greater than 1: an increase in P will lead to a decrease in D but a decrease in TR. A decrease in P will lead to an increase in D but an increase in TR

5. Price elasticity of demand – relevance to business Price inelastic Perfectly inelastic D D Price Price Why can Premiership clubs charge such high prices? A perfectly inelastic product will have a PED coefficient of 0. If price was to change the quantity demanded would not be affected. In theory, the firm could charge as high a price as it wanted. A price inelastic product will have a PED coefficient between 0 and -1. If price was to change the quantity demanded would change by a lesser amount. Therefore, a firm should look to raise price. This would lead to higher sales revenue. Quantity Quantity

6. Price elasticity of demand – relevance to business Price elastic Perfectly elastic Price Price D The elasticity of air travel. D A price elastic product will have a PED coefficient between -1 and ∞. If price was to change the quantity demanded would change by a greater amount. Therefore, a firm should look to lower price. This would lead to higher sales revenue. A perfectly elastic product will have a PED coefficient of ∞. If price was to change the quantity demanded would be infinite. In theory, the firm could not increase price as there would be no demand. Quantity Quantity

7. Test yourself • Draw 4 demand diagrams - one to show each of the following: • Perfectly inelastic • Inelastic • Perfectly elastic • Elastic • In each case explain its relevance to a business

8. Price elasticity of demand The formula for PED can be rearranged to make it easier to work out an answer: a) ? b) ? c) = ? Example: A firm sells 100 units at a price of £10.00 per unit. It raises price by £5.00 and demand falls to 90 units. Work out the price elasticity of demand. Step 1: Step 2: Step 3: • x 100 = 10/100 x 100 = 10% • x 100 = 5/10 x 100 = 50% • = 10/50 = - 0.2 Complete the equations a-c to prove that PED is the same using all three formulas. PED = -2 Why is it expressed as a negative?

9. Determinants of price elasticity of demand A substitute product is a competing alternative for another product e.g. Coca-Cola and Pepsi-Cola are substitutes of each other. • Price elasticity of demand is determined by: • Substitutes • The number and closeness of available substitutes will help to determine PED • If there are no close or lack of available substitutes the product is likely to be very price inelastic and vice versa • Time • In the short run products are likely to be more price inelastic as consumers find it difficult to change their shopping habits • In the long run products are likely to be more price elastic as consumers adjust to changing market conditions • Definition of the market • As we widen the market so PED becomes more inelastic • For example, cigarettes are very price inelastic as there are no close substitutes • However, the demand for specific brands of cigarette will have a higher PED Economists like to define time under different categories: In the short runit is difficult to change factor inputs i.e. land, labour capital and entrepreneurship tend to be fixed in supply. In the long run it is easier to change factor inputs and their supply will vary according to the needs of the market. Are electronic cigarettes a close substitute for real cigarettes? What do you think will happen to the PED for cigarettes?

10. Test yourself Define the term price elasticity of demand. Always make use of relevant calculations when doing elasticity questions. The following table shows estimated changes in the price and demand of organic tomatoes: • Using the information in the table comment on the price elasticity of demand for organic tomatoes between each year. • In Germany the estimated price elasticity of demand for cinema tickets is -2.3 and for theatre tickets -0.4. Comment on the business relevance of these figures for the providers of cinema and theatre tickets.

11. Quick test To calculate the percentage change in the quantity supplied of a good following a change in price, the price elasticity of supply should be • Multiplied by the percentage change in price • Multiplied by the percentage change in quantity • Divided by the percentage change in price • Divided by the percentage change in quantity • Can you explain your answer?

12. Quick test Demand for good x has a PED of 0. The cost of the raw materials goes up by 5%. The increase in production costs will • Reduce the firms profit margins • Reduce the supply of the product • Shift the demand curve to the left • Be passed to the consumer in the form of higher prices • Can you explain your answer?

13. Quick test D D Which one of the following diagrams shows demand for a perfectly price inelastic product? Price Price Price Price a) b) D c) d) D • Can you explain your answer? Quantity Quantity Quantity Quantity

14. Quick test The PED for rail journeys is predicted to be 0.8. This shows that the demand for rail journeys is: • Perfectly inelastic • Inelastic • Perfectly elastic • Elastic • Can you explain your answer?

15. Income elasticity of demand When demand for a product increases when incomes increase we call this a normal good. Normal goods will always have a positive income elasticity of demand i.e. a + sign. When demand for a product decreases when incomes increase we call this an inferior good. Inferior goods will always have a negative income elasticity of demand i.e. a – sign. • Income elasticity of demand (YED) is a measure of the responsiveness of demand to a change in income • Calculated by the formula: • = YED Or: = YED What does the answer mean? Example: Incomes increase by 15%. This leads to an increase in the demand for iPads of 20%. The income elasticity of demand is: = 20/15 = +1.33

16. Determinants of income elasticity of demand There are two types of normal good: Necessities are products that have a positive YED that is between 0 and 1. Luxuries are products that have a positive YED that is greater than 1. Remember, products that have a negative YED i.e. less than 0 are an inferior good or service. • Income elasticity of demand is determined by: • Whether the good is a necessity or a luxury • At higher standards of living increased consumer incomes see additional demand tend towards luxury goods as demand for necessities is satiated • The level of income of a consumer • Poorer consumers tend to spend their income on necessities • As they become wealthier the YED for necessities moves towards zero as consumers are satisfied with the amount of the product e.g. staple foods that they can buy • Normal goods that are necessities will have lower positive YED coefficients • As consumer incomes increase they are likely to spend some of their income on luxuries • These products e.g. cars and foreign holidays will have higher positive YED coefficients

17. income elasticity of demand – relevance to business As global standards of living increase we would expect to see an increase in demand for luxury goods and a movement away from inferior goods. • Standards of living • Wealthier countries are likely to have consumers with higher disposable incomes • This means that they have greater spending power and are likely to use some of this greater income to buy luxury goods and services • Therefore, firms will produce superior products that meet the needs of these consumers e.g. high technology goods and complex financial services • The economic cycle • When the economy is in recovery mode and leading into boom disposable incomes increase and consumers spend a greater proportion of this increase in income firstly on necessities and then on luxury goods • When the economy is in decline and leading into slump disposable incomes decrease and consumers spend a lesser proportion of their incomes on luxury goods, moving to necessities and then inferior goods Firms will identify the state of the economy e.g. recession and produce goods and services to meet the demand of consumers. For example, pound shops selling necessities and inferior goods are likely to expand in these market conditions. How are increases in living standards fuelling the demand for luxury goods?

18. Test yourself Define the term income elasticity of demand. • In Italy the demand for fresh pasta is expected to increase by 5% as incomes increase by 2%. In the USA demand for fresh pasta is expected to increase by 1% as incomes increase by 3%. Use YED calculations to compare and comment on these findings. • Demand for small cars is expected to fall by 2% as incomes rise by 4%. Use YED calculations to comment on these findings. • The estimated income elasticity of demand for gym membership is shown in the table for three groups of consumers: Explain what each YED coefficient means. Comment on their business relevance for a gym targeting new members.

19. Quick test An inferior good which is relatively inelastic will have an income elasticity of demand coefficient that is • Less than -1 • More than -1 • Less than + 1 • More than + 1 • Can you explain your answer?

20. Quick test The income elasticity of demand for a good provided by a firm is - 0.7. What type of good is this most likely to be? • Inferior • Necessity • Luxury • Giffen • Can you explain your answer?

21. Cross-elasticity of demand • Cross-elasticity of demand (XED) is a measure of the responsiveness of demand for one good, x to a change in price of another good, y • Calculated by the formula: • = XED Or: = XED What does the answer mean? • Example: The price of good Y (Mars Bars) increases by 10%. • This leads to an increase in the demand for good X (Snickers) of 5%. • The cross-elasticity of demand is: • = 5/10 = +0.5

22. Determinants of cross-elasticity of demand Complementsare products that are bought alongside another product e.g. tennis balls will be bought as a complement to tennis rackets. These products are consumed together. Most goods have no relationship i.e. they are neither substitutes or complements. If the price of newspapers increases this will have no impact on the demand for toilet paper! • Cross-elasticity of demand is determined by whether the product is a: • Substitute • Substitutes will have a positive cross-elasticity of demand • As the price of good Y increases (positive) the demand for good X will increase (positive) • Close substitutes will have a higher XED as consumer demand for good X will be more sensitive to a change in price of good Y • Complement • Complements will have a negative cross-elasticity of demand • As the price of good Y increases (positive) the demand for good X will decrease (negative) • Close complements will have a higher XED as consumer demand for good X will be more sensitive to a change in price of good Y • Has no relationship • The change in the price of good X will have no impact on the demand for good Y • XED will be 0

23. cross-elasticity of demand - relevance to business • Firms will attempt to change the cross-elasticity of their products: • Substitutes • Firms will try to differentiate their products from the competition • This can be done through advertising and branding of the product so that consumers are less likely to switch to competitor’s products • A firm with plenty of close substitutes will be less able to increase its prices • Complements • Firms will produce a range of complements to accompany their core products • For example, Apple produce accessories, such as cases and docks, that consumers are likely to buy alongside their core products, such as the iPhone • A firm that sells a range of complements is likely to increase total revenue How does the latest technology impact on XED?

24. Test yourself Define the term cross elasticity of demand. Always make use of relevant calculations when doing elasticity questions. The following table shows estimated changes in the price of organic tomatoes and the demand for non organic tomatoes: Using the information in the table discuss whether organic and non organic tomatoes are substitutes.

25. Quick test Cross-elasticity of demand measures the responsiveness of demand for good x to a change in • Demand for good y • Price of good x • Price of good y • Availability of substitutes • Can you explain your answer?

26. Quick test Which of the following statements is most likely to be true about games consoles and games? • Income elasticity of demand is negative • Cross elasticity of demand is negative • Cross elasticity of demand is positive • Price elasticity of demand is unitary • Can you explain your answer?