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(i) Price Elasticity of Demand measures the proportionate change in quantity demanded
in response to a proportionate change in price. The Arc Elasticity Formula
An example of Price Elasticity of Demand is cigarettes. The Annual Budget announced for the year 2000 increased cigarettes by 50p per packet of 20. This did not cause a decrease in the sale of cigarettes - in fact it has added 0.7% to the inflation rate. This shows that even though the price of cigarettes increased, there was an increase in revenue to the exchequer. Hence, cigarettes are demand inelastic. (ii) Income Elasticity of Demand measures the proportionate change in quantity demanded
in response to a proportionate change in income. The Arc Elasticity Formula An example of Income Elasticity of Demand is the increased demand for cars even though the price of the cars has remained unchanged. Increased disposable income has generated the increased demand for the cars.
This is the type of question you show pray for. Just apply the numbers to the Arc Elasticity formula, do a little arithmetic (correctly) and you've got 100% of the available marks.
P1 = 100 (cent); P2 = 125 cent; Q1 = 100; Q2 = 78 ; Change in Quantity = -22; Change in Price = +25 Referring to the Arc Elasticity Calculator on this website, the answer is -1.11. Using the absolute value of the number, the answer is 1.11, a number which is greater than 1. A number greater than 1 indicates that Price Elasticity of Demand is elastic for this good. Calculating the change in total revenue, it can be seen that the increase of 25p has caused a loss in total revenue of 250p.
Giffen goods are Inferior goods which have a perverse (regressive) Demand Curve. The demand for them increases as price increases. See Key Terms page for further explanation of Giffen Goods. Inferior Goods are all goods that are not Normal goods. Inferior goods, therefore, include Giffen goods, but not all Giffen goods are Inferior goods. Inferior goods that are not Giffen goods relate to Income Elasticity of Demand - they have a negative income effect. A negative income effect means that less will be bought as the population's income rises, with nothing happening to the price of the good in question. Remould tyres is a classic example of Inferior goods. See Key Terms page for further explanation of Inferior Goods. Normal Goods are goods that have a negative demand effect and a positive income effect. Both these criteria must be present if the goods are to be classified as Normal goods. A negative demand effect means that less will be bought as the price increases (and vice versa). A positive income effect means that more will be demanded as incomes rise (and vice versa). See Key Terms page for further explanation of Normal Goods. Price Elasticity of Demand is a very important concept to the producers of goods and services. On the assumption that they are supplying Normal goods, the producers know that as they increase prices, the demand will tend to fall. PED will help to show them by exactly how much they can expect demand (and revenue) to change as a result of a change in their pricing strategy. On the basis of market research previously carried out, they will be able to put figures on the notation of the Arc Elasticity formula to calculate the coefficient. This coefficient will tell them, in absolute terms, what percentage change they can expect in quantity demanded as a result of each 1% change in price. Inelastic demand (<1 in absolute terms) will indicate an increase in total revenue if price is increased; elastic demand (>1 in absolute terms) will mean a decrease in total revenue if price is increased; unitary demand (= -1) means that there will be no change in total revenue caused by a change in price. It should be noted, however, that, while unitary elasticity will not bring about a change in revenue, it could result in an increase in profit. On the assumption that it costs less to produce less, producers who know that PED for their goods is unitary could increase the price of those goods. This would bring about a decrease in demand for them, but with the same revenue being generated. If the same amount of money is being accrued, but costs have fallen, profit levels will have risen. PED is neither always positive or negative. PED for Normal goods is always negative because as the price of a Normal good increases the demand for it will decrease. In the application of the Arc Elasticity formula, if the price rises the change in price will be a plus but the change in quantity will be a minus. Multiplying a plus by a minus will result in a minus or negative sign. Hence PED for Normal goods will always be negative. PED for Giffen goods will always be positive. As the price of a Giffen good increases, so also will the demand for it. This is a plus by a plus in the Arc Elasticity formula which must result in a plus. Of course, if the price of the Giffen good decreases, so also will the demand for it. This is a minus by a minus, which results in a plus. Hence PED for Giffen goods will always be positive. YED is neither always positive or negative. YED for Normal goods is always positive because as the income of the population increases the demand for Normal goods will also increase. In the application of the Arc Elasticity formula, if income rises the change in income will be a plus and the change in quantity will be a plus. Multiplying a plus by a plus will result in a plus (or positive) sign. Hence YED for Normal goods will always be positive. YED for Inferior goods will always be negative. As income increases, the demand for it will decrease. This is a plus by a minus in the Arc Elasticity formula which must result in a minus. Of course, if the population's income decreases, the demand for Inferior goods will increase. This is a plus by a minus, which results in a minus. Hence PED for Giffen goods will always be minus.
Explain means that you accept the statement in the question, and show that it is true. Cross Elasticity of Demand measures the change in the quantity demanded of one good in respect of a change in price of another good. To have a ratio between them, there must be a relationship - either the goods are substitutes for each other or they are complementary to each other. If there is no relatonship, there is no cross elasticity. If the Cross Elasticity of Demand between two goods is positive, then that means that as the price of one good increases so also does the demand for the other good. This means that the goods are substitutes for each other. An example of CED for substitute goods would be between two competing brands of breakfast cereal. If the price of Shredded Flakes increases, the demand for Shredded Flakes, all other things being equal, will tend to fall. Given that you still want to pour some cereal into your breakfast bowl, you would tend to buy Corn Pops, i.e., a substitute cereal that has not increased in price. So you can see that the price of Shredded Flakes went up and so did the demand for its substitute. A plus by a plus resulting in a plus. If the Cross Elasticity of Demand between two goods in negative, this means that as the price of one good increases, the demand for the other good decreases. This would happen if the goods were complementary to each other. An example will illustrate the point. If the price of DVD players is reduced (a minus), the demand for DVD players will increase (a plus), but so also will the demand for DVDs to play on the DVD players (DVDs are complements to DVD players). As the price of the DVD players falls, the demand for DVDs rises - a plus by a minus gives a minus.
Don't fall into the trap of thinking that the consumer is buying the same amount of petrol each week. She is spending the same amount of money, but purchasing less petrol. Applying the Arc Elasticity formula, P1 is 60 cent, P2 is 62 cent. Quantity 1 is �20 divided by 60 cent = 33.33 litres. Quantity 2 is �20 divided by 62 cent = 32.25 litres. The answer is, according to the Arc Elasticity Calculator -1.004 which is close enough to be treated as Unitary Elasticity.
If we assume Unity, then we know that a change in price will not result in a change in revenue for the supplier. The question, however, refers to profits. She should increase her price for petrol if she wants to maximise profits. By increasing the price, she will have lower demand and, assumingly, lower costs, but she will still have the same revenue. The same revenue, with lower costs, means higher profits. She should continue to increase petrol prices for as long as the consumer's PED is unitary.
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is used to calculate the elasticity.
The formula shows the ratio between change in price and change in demand. A
1:1 ratio means that a 1% change in price will cause a 1% change in quantity demanded.
This 1:1 ratio is called Unitary elasticity. A less than 1:1 ratio means that
the goods are demand inelastic, so a 1% change in price will cause less than a 1% change
in quantity demanded. A greater than 1:1 ratio signifies demand elasticity, where a
1% change in price will lead to a greater than 1% change in quantity demanded. Care
must be taken to use the absolute value of the number generated by the formula. The
sign will show whether the goods are Normal Goods (negative sign) or Giffen Goods
(positive sign) under Price Elasticity of Demand.
is used to measure the elasticity.
The formula shows the ratio between change in income and change in demand. A 1:1
ratio means that a 1% change in income will cause a 1% change in quantity demanded.
This 1:1 ratio is called Unitary elasticity. A less than 1:1 ratio means that the
goods are demand inelastic, so a 1% change in income will cause less than a 1% change in
quantity demanded. A greater than 1:1 ratio signifies demand elasticity, where a 1%
change in income will lead to a greater than 1% change in quantity demanded. Care
must be taken to use the absolute value of the number generated by the formula. The
sign will show whether the goods are Normal Goods (positive sign) or Inferior Goods
(negative sign) under Income Elasticity of Demand.