Carefully Explain What It Is That Price, Income and Cross Elasticities of Demand Are Meant to Measure. Use Appropriate Diagrams and Numerical Examples

Elasticity is a measure of responsiveness. It shows us how much something changes when there is another change in one of the other variables that determines it. There are three elasticities of demand that we consider, price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED). An important aspect of a product’s demand curve is how much the quantity demanded changes when price is changed. The economic measure of this response in the price elasticity of demand (PED).

It is most commonly calculated with the following equation: PED = % change in quantity demanded of the product % change in price of product The above formula will usually give a negative value, due to the inverse nature of the relationship between price and quantity demanded. This is given, and explained, by the “law of demand”. For example, if the price of a product increases by 5% and quantity demanded decreases by 5%, therefore: PED = ? 5% 5% PED = ? 1

The PED is negative for the vast majority of goods and services, however, economists often refer to price elasticity of demand as a positive value (i. e. , in absolute value terms). Here is a graph, showing all the possible outcomes of PED according to elastic, inelastic, perfectly elastic, perfectly inelastic and unitary. As the difference between the two prices or quantities increases, the accuracy of the PED given by the formula decreases for a combination of two reasons. First, the PED for a product is not necessarily always constant.

PED can vary at different points along the demand curve, due to its percentage nature. Elasticity is not the same thing as the slope of the demand curve, which is dependent on the units used for both price and quantity. Second, percentage changes are not symmetric, more like the percentage change between any two values depends on which one is chosen as the starting value and which as the ending value. For example, if quantity demanded increases from 10 units to 15 units, the percentage change is 50%, i. e. , (15 ? 10) ? 10 (converted to a percentage).

But if quantity demanded decreases from 15 units to 10 units, the percentage change is ? 33. 3%, i. e. , (15 ? 10) ? 15. Income elasticity of demand is a measure of how much the demand for a product changes when there is a change in the consumer’s income, holding all prices constant. It is calculated as the ratio of the percentage change in demand to the percentage change in income. It is often calculated using the equation shown below: YED = % change in quantity demanded of the product % change in income of the consumer For example, a person has an increase in annual income from ? 0,000 per year to ? 66,000. They then increase their annual spending on holidays from ? 2,500 to ? 3,000. Their income has risen by ? 6,000, which is a change of 10%. The quantity demanded of holidays has increased by ? 500, which is a change 20%. Therefore: YED = 20% 10% YED = 2 Normal goods have a positive income elasticity of demand so as consumers’ income rises, so more is demanded at each price level, there is an outward shift of the demand curve. Inferior goods have a negative income elasticity of demand. Demand falls as income rises.

Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties. So there is an inward shift of the demand curve. The results are important since the values of income elasticity tell us something about the nature of a product and how it is perceived by consumers. It also affects the extent to which changes in economic growth affect the level and pattern of demand for goods and services.

This graph is a typical diagram for YED. The income elasticity of demand for a product will also change over time – the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Cross elasticity of demand is a measure of how much the demand for a product changes when there is a change in the price of another product.

It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good, using the following equation: XED = % change in quantity demanded of the product X % change in price of product Y For example, the owners of a pizza stand find that when their competitor, a hamburger stand, lowers the price of a burger from ? 2 to ? 1. 80, the number of pizza slices that they sell each week falls from 400 to 380, because of the lowered price of a burger.

The competitors price has fallen by -10% and the quantity demanded of the pizza slices has fallen by -5%, therefore: XED = -5% -10% XED = 0. 5 Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls (Graph 1), two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises (Graph 2) and two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant (Graph 3).