Flashcards in 1.2 Elasticity Deck (51)
What is price elasticity of demand?
Measures the degree of responsiveness of quantity demanded for a product following a change in its price.
How is PED calculated?
(percentage change in quantity demanded)/(percentage change in price)
Why is PED always negative?
Because of the law of demand.
What does the PED of a product depend on?
The degree of customers ability and willingness to pay.
When is demand price inelastic?
If a change in price causes a relatively small change in quantity demanded.
What does the inelastic demand curve look like?
When is demand price elastic?
If a change in price causes a relatively large change in the quantity demanded.
What does the elastic demand curve look like?
When is demand perfectly price inelastic?
If a change in price has no impact on the quantity demanded PED = 0.
What does perfectly price inelastic demand suggest?
There are no substitutes for the product?
What does perfectly price inelastic demand curve look like?
When is demand perfectly price elastic?
If a change in price leads to no demand
PED = infinity.
What does perfectly price elastic demand suggest?
Customers switch to buying other substitutes if firms increase their price.
What does perfectly price elastic demand curve look like?
When is demand unit elastic?
If a given price change leads to the same percentage change in the quantity demanded PED = 1.
What does unit price elastic demand curve look like?
A negative exponential.
On a normal downwards sloping demand curve how does the value of PED change and why does this occur?
The value of PED increases as the price level rises, this occurs because customers will be more responsive to changes in prices at higher levels.
What are the determinants of PED?
Substitution - the greater the number, availability and price of close substitutes there are for a good the higher the value of its PED tends to be. Products with few substitutes have price inelastic demand.
Income - the greater the proportion of consumers income spent on a good or service the more price elastic demand will be.
Necessity - products that are regarded as essential tend to be price inelastic as households will continue to purchase these even if price rise. By contrast the demand for luxuries is relatively price elastic.
Habits, addiction and fashion - if a product has a habit forming tendency or is highly fashionable PED tends to be price inelastic.
Advertising and brand loyalty - effete advertising for certain products can reduce the PED for the product and make it more price inelastic.
Time - the more time people have to change their preferences the more price elastic demand for the product will be.
Durability - the more durable a product is the more price elastic its demand is since there is no urgency to replace these if prices are high.
Costs of switching - if there are high costs involved for customers to switch between brands or products then demand tends to be price inelastic.
What are some applications of PED?
A firm that faces price inelastic demand can increase its prices to earn more total revenue, similarly if a device has price elastic demand it can reduce its prices to earn more revenue.
Assuming that the PED for a firms exports is price elastic it will generally benefit from lower exchange rates as export prices fall so the firm becomes more price competitive.
Firms with different PED values fro their products can use price discrimination to change different customers different prices for essentially the same product.
Firms can pass on most of the incidence of indirect taxes on products that are highly price inelastic.
Governments use PED to determine taxation policies.
What should a firm do if the demand of the good is price inelastic to get more revenue?
Increase the price of the good.
What should a firm do if the demand of the good is price elastic to get more revenue?
Decrease the price of the good.
What is cross price elasticity of demand?
measures the degree of responsiveness of demand for one products following a change in price of another product.
What are complements?
Products that are jointly demanded.
What are substitutes?
products that can be used as alternatives.
How is XED calculated?
(percentage change in quantity demanded of product A)/(percentage change in price of product B)
What XED do complements have?
Negative XED since a fall in the price of one product leads to an increase in the demand for the complementary products. The more negative the XED the stronger the complement.
What XED do substitutes have?
Positive XED since an increase in the price of one product leads to a rise in the demand for the alternative product. The more positive the XED the stronger the substitute.
What XED do unrelated products have?
Zero because the change in the price of one product does not directly affect the demand for the other.
What are applications of XED?
Knowledge of XED can be useful for firms because it can help to predict the effect on the quantity demanded if the price of the complementary good changes.
It can affect a firms pricing strategy depending on whether the XED value is very high or otherwise.
It allows firms to predict the effect on the quantity demanded for their product and hence total revenue if a rival firm changes its price.
It also lets firms know the extent to which customers will switch between competing brands thus informing their pricing and marketing strategies to remain competitive.