Explain what is meant by the terms price elasticity, income elasticity and cross elasticity of demand and discuss the main determinants of each of these. Discuss the importance of each of these to the decision making process within a typical business.
Elasticity is the responsiveness to which one variable responds to a change in another variable Price elasticity of demand (PED) measures the responsiveness of quantity demanded of a product to a change in its price. If a relatively small change in price leads to a relatively large change in demand, the product is said to be ‘elastic’.
Whereas if quantity demanded is relatively unresponsive to a change in price the product is said to be ‘inelastic’.
Price elasticity of demand can be given a numerical value which is just a number and not in terms of any particular unit. The resulting numerical figure will always be a negative number due to the inverse relationship between price and quantity demanded, but can be ignored. This numerical figure can be calculated by:Price elasticity of demand = percentage change in quantity demanded Percentage change in price For example if the price of a product rises from £20 to £24, which is a 20%change and demand falls from 400 units to 300 units, which is a 25% change, the calculation will be:25% = -1.2520%When the percentage change in price leads to a smaller percentage change in quantity demanded price elasticity of demand will be a number between 0 and -1 and the product is said to be ‘inelastic’.
On the other hand when the percentage change in price leads to a larger percentage change in quantity demanded price elasticity of demand will be a number between -1 and – infinity and the product is said to be ‘elastic’ such as the product used in the example above.
If the price elasticity of demand is exactly 1 the product is said to have ‘unit’price elasticity of demand. This occurs when a percentage change in price leads to an equal percentage change in quantity demanded.
If a change in price causes an infinite change in quantity demanded the product is said to have ‘perfectly elastic’ demand. For example if there were a number of people selling football shirts outside a football stadium, if one of the sellers lowered their price below all of their competitors, they may capture all of the customers going to the stadium.
The final result is when a change in price causes no change to the quantity demanded and this is known as ‘perfectly inelastic’ demand. For example a person who has a serious illness and has to take drugs to survive may be prepared to purchase the same amount of the drugs however much the price rises and will not benefit in purchasing a larger quantity of the drugs if the price was to fall.
There are many influences determining weather products will be elastic or inelastic for example if there are many close substitutes for a product, demand for it will tend to be elastic. An example of this would be a particular brand of paint, if’Dulux’ were to raise its price, people who previously used ‘Dulux’ paint would switch to another, cheaper brand. Paint as a whole is very much an inelastic product as it has no close substitutes.
Also if products are addictive price elasticity of demand will tend to beinelastic. For example alcohol and tobacco are addictive products so even a relativelylarge raise in price will not cause people to stop buying them.
Also if goods are seen to be a ‘luxury’ which people can generally go withoutthey will tend to be price ‘elastic’. On the other hand if goods are seen as ‘necessities’which people generally need to live, they will be prepared to buy them even with araise in price and tend to be price ‘inelastic’.
Income elasticity of demand (YED) measures the responsiveness of demand toa change in people’s income. Income elasticity of demand can also be given anumerical figure, which can be calculated by:Income elasticity of demand = Percentage change in quantity demandedPercentage change in incomeMost goods have a positive income elasticity of demand, meaning a raise inincome will lead to a raise in demand for the product and vice versa. Goods whichhave a positive income elasticity of demand over 1 are said to be superior goods andare also seen as being luxury goods. Examples of these would be travel abroad,catering and alcohol which would be consumed greatly more with a raise in a person’sincome.
Goods which have a negative income elasticity of demand are known asinferior goods or giffin goods. These are products where a raise in income will lead tofewer of the product being consumed. An example of this could be sliced white bread,when people have a raise in income they can afford to pay for more ‘exiting’ and’better’ types of bread such as freshly baked loafs from the baker. Other examples ofgiffin goods are poor quality clothing, public transport and other staple foodstuffs.
Cross elasticity of demand (XED) measures the responsiveness to a change inprice of one product to the resulting change in demand of another. This can be used totell weather products are substitute goods or complementary goods. Similarly crosselasticity of demand can also be given a numerical value which is just a number andnot in terms of any unit. This can be calculated by:Cross elasticity of demand = Percentage change in quantity demanded of good APercentage change in price of good BIf cross elasticity of demand is a positive number the goods will be substitutesfor each other, meaning an increase in the price of good A will lead to an increase indemand for the good B (and vice versa). An example of this would be butter andmargarine, if the price of butter were to raise by too much people who previouslybought butter would switch to the now cheaper margarine.
If cross elasticity of demand is a negative number the goods will becomplementary products, meaning and increase in the price of good A will lead to adecrease in demand for good B (and vice versa). An example of this would befountain pens and ink cartridges.
Finally if cross elasticity of demand is 0 it means there is no relationshipbetween the products, such as jeans and watercress.
Businesses can use price elasticity of demand figures to check they are sellingtheir products at the correct price to maximise profits. For example if a firm is selling1,000 units of its product each week at £20 per unit their weekly revenue will be1,000 x £20 = £20,000.
If the firm were to increase the price of each unit from £20 to £22, a 10%increase the volume of units sold may drop from 1,000 to around 950, a 5% fall.
Although the firms output has fallen their revenue has risen due to 950 x £22 =£2,900. The higher price of each unit more than offsets the lost quantity of units sold.
The general rule for this is if a products price elasticity of demand is ‘inelastic’a rise in price will lead to people spending more. An increase in price of a productwith an ‘elastic’ price elasticity of demand will lead to people spending less.
The government also has to think about price elasticity of demand when itcomes to the budget and the increase of taxes. If tax is raised on an elastic good thenthe government may find that less revenue is raised on that good compared to theprevious year when the tax on it was less. This has been the argument for therelatively modest increases in the tax on spirits in the UK over the past few years.
Income elasticity of demand will only affect certain businesses that deal withluxury goods with a positive income elasticity of demand. Businesses such as travelagents may need to act more on signs of a recession compared with businesses whichdeal in necessity goods such as the large supermarkets. The large supermarkets willnot loose sales in a time of recession but will also not experience a growth in sales at atime of economic growth.
Businesses may also be keen to use cross elasticity of demand to find out itsclosest complementary products and its closest substitutes. For example strawberryjam and raspberry jam may be seen as substitutes. If a firm producing strawberry jamfound out there was a particularly poor raspberry season they may decide to increaseoutput in preparation of more customers wanting to purchase strawberry jam.
Firms which operate with strong complementary products must scan theenvironment for signs of any changes that may affect them. The problem with lookingat cross elasticity of demand is because markets change so quickly the information islikely to be out of date as soon as it is discovered.
Begg, D. Fischer, S. Dornbusch, R. (1987) Economics, Second Edition, McGraw hill, Maidenhead, Berkshire.
Grant, SJ. (2000) Stanlake’s Introductory Economics, Longman, Harlow, Essex.
Hall, D. Jones, R. Raffo, C. (1999) Business Studies, Causeway Press, Ormskirk, Lancashire