Cambridge Economics A Level Qualification (eBook)

Cross Elasticity of Demand (XED)

Formula and Calculation:

Cross Elasticity of Demand measures how much the quantity demanded of one good responds to a change in the price of another good.

Example: If the price of tea increases by 10% and the demand for coffee (a substitute) increases by 5%, the XED would be 0.5, indicating that coffee and tea are substitutes, but the demand for coffee is somewhat responsive to the price change in tea.

Significance:

A positive XED indicates substitute goods; as the price of one increases, the demand for the other also increases.

A negative XED indicates complementary goods; as the price of one increases, the demand for the other decreases.

The magnitude of XED helps in understanding the degree of substitutability or complementarity between two goods.

2. Significance of Relative Percentage Changes

Understanding the significance of relative percentage changes is crucial in economics as it provides a standardized way to measure how responsive, or elastic, the demand for a good. This standardization allows economists and businesses to compare the sensitivity of different goods across different contexts and price points, offering insights into consumer behavior and market dynamics.

Size and Sign of the Coefficient:

Price Elasticity of Demand: The size of the PED coefficient indicates the extent of responsiveness. A large absolute value suggests high sensitivity to price changes. The sign (usually negative due to the inverse relationship between price and quantity demanded) indicates the direction of this responsiveness.

Income Elasticity of Demand: The sign of the YED coefficient distinguishes between normal (positive sign) and inferior (negative sign) goods. The size shows how much of a luxury or necessity a good is.

Cross Elasticity of Demand: The sign indicates whether goods are substitutes (positive) or complements (negative). The size shows the strength of the relationship.

Part 1: Descriptions of Elasticity Values

Elasticity in economics is a fascinating way to understand how much the quantity demanded of a good or service changes in response to a price change. Think of elasticity as a measure of sensitivity—how sensitive are consumers to price changes?

Perfectly Elastic Demand is the ultimate sensitivity level. Imagine you're selling ice cream and decide to raise your price by just one penny, but suddenly, no one buys your ice cream anymore. This is because consumers will switch to a substitute at any slight increase in price. The demand curve here is a horizontal line, indicating that consumers are infinitely sensitive to price changes.

Highly Elastic Demand reflects a scenario where a small change in price leads to a large change in quantity demanded. Let’s say you're selling concert tickets. If you slightly lower the price, you’ll see a huge surge in sales. This shows that consumers are very responsive to price changes, but not to the infinite degree of perfectly elastic demand. The demand curve is steep but not horizontal.

Unitary Elasticity is the Goldilocks zone of elasticity. A change in price leads to a proportional change in quantity demanded. If you raise the price of your handmade soap by 10%, and as a result, sales drop exactly by 10%, you've hit unitary elasticity. The total revenue from sales remains unchanged because the percentage drop in demand matches the percentage rise in price.

Highly Inelastic Demand means consumers are quite stubborn about changing their buying habits despite price changes. For instance, insulin for diabetics has highly inelastic demand. Even significant price hikes may not drastically reduce the quantity demanded, as it is essential for survival. The demand curve is relatively flat, showing that quantity demanded is not very sensitive to price changes.

Perfectly Inelastic Demand is where the sensitivity hits zero. No matter how much the price changes, the quantity demanded stays the same. Imagine a life-saving drug: even if the price doubles or triples, those in need will still buy it if they can afford it, because there are no substitutes. The demand curve here is a vertical line.

Part 2: Variation in Price Elasticity of Demand Along a Straight-Line Demand Curve

The price elasticity of demand varies along the length of a straight-line demand curve, which is a crucial concept in understanding market dynamics. This variation tells us that not all price changes affect quantity demanded in the same way along the curve.

Upper Portions of the Curve: Here, the demand is more elastic. Why? Because at higher prices (and lower quantities), consumers are more sensitive to price changes. They have more alternatives and are more willing to change their purchasing decisions. If the price of a luxury car drops slightly from a very high price point, you might see a significant increase in quantity demanded, as those who were just out of reach of affording it can now consider buying.

Middle Portion of the Curve: This is where we encounter unitary elasticity. At this point, a price change leads to a proportional change in quantity demanded. It's a critical area for businesses because it represents a balance between price changes and sales volume, often maximizing total revenue.

Lower Portions of the Curve: Demand becomes inelastic. At lower prices (and higher quantities), consumers become less sensitive to price changes. Here, even substantial price reductions result in relatively small increases in quantity demanded. For staple goods like bread or rice, price decreases won’t significantly boost the quantity people buy because there’s a limit to how much more they can consume.

Imagine a demand curve for a popular smartphone. Initially, when prices are high, a small price cut could significantly boost sales, as tech enthusiasts and those waiting for a slight decrease jump on the opportunity. As prices continue to drop, more people can afford the phone, but the increase in quantity demanded for each price reduction becomes smaller. Eventually, nearly everyone who wants and can afford the phone has purchased it. Further price reductions might not significantly increase sales, as the market becomes saturated.

1. Factors Affecting Elasticity Measures

Price Elasticity of Demand

Price Elasticity of Demand (PED) indicates how sensitive the quantity demanded of a good or service is to a change in its price. Several factors influence PED:

Substitutability: The more substitutes a product has, the higher its price elasticity. Imagine a world where tea and coffee are seen as direct substitutes. If the price of coffee increases, people might easily switch to tea, indicating high price elasticity.

Necessity vs. Luxury: Necessities tend to have inelastic demand because consumers will buy them regardless of price changes. In contrast, luxury goods exhibit elastic demand; a slight price increase can significantly reduce their quantity demanded.

Proportion of Income Spent: Products that consume a large portion of a consumer's income tend to have elastic demand. For example, a rise in housing costs significantly affects demand because housing takes up a large share of most people's budgets.

Time Horizon: The elasticity of demand for a product increases over time. Immediately after a price increase, consumers might not reduce their consumption by much, but over time, they may find alternatives or adjust their habits, leading to greater sensitivity to price.

Income Elasticity of Demand

Income Elasticity of Demand (YED): Influential factors include:

Type of Good: For normal goods, YED is positive, meaning demand increases as income rises. For inferior goods, YED is negative; demand falls as income goes up. A classic example is that as people's income increases, they may switch from public transportation (an inferior good) to owning a car (a normal good).

Income Levels: The stage of economic development and overall income level of a society can influence YED. In wealthier societies, the demand for luxury goods (with high YED) might increase faster compared to basic necessities.

Cross Elasticity of Demand

Cross Elasticity of Demand (XED) gauges how the quantity demanded of one good responds to a price change in another good. Key factors include:

Substitutes and Complements: For substitute goods, XED is positive; as the price of one good goes up, demand for its substitute increases. For complementary goods, XED is negative; an increase in the price of one good reduces the demand for its complement. For instance, if the price of printers goes down, the demand for complementary goods like ink cartridges might increase.

2. Relationship Between Price Elasticity of Demand and Total Expenditure

The relationship between PED and total expenditure (or total revenue) on a product is critical for understanding market dynamics. This relationship is often illustrated through the expenditure approach, where total expenditure equals the price of a product multiplied by the quantity...