Distinguish between the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand [12]

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Essay requirements:

1. Distinguish the three concepts of elasticity of demand through:
   1. Definitions
   2. Formulas
   3. Factors that affect them
   4. Implications of their values
2. Change in demand rather than change in quantity demanded SHOULD BE used when there is a shift in demand curve (Eg during Increase in income of population)

Introduction (Overview of the different concepts)

The elasticity of demand for a good is the measure of the degree of responsiveness of the quantity demanded to a change in the determinant of demand, ceteris paribus. There are three concepts of elasticity of demand, each relating to one of the determinants of demand: price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED).

There are different definitions and formulas for PED, YED and XED.

The PED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. Mathematically, it can be expressed as:

The YED of a good is a measure of the degree of responsiveness of the quantity demanded to a change in income, ceteris paribus. Mathematically, it can be expressed as:

The XED for a good with respect to another good is a measure of the degree of responsiveness of the quantity of the first good demanded to a change in the price of the second good, ceteris paribus. Suppose that the 2 goods are good A and good B. Mathematically, it can be expressed as:

Point: Implications of PED, YED and XED

• Sub point: Price elasticity of demand (PED)
  • The PED for a good is negative due to the law of demand and the common practice among economists is to drop the negative sign.
  • If the PED for a good is greater than one, such as in the case of private cars, the demand is price elastic, which means that a change in the price will lead to a larger than proportionate percentage change in the quantity demanded.
  • In the case of PED, economists are concerned with weather the value is greater or less than 1.
• Sub point: Income elasticity of demand (YED)
  • Economists look at the sign of YED, if it is positive or negative
  • YED distinguishes between normal and inferior goods
  • If the YED for the good is positive, such as in the case of clothing, the demand will rise when consumers’ income rises and good of this nature are known as normal good.
  • A normal good with a YED greater than one is known as a luxury good
  • A normal good with a YED less than one is known as a necessity
  • If the YED for a good is negative, such as in the case of public transport, the demand will fall when consumer’ income rises and goods of this nature are known as inferior goods.
• Sub point: Cross elasticity of demand (XED)
  • Economists look at the sign of XED, if it is positive or negative
  • XED distinguishes between substitutes and complements
  • If XED_AB is positive, such as in the case of Coke and Pepsi, good A and good B are substitutes, which means that the two goods are alternatives to each other.
  • If there XED_AB is negative, such as in the case of car and petrol, good A and good B are complements, which means that the two goods are consumed together.

Point: Factors determining extent of PED, YED and XED

• Sub point: Factors affecting price elasticity of demand (PED)
  • The PED for a good will be higher if the following factors are present:
    • The larger the number of substitutes
    • The closer the substitutes
    • The lower the degree of necessity
    • The larger the proportion of income spent on the good
    • The longer the time period under consideration.
  • Sub point: Factors affecting income elasticity of demand (YED)
    • The YED for a good will be higher if the following factors are present:
      • The more luxurious the good
      • The lower the level of income
    • Sub point: Factors affecting cross elasticity of demand (XED)
      • The XED for a good will be higher if the following factors are present:
        • The more closely related the two goods
          • A large positive XED indicates very close substitutes and a large negative XED indicates very close complements

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