Answer to Question #203169 in Economics of Enterprise for Nawo Ranasinghe

Question

7. Explain following concepts by using appropriate graphs.

1.     Price elasticity of demand

2.     Income elasticity of demand

3.     Cross price elasticity of demand

4.     Market equilibrium

5.     Government interference in the market

Answer 1

1. Price elasticity of demand.

Price elasticity of demand is the responsiveness of demand to change in price. Demand extends or contracts respectively with a fall or a rise in price.

perfect elasticity of demand

This is an infinite case of elasticity of demand where a negligible fall in the price of the commodity leads to an infinite extension in the demand for it.

Perfectly inelastic demand

This means that however great the rise or fall in the price of the commodity given, its demand remains unchanged or constant.

2.Income elasticity of demand

This is the ratio of the percentage change in the quantity demanded to percentage change in income.

positive income elasticity of demand

Refers to a situation when the demand for a product increases with increase in consumer's income and decreases with decrease in consumer's income.

The slope of the curve is upward from left to right, which indicates that the increase in income causes increase in demand and vice versa.

Negative income elasticity of demand

This is a kind of income elasticity of demand in which the demand for a product decreases with increase in consumer's income. Income elasticity of demand is negative for inferior goods.

The graph above shows that when income is 10, then demand for goods is 4 units. On the other hand, when income increases to 20, then the demand is 2 units. The curve slopes downwards from left to right which indicates that an increase in income causes decrease in demand and vice versa.

Zero income elasticity of demand

This is income elasticity of demand whose numerical value is zero. This is because there is no effect of increase in consumer's income on the demand of product. Income elasticity of demand is zero incase of essential goods. This is as illustrated by the graph below:

3.Cross price elasticity of demand.

This is the measure of how sensitive the demand of a product is over a shift of a corresponding product price. When goods in the market are related, this means a product's price increase or decrease can positively or negatively affect the other product's demand.

cross elasticity of substitute goods

An increase in price of a substitute product increases the demand for the competing product. This is because consumers try to maximize utility.

A close substitute is realized when a minimal increase in price leads to a large demand increase of the substitute product.

A weak substitute is realized when a large increase in the price of a product X leads to only a small increase in demand for product Y.

Cross elasticity for complementary products.

If the price of one product increases, the demand for the complementary product decreases.

For a close complement, a minimal price decrease leads to a large increase in demand for the complement product. This is illustrated by the following graph:

For a weak complement, a large price decrease leads to a small increase in demand for the complementing products. Graph below illustrates this:

4.Market equilibrium

This is a situation where for a particular good, supply=demand. When the market is in equilibrium, there is no tendency for prices to change. We say the market clearing price has been achieved.

If the price is below equilibrium , the situation is illustrated graphically as follows:

If the price is above equilibrium, the situation is illustrated graphically as follows:

5.Government interference in the market

This involves a situation where the government sets the prices in the market. This is by enforcing price floors and price ceilings.

Price floors

Refers to a minimum allowable price set above the equilibrium price . The government forbids a price below the minimum. A price floor that is set above equilibrium price creates a surplus. This is as shown by the following graph:

the price $P_f$ indicates the price floor that is above the market equilibrium price.

Price ceiling

This is a maximum allowable price. The government forbids a price above the maximum. A price ceiling that is set below equilibrium price creates a shortage that will persist. The graph below illustrates this:

The price, $P_c$ represents the price ceiling that is below the equilibrium price.