Answer to Question #131582 in Microeconomics for sahar

Question

II. Differentiate between cross price elasticity and income elasticity of demand. also provide interpretation of signs
III. Assume a straight line demand curve, what would happen to elasticity of demand if a consumer moves on the demand curve from left to right?
IV. List five determinants of price elasticity of demand. How each determinant causes price elasticity of demand, explain through examples?

Answer 1

II) Cross price elasticity of demand (XED) refers to the measure of the responsiveness of quantity demanded of one good to the change in price of another good. $XED = \dfrac {\% change \space in \space quantity \space demanded \space for \space good \space Y}{\% change \space in \space price \space of \space good \space X}$

XED can be positive (XED > 0) or can be negative (XED < 0). When XED is positive, the goods X and Y are substitutes. This is because an increase in the price of a substitute good, say Nokia handset, will increase the demand for the other substitute, say Samsung handset. The opposite holds true for a fall in price. Therefore, price and quantity demanded move in the same direction. On the other hand, when XED is negative, the goods are complements. An increase in the price of a complement good such as a film camera will result in a fall in demand for the other complement such as films. The opposite holds for a decrease in price. As a result, for complements, price and quantity demanded move in different directions and hence negative XED.

However, income elasticity of demand (YED) is a measure of the responsiveness of quantity demanded to a change is disposable income.

$YED = \dfrac {\% change \space in \space quantity \space demanded}{\% change \space in \space disposable \space income}$

YED can also be positive (YED > 0) or negative (YED < 0). When YED is positive, the good concerned is a normal good. A normal good is a good whose demand increases as income increases, and vice-versa. There is therefore a positive correlation between disposable income and demand for a normal good. On the other hand, when YED is negative, the good is an inferior good. An inferior good is a good whose demand falls as disposable income rises. A good example are second hand clothes. Therefore, there is a negative correlation between demand for inferior goods and disposable income.

II) Along the demand curve, from left to right, the absolute value of the price elasticity of demand decreases in value, that is, it changes from elastic to inelastic.

During the upper section of the demand curve, price is high and quantity demanded is small. As a result, the percentage change is quantity demanded is higher than the percentage change in price resulting in elastic price elasticity of demand. During the middle section of the demand curve, the price elasticity of demand approaches unit as quantity demanded and price change proportionately in percentage terms. On the lower section of the demand curve, price is low and quantity demanded high. The percentage change is quantity demanded is therefore lower than the percentage change in price resulting in an inelastic demand. The graph below summarizes this explanation.

III) Determinants of price elasticity of demand include nature of the good, type of the good, expensiveness of the good, availability of close substitutes, definition of the good, and time period.

Nature of good - habit forming goods such as cigarettes and alcohol are inelastic in demand for they lead to addiction causing people to fail to live without them. However, non habit forming goods such as soft drinks, fruits, and more do not cause addiction and hence are elastic in demand.

Type of the good - necessities such as basic goods and medical drugs such as sugar diabetes drugs are inelastic in demand for people cannot live without them. However, luxury goods such as expensive clothes and food are elastic in demand for people can live without them.

Availability of close substitutes - goods with no close substitutes such as electricity and many basic goods are inelastic in demand since consumers do not have alternatives. However, goods with many substitutes such as clothes, transport and more are elastic in demand since consumers can switch to substitute goods.

Expensiveness of the good - inexpensive goods such as needles, razor blades, and match boxes consume an insignificant proportion of the consumer's budget and hence they remain inexpensive even after price increases. They are therefore inelastic in demand. However, expensive goods such as cars, houses and more consume a great proportion of the consumer's budget and hence are elastic in demand.

Time period - in the short run economic period, goods will have little substitutes and hence inelastic in demand. This is very common with agricultural goods. However, in the long run, most goods develop close substitutes and hence becoming elastic in demand.