Chapter 3 · Microeconomics
Applications of Demand and Supply
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Key Definitions
- Price elasticity of demand (PED)
- Percentage change in quantity demanded divided by percentage change in price. Inelastic when the absolute value lies between 0 and 1, elastic when above 1.
- Income elasticity of demand (YED)
- Percentage change in quantity demanded divided by percentage change in income. Normal goods are positive; inferior goods are negative.
- Cross elasticity of demand (XED)
- Percentage change in quantity demanded of good X divided by percentage change in price of good Y. Substitutes are positive, complements are negative, unrelated goods are zero.
- Price elasticity of supply (PES)
- Percentage change in quantity supplied divided by percentage change in price. A perfectly inelastic example is exclusive, one-off paintings.
Core Concepts
PED determinants (TIN CANs)
- T: number of substitutes.
- I: nature of the good - necessities and addictive goods are inelastic (rice, cigarettes); luxuries such as neckties are elastic.
- N: proportion of income spent on the good.
- CANs: time available to adjust.
YED ranges
- Normal necessities: YED between 0 and 1.
- Luxuries: YED above 1.
- Inferior goods: YED negative.
XED applications
- Substitutes, positive XED: petrol and electric cars.
- Complements, negative XED: petrol cars and petrol.
- Unrelated goods: XED of zero.
PES determinants (TALL)
- T: time period.
- A: availability and mobility of factors of production.
- L: level of stocks and storage.
- L: length of the production process.
Elasticity and revenue
Link between PED and total revenue
- When demand is inelastic, a price rise increases total revenue.
- When demand is elastic, a price rise reduces total revenue.
- Firms use this to guide pricing decisions.