of cars, and beds, and tvs, and root beer (Chapter 4 Q&A)

02/10/2012 § 1 Comment

#2: A two-parter question. Total: 25 marks.

(a) Carefully explain what it is that price, income and cross-elasticities of demand are meant to measure.

The price elasticity of demand (PED) is meant to measure the consumers’ responsiveness to a change of price in a good. This asks how sensitive are consumers should the price of a certain product change. If the price of a certain product, let’s say TV’s, were to increase slightly and it led to a large decrease in the quantity demanded, then the good (the TV) is elastic because a small change in the price induces a large change in the quantity demanded. It goes both ways – if the price of the TV’s were to increase largely and it only led to a small decrease in the quantity demanded, then the good is inelastic because the producers don’t care that much about the good and aren’t sensitive to it as they would be to more elastic goods.

The income elasticity of demand (YED) is meant to measure the consumers’ responsiveness for a particular good in regards to a change in their income. As their income rises or falls, how sensitive are they then to normal and inferior goods? For example, if Japan’s economy regains its strength and its people’s incomes start to rise again, we would see an decrease in the purchase of bikes and an increase in the purchase of cars. If a small increase in income causes a large increase in purchasing cars, then cars would be considered income elastic and a normal good. On the other hand, if a large decrease in income caused a small increase in Family Mart or Lawson food, then that good is inelastic and inferior. If the value of the YED coefficient is positive, it indicates that the good is a normal good whereas if the YED coefficient is negative, it indicates that the good is an inferior good.

The cross-price elasticity of demand (XED) is meant to measure the consumers’ responsiveness of one good in regards to a change in the price of a related good – complementary and substitute. Say for example we have the substitute drinks Dad’s Root Beer and A&W – they’re both root beers. If A&W shows a small increase in price and Dad’s quantity demanded shoots up, then the two drinks are strong substitutes for each other and are elastic. Likewise, if A&W shows a large increase in price and Dad’s quantity demanded hardly goes up, then the two drinks are not considered strong substitutes for the other. With complementary goods, like beds and mattresses, if an increase (or decrease) in the price of beds leads to a small change in the quantity demanded, then the two goods are not sensitive to one another and are inelastic. The positive and negative coefficients of the XED value identify whether there is a direct relationship (+) or not (-).

(b) Discuss the practical importance of the concept of price elasticity of demand for the government. 

It’s practical, almost vital, that governments are familiar and up to date with the price elasticity of demand of multiple goods so that they can address the effects of what these goods do. If certain goods are inelastic, therefore a normal good and always in demand, then the government could support the suppliers by giving them subsidies. If other goods are elastic, therefore an inferior good, then the government will know whether or not to limit or to help the producers advance. By understanding the concept of price elasticity of demand, a government will know what in their country is a luxury, necessity, a normal good or just an inferior good. With this information, they can help direct traffic – the flow of money – and further understand how to distribute and allocate their resources to producers.

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