Elasticity of Demand and Business Applications: Price, Income and Cross Elasticity (Measurement and Uses) Questions

Q: Explain cross elasticity of demand and interpret its sign.

Cross elasticity (Exy) = %ΔQx / %ΔPy measures how demand for X changes when price of Y changes. Interpretation: - Exy > 0: substitutes (tea and coffee). - Exy < 0: complements (car and petrol). - Exy = 0: unrelated goods. It helps understand competition and product bundling.

Q: Explain factors affecting price elasticity of demand (any three).

Factors affecting price elasticity (any three): 1) Availability of substitutes: more substitutes → more elastic demand. 2) Nature of good: necessities are inelastic, luxuries are elastic. 3) Proportion of income spent: higher share of income → more elastic. Other factors include time period, number of uses, and habit-forming nature.

Question 1

Define elasticity of demand.

Accepted Answer

Elasticity of demand is the degree of responsiveness of quantity demanded to a change in a determinant such as price or income.

Question 2

Write the formula of price elasticity of demand.

Accepted Answer

Price elasticity of demand (Ep) = % change in quantity demanded / % change in price.

Question 3

What is unitary elastic demand?

Accepted Answer

Unitary elastic demand means % change in quantity demanded equals % change in price (|Ep| = 1).

Question 4

What is income elasticity of demand?

Accepted Answer

Income elasticity measures the responsiveness of demand to changes in consumer income.

Question 5

What is cross elasticity of demand?

Accepted Answer

Cross elasticity measures how demand for one good changes when the price of another good changes.

Question 6

State one determinant of price elasticity.

Accepted Answer

Availability of close substitutes is a key determinant of price elasticity.

Question 7

Explain the degrees/types of price elasticity of demand.

Accepted Answer

Degrees/types of price elasticity (based on |Ep|):
1) Perfectly inelastic (Ep=0): quantity does not change with price.
2) Relatively inelastic (Ep<1): small response to price changes.
3) Unitary elastic (Ep=1): %ΔQ = %ΔP.
4) Relatively elastic (Ep>1): quantity responds strongly.
5) Perfectly elastic (Ep=∞): very small price change leads to large demand change (theoretical).

These categories help in pricing decisions.

Question 8

Explain income elasticity of demand and classify goods based on it.

Accepted Answer

Income elasticity (Ey) = %ΔQ / %ΔY measures how demand changes with income. Classification: - Ey > 0: normal goods. - 0 < Ey < 1: necessities (demand rises less than income). - Ey > 1: luxuries (demand rises more than income). - Ey < 0: inferior goods (demand falls when income rises). It helps firms position products for different income groups.

Question 9

Explain cross elasticity of demand and interpret its sign.

Accepted Answer

Cross elasticity (Exy) = %ΔQx / %ΔPy measures how demand for X changes when price of Y changes.
Interpretation: 
- Exy > 0: substitutes (tea and coffee).
- Exy < 0: complements (car and petrol).
- Exy = 0: unrelated goods.

It helps understand competition and product bundling.

Question 10

Explain factors affecting price elasticity of demand (any three).

Accepted Answer

Factors affecting price elasticity (any three):
1) Availability of substitutes: more substitutes → more elastic demand.
2) Nature of good: necessities are inelastic, luxuries are elastic.
3) Proportion of income spent: higher share of income → more elastic.

Other factors include time period, number of uses, and habit-forming nature.

Question 11

State the relationship between elasticity and total revenue.

Accepted Answer

Total revenue (TR) = P×Q. Relationship:
- If demand is elastic (|Ep|>1): price ↓ causes TR ↑, and price ↑ causes TR ↓.
- If demand is inelastic (|Ep|<1): price ↑ causes TR ↑, and price ↓ causes TR ↓.
- If unitary (|Ep|=1): TR remains unchanged when price changes.

This guides pricing decisions.

Question 12

Explain two business uses of elasticity of demand.

Accepted Answer

Business uses of elasticity (any two):
1) Pricing and discount decisions: elasticity predicts how sales and revenue change with price changes; helps decide whether to increase price or offer discounts.
2) Product/market strategy: income elasticity helps decide whether to position product as necessity or luxury; cross elasticity indicates competitive pressure and substitute threats.

Thus elasticity supports revenue planning and competitive strategy.

Question 13

Explain price elasticity of demand in detail. Describe measurement methods and relate elasticity to total revenue.

Accepted Answer

Price elasticity of demand (PED) measures how quantity demanded responds to a change in price. Formula: Ep = %ΔQ / %ΔP (usually negative due to inverse relation; often taken in absolute value). Degrees of PED: perfectly inelastic (0), relatively inelastic (<1), unitary (=1), relatively elastic (>1), perfectly elastic (∞). Measurement methods: 1) Percentage method: Ep = % change in Q / % change in P. 2) Total outlay/total revenue method: observe change in TR (P×Q) when price changes. 3) Point (geometric) method: for straight-line demand curve, Ep = (lower segment / upper segment) at a point. 4) Arc elasticity method: Ep = (ΔQ/ΔP) × ((P1+P2)/(Q1+Q2)) between two price-quantity points. Elasticity and total revenue relationship (TR test): - If |Ep| > 1 (elastic): price ↓ → TR ↑; price ↑ → TR ↓. - If |Ep| < 1 (inelastic): price ↑ → TR ↑; price ↓ → TR ↓. - If |Ep| = 1 (unitary): TR remains unchanged. Managerial use: firms with elastic demand should be careful in raising prices; firms with inelastic demand can increase price to raise revenue.

Question 14

Explain income and cross elasticity of demand with formulas, interpretation and business applications.

Accepted Answer

Income elasticity (YED): Ey = %ΔQ / %ΔY measures demand responsiveness to income changes. Interpretation: - Ey > 0: normal goods. - 0 < Ey < 1: necessities. - Ey > 1: luxuries. - Ey < 0: inferior goods. Business applications: helps firms decide product positioning (basic vs premium), forecasting demand with income growth, and selecting target segments. Cross elasticity (XED): Exy = %ΔQx / %ΔPy measures how demand for X changes when price of Y changes. Interpretation: - Exy > 0: substitutes (competition is strong). - Exy < 0: complements (joint demand). - Exy = 0: unrelated goods. Business applications: - Competitor analysis: high positive XED means rival's price change affects your sales. - Product strategy: complements suggest bundling/cross-selling (phone and accessories). - Pricing decisions: knowing substitute threats helps set competitive prices. Thus YED helps understand income effects; XED helps understand market relationships and competitive environment.

Question 15

Explain factors affecting price elasticity of demand and show how managers use elasticity for pricing decisions.

Accepted Answer

Factors affecting price elasticity:
1) Availability of close substitutes: more substitutes → more elastic demand (customers can switch).
2) Nature of good: necessities are usually inelastic; luxuries are elastic.
3) Proportion of income: goods taking a high share of income are more elastic.
4) Time period: demand becomes more elastic in the long run as consumers adjust habits and find alternatives.
5) Number of uses: goods with multiple uses show higher elasticity because consumers can reduce some uses.
6) Habit-forming/addictive goods tend to be inelastic.

Managerial use in pricing:
- If demand is elastic, increasing price will sharply reduce quantity and total revenue; better strategy may be to reduce price, improve value, or differentiate product.
- If demand is inelastic, increasing price may increase total revenue; firms can raise prices (carefully) to improve revenue, especially for necessities.
- Elasticity also guides discount policy: discount works better when demand is elastic.

Hence managers estimate elasticity before changing prices to avoid unexpected revenue loss.

Elasticity of Demand and Business Applications: Price, Income and Cross Elasticity (Measurement and Uses)

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