Price, income and cross elasticity of demand and price elasticity of supply, their calculation and determinants, and the link between price elasticity of demand and total revenue.

What this dot point is asking

AQA wants you to define and calculate price, income and cross elasticity of demand and price elasticity of supply, explain their determinants, and use PED to analyse the effect of a price change on total revenue. Numerical questions on elasticity appear regularly, so the formulae must be automatic.

The four elasticities

A percentage change is calculated as $\frac{\text{new} - \text{old}}{\text{old}} \times 100$. Always work out the two percentage changes first, then divide.

Interpreting the values

• PED is negative. If $|PED| > 1$ demand is elastic; if $|PED| < 1$ it is inelastic; if $|PED| = 1$ it is unit elastic. Determinants: availability and closeness of substitutes, the proportion of income spent on the good, whether it is a necessity or luxury, whether it is habit-forming, and the time period.
• YED: positive for normal goods (and above 1 for luxuries, also called superior goods); negative for inferior goods, whose demand falls as income rises.
• XED: positive for substitutes, negative for complements, and near zero for unrelated goods; the larger the magnitude, the stronger the relationship.
• PES: usually positive. Determinants: spare capacity, level of stocks, ease and mobility of factors of production, and the time period (supply is more elastic in the long run).

PED and total revenue

This is why firms with price-inelastic products, and governments taxing inelastic goods such as tobacco, alcohol and fuel, can raise revenue by raising price. It also explains why a bumper harvest can reduce farmers' incomes: demand for staple foods is inelastic, so the price falls proportionately more than quantity rises.

Why elasticities matter for policy

Elasticity is one of the most powerful evaluation tools in the whole course. The effect of an indirect tax depends on PED: with inelastic demand the tax falls mainly on consumers and reduces quantity little, so it raises revenue effectively but does little to curb consumption; with elastic demand it reduces quantity sharply but raises less revenue. The success of a minimum or maximum price, the burden of a tariff, and the effect of a currency depreciation on the trade balance (the Marshall-Lerner condition) all turn on elasticities. YED helps firms forecast how demand for their product will change as the economy grows, which matters for long-run planning, while XED guides decisions about pricing relative to rivals and complements. Whenever a question gives you numbers, calculate the relevant elasticity and let its value drive your judgement.