# Example of Exam Essay by lmj69923

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STQP 1513: Basic Economics I

(a) Distinguish between price elasticity of demand, income elasticity of demand and cross elasticity of
demand.                                                                                        [10]
(b) Why may businesses and governments be interested to know the price elasticity of demand of
products?                                                                                      [15]

Comment:

Part (a) is very straightforward and probably offer 3 marks for each elasticity. A clear definition plus the
appropriate method of calculation is necessary, plus possibly an example of a product with elastic demand
and one with inelastic demand.

For part (b), the key reason why governments and businesses are interested in the knowledge of PED
relates to tax revenue and sales revenue respectively. Drawing appropriate diagrams is very important to
illustrate this. Try not to repeat points that you have mentioned in part (a) in your answer for part (b).

(a)     Price elasticity of demand (PED) is the ratio of proportionate changes in quantity demanded of
the product to proportionate changes in its own price. It tells us how the demand for a particular product
will change when its price changes as well. Its mathematical formula is expressed as
. When the magnitude of PED is greater than one, the demand is said
to be price elastic. In this case, an increase in price of a product will lead to a more than proportionate
decrease in quantity demanded and hence a fall in total revenue. However, when the magnitude is less
than one, the demand is then said to be price inelastic and an increase in price will lead to a less than
proportionate fall in quantity demanded. In this instance, total revenue will rise.

Income elasticity of demand (YED) is the ratio proportional change in the quantity demanded of a
product to a change in consumers’ disposable income. It enables us to predict how much the demand
curve will shift for a given change in income. While an increase in disposable income will lead to an
increase in the quantity demanded of normal goods, the demand for inferior goods, such as cheap
margerin, will fall following an increase in consumers’ disposable income. We can then deduce that
inferior goods have a negative YED. Luxury goods such as foreign holidays have a high YED whereas
basic normal goods such as potatoes and bus journeys have a low YED. The formula for the YED is given
as                                     .

Cross elasticity of demand (CED) measures the responsiveness of demand for one product to a
change in the price of another (either a substitute or a complement). It enables us to predict how much the
demand curve for the first product (call it product A) will shift due to changes in the price of the second
product     (call    it   product      B).    The      formula    for     the    CED      is     given   by
. If a rise in the price of B leads to a fall in the demand
for A, then A and B are said to be complementary goods, for instance motor car and petrol. On the other
hand, should a rise in the price of B instigates higher demand for A, then A is a substitute goods for B. An

Instructor: Siti Norafidah Mohd Ramli                              UKM School of Mathematical Sciences
Example of Exam Essay
STQP 1513: Basic Economics I

example of substitute goods are lamb and beef. The sign of CED for substitute product is therefore
positive and vice versa for complementary goods.

(b)      The concept of elasticity is central to any attempt to measure the effect of changes in demand
conditions and accurate calculation is becoming increasingly important to both government and business.
Governments are interested in elasticities for they need to know the effect of changes in income tax,
indirect taxes and taxes on imports. Adjustments in income tax has an effect of changing the level of
disposable income while adjustments on indirect taxes will change relative prices of goods and services.
Adjustments in taxes on imports will affect the national income as it has the consequence of raising or
lowering the price of imports. It is also important for the governments to know about the changes in
demand for labour, which depends, to a certain extent, on the changes in product demand. Any attempt at
economic planning must utilize the concept of demand elasticity so that the government can forecast the
effect of any changes made to the economic policies.

Business managers need to know the demand elasticities for their own product as well as their
rivals’ since demand forecasting is imperative to plan future production. The gap of period between
taking production decisions and actually achieving the planned production level may take several years
and hence the cost of production must be carefully measured. It is hard to calculate the average cost of a
product without making an estimate of the future demand of the product itself. Future estimates of
revenue and profit must take into account the expected changes in taxes, level of disposable income as
well as rivals’ product influences. Hence the effect of these variables must be known with a certain degree
of certainty.

RM                                                         RM

D

D
Qtty                                                      Qtty

(a) A product with inelastic demand                        (b) A product with elastic demand
Figure 1

Instructor: Siti Norafidah Mohd Ramli                             UKM School of Mathematical Sciences
Example of Exam Essay
STQP 1513: Basic Economics I

Businesses will tend to be quite prepared to raise the price of goods with inelastic demand
because this wil raise their revenue. Often by building up brand loyalty throuhg advertising campaign and
special promotions businesses can make their products more inelastic in demand, which is of course in
their interest. Figure 1(a) shows that demand falls less than proportionately when there is a rise in the
price of a product with inelastic demand. On the other hand, if a product has an elastic demand, firms may
cut the price in an attempt to increase revenue since demand will grow more than proportionately (refer to
Figure 1(b)).

As the two diagrams in Figure 1 show, the concept of price elasticity of demand (PED) has a
major bearing on the tax levels on products and price settings by businesses. Goods with an inelastic tend
to have the highest burden on sales tax such as VAT and excise tax. The heavy level of tax tends to have
small effects on output and employment in the industries affected, with the burden falling mainly on the
consumer. In Figure 2, the shaded area represents the tax revenue colected from the consumer with little
effect on demand. Government can predic their tax revenue more accurately on goods with inelastic
demand. Thus, it is addictive products that face a heavy tax burden.

RM                      Stax

S

D
Qtty

Figure 2 Tax revenue imposed on demand inelastic product

Instructor: Siti Norafidah Mohd Ramli                             UKM School of Mathematical Sciences

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