a) Explain, with examples, the significance of a value of a good's cross-elasticity of demand in relation to its substitutes and complements.
Cross-elasticity of demand (XED) measures the responsiveness in quantity demanded of a good as a result of a change in the price of its related goods. The value of XED may be positive or negative and the sign is important since it tells us what the relationship between the two goods in question is.
Substitute goods are the ones with positive value of XED. When the price of product X falls, demand for product X increases causing the demand of its substitute, Y, to decrease. There is a decrease in quantity demanded for good Y and an increase in quantity demanded for good X therefore a positive XED value is produced. For example, Iphone and Samsung. Assuming they are a close substitute. It will produce a higher positive value than products that are not so close. If the price of Iphone increases, consumers will switch over to Samsung causing the sales to increase.
Complement goods have a negative value of XED. When the price of good A falls, the demand for good A increases and its complement, good B will also increase. There is an increase in good B and a decrease in the price of good A thus a negative XED value is produced. For example, mobile phones and sim cards. Assuming they are a close complement. It will produce a lower negative value than products that are not so close. An increase in prices of mobile phones may lead to a significant fall of quantity demanded of it and so a large fall in the demand for sim cards.
b) Discuss the usefulness to businesses of a knowledge of price elasticity of demand and income elasticity of demand.
Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a good to a change in its price. PED is useful to a business because businessmen will be able to know whether they should increase or decrease their prices for a good so that they will gain profits and earn more revenue.
For example, if the product is and elastic good, businessmen can decrease the price of the good because a small decrease in price will lead to a big increase in quantity demanded. The total revenue will increase. Businessmen should not increase the price of an elastic good because it will result in a big decrease in quantity demanded and total revenue will also decrease.
If the product is an inelastic good, businessmen can increase the price of a good because an increase in price causes a small decrease in quantity demanded and therefore total revenue increases. Businessmen should not decrease the price of an inelastic good because it only affects a small increase in quantity demanded and therefore a decrease in total revenue
Income elasticity of demand (YED) measures the responsiveness of the demand for a good to a change in income. During an economy boom period, people tend to buy more as they can afford more of it. This applies to normal goods such as cars. Firms producing normal goods will tend to increase their production.
For some goods, during an economy boom, when price increases, there is a decrease in quantity demanded because people can afford better. People start switching from inferior goods that they had been using to superior goods. For example, people who always carry inexpensive bags will tend to change to using branded handbags when income increases. Firms producing inexpensive handbags during an economy boom period should cut down on their production while firms producing branded handbags should increase production.
During an economy downturn, people will give up on luxury goods such as the branded handbags and carry inexpensive handbags. This time, firms producing branded handbags should cut down on production while firms producing inexpensive handbags increases their production.
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