Level 1 CFA® Exam:
Demand Elasticities
Elasticity is a ratio of a percentage change of one variable to a percentage change of another variable. There are 3 types of elasticity that are connected with the demand function:
- own-price elasticity of demand,
- income elasticity of demand, and
- cross-price elasticity of demand.
Own-Price Elasticity of Demand
The own-price elasticity of demand is calculated with the following formula that you can use in your level 1 CFA exam:
Interpretation of elasticity:
- If the absolute value of price elasticity of demand is greater than 1, then the demand for a certain good is elastic – in other words, it is highly sensitive to changes in price.
- If the absolute value of price elasticity of demand is less than 1, then the demand for a certain good is inelastic, which means that it is not highly sensitive to changes in price.
- If the price elasticity of demand is equal to -1 then demand is unitary elastic. If demand is unitary elastic then a one percent change in price results in a one percent change in quantity demanded.
- Demand is perfectly inelastic if the change in price doesn’t affect the quantity demanded. We deal with perfectly inelastic demand if the demand curve is a vertical line. For perfectly inelastic demand, the own-price elasticity of demand equals 0.
- We deal with perfectly elastic demand if the demand curve is a horizontal line. For perfectly elastic demand, the own-price elasticity of demand equals infinity.
Remember: Own-price elasticity is measured at a given price and will change if the price of the good changes.
The factors that affect the price elasticity of demand include the following:
- the number of substitutes for a good – when it is small or there are none, the demand is inelastic,
- the share of the consumer's budget spent on the product – the higher the value of bought items in relation to the budget, the higher the elasticity of demand,
- time – in the long run, the price elasticity of demand is higher than in the short run.
The demand curve is given by the formula:
\(Q=100-5\times{P}\)
If P is equal to 10, what is the own-price elasticity of demand? Also, decide whether demand is elastic or not and interpret the answer.
(...)
The income elasticity of demand is calculated with the following formula:
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The cross-price elasticity of demand is calculated with the following formula:
Based on the cross-price elasticity of demand, we can distinguish between 2 types of goods:
- substitutes, and
- complements.
If the cross-price elasticity of demand is positive, then a given good is a substitutive product. A rise in the price of another good leads to a rise in demand for the given good.
If the cross-price elasticity of demand is negative, then a given good is a complement. A rise in the price of another good leads to a drop in the demand for the given good.
- Elasticity is a ratio of a percentage change of one variable to a percentage change of another variable.
- There are 3 types of elasticity that are connected with the demand function: own-price elasticity of demand, income elasticity of demand, and cross-price elasticity of demand.
- If the absolute value of price elasticity of demand is greater than 1, then the demand for a certain good is elastic – in other words, it is highly sensitive to changes in price.
- If the absolute value of price elasticity of demand is less than 1, then the demand for a certain good is inelastic, which means that it is not highly sensitive to changes in price.
- The income elasticity of demand helps us answer the question: By how many percentage points will the demand change if there is one percentage change in income?
- If the income elasticity of demand is positive, then a given good is a normal good.
- If the income elasticity of demand is negative, then a given item is an inferior good.
- If the cross-price elasticity of demand is positive, then a given good is a substitutive product.
- If the cross-price elasticity of demand is negative, then a given good is a complement.