a. Distinguish between the following pairs of concepts i. elastic demand and inelastic demand ii. Income elasticity of demand and cross elasticity of demand...

Answer Details

(a)(i) Elastic vs inelastic demand.

(a)(ii) Income elasticity vs cross elasticity of demand.

• Income elasticity of demand measures the responsiveness of quantity demanded of a good to a change in consumers' income: \[ e_y = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in income}} \]
• Cross elasticity of demand measures the responsiveness of quantity demanded of one good (X) to a change in the price of another good (Y): \[ e_{xy} = \frac{\% \text{ change in quantity demanded of X}}{\% \text{ change in price of Y}} \] It is positive for substitutes and negative for complements.

(b) Effect of a price increase on total revenue. Total revenue is \( TR = P \times Q \).

• (i) If demand is price elastic: a rise in price causes a larger proportionate fall in quantity demanded, so total revenue falls. On a diagram, the demand curve is fairly flat (gentle slope); the revenue lost from selling far fewer units outweighs the revenue gained from the higher price.
• (ii) If demand is price inelastic: a rise in price causes only a small proportionate fall in quantity demanded, so total revenue rises. On a diagram, the demand curve is fairly steep; the higher price more than makes up for the small drop in sales.

Examination reminder: the second part of (b) reads "price elastic" twice in the paper, but the intended contrast is elastic versus inelastic, which is answered above.