Download Chapter 1 – the market system - The Good, the Bad and the Economist

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IGCSE1B and D Chapter 7 – PED (Week 5A)
Objectives of the chapter
Supply
curve
•
Define PED, elastic, unitary and
inelastic demand
•
Explain the range of possible
values and that PED is NOT THE
SLOPE!!!!
Identify and draw D-curves
illustrating “extreme” values, e.g.
completely elastic/inelastic goods.
•
i.
Define: PED, unitary, inelastic, elastic
ii.
Describe/outline: range of possible PED
values
iii.
Explain/distinguish/draw: different Dcurves and their elasticities, determinants of
PED
iv.
Evaluate/discuss: the difficulties in
measuring real life PED values, why tax
certain goods; why goods that have
negative externalities are often difficult to
“tax away”
•
Explain why some goods have
higher PED values than others –
e.g. the determinants of PED such
v.
as a) time; b) avail/closeness of
substitutes; c) proportion of income
spent on the goods
•
Interpret PED values and link
these values to real life examples.
•
Explain why govts might tax certain
goods and why some goods might
fluctuate in price more than others.
Notes on syllabus:
 no calculations of PED necessary
 you need to be able to show different PED in diagrams
 important to show TR and link it to different PED
 PED – definition
The price elasticity of demand shows how sensitive demand is in relation to a change in price. We
are dealing with the relative responsiveness of demand (e.g. Qd) due to a relative change in price.
Which of the goods below is “sensitive” to a change in price?
Fig. 2.2.1a, b, c Demand patterns for three goods
Good a
Good b
Good c
P ($)
P ($)
P ($)
14
10
Db
Da
7 10
Q/t
3
10
Q/t
9 10
Dc
Q/t
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
Formula – % ∆Qd / % ∆P
Definition: Price elasticity of demand (PED)
The price elasticity of demand is a measure of the responsiveness of the
quantity demanded for a good with respect to a change in the price of the
good. It is the relative change in quantity demanded (Qd) due to a relative
change in price (P). As the demand curve is downward-sloping, PED will have
a negative value. The formula is:
%∆ in Qd
Price elasticity of demand (PED)
%∆ P
=
o
o
it is the change in P which causes the change in Qd (yes, I’m repeating this)
note that we are speaking of relative change of Qd due to a relative change in P
Exam tip; referring to elasticities in exam answers
When either using elasticities or defining them, always include the basic formulaic expression
– just to make sure. Your definition should include the term relative – e.g. “…the relative
change in quantity demanded due to the relative change in price…” Also, remember
“Quantity rules!” or “Quantity on top!” – no matter which measure of elasticity you are using,
quantity is always the numerator (“on top” in the formula).
 Examples – you need to be able to give examples of goods with low/high PED and explain why
the good is price inelastic or price elastic
o goods with few substitutes; low PED
o goods
By dividing ‘percentage change in quantity demanded with percentage change in price’ we get a value
of the price elasticity of demand. If the price of margarine rises by 10% and households respond by
decreasing their quantity demanded by 20% we get;
% in Qd
– 20 %
-----------------------------  -------------- = – 2
%
in
price
+10%
Price elasticity of demand (PED) =
Note the negative value; any downward sloping curve will have a negative slope, which means that
virtually all demand curves will have a negative value of price elasticity of demand. This is why
economists seldom bother in actually saying ‘price elasticity of demand is minus 2 ’ but simply ‘price
elasticity of demand is two’.1 However, do NOT confuse the values above with ‘slope’. The value of –2
is just the value of price elasticity of demand along a given section of the demand curve (or, more
commonly, at a given point on the demand curve), nothing else. Nor do price elasticity values have any
sort of relativistic meaning, such as kilograms and centimetres might have. What I mean by this is that
while two kilos is twice as heavy as one kilo, a price elasticity of 2 is not ‘twice as elastic ’ as a price
elasticity of 1.
Here’s a simple table of the outcomes in terms of quantity demanded when the price is raised from 10
to 12, and the calculated PED for each good;
Good
1The
P0  P1
∆P
%∆P
Q0 Q1
∆Qd
%∆Qd
PED
mathematically inclined will realise that we are simply referring to PED as an absolute value, i.e. |2|
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Cars
€10,000 
€12,000
+ €2,000
+20%
100 80
-20
-20%
- 1.0
DVDs
$10  $12
+ $2
+20%
100,000
40,000
-60,000
-60%
-3
Drugs
£10  £12
+ £2
+20%
100,000
90,000
-10,000
-10%
-0.5
The PED values at the far right were calculated by using the formula % ∆Qd / %∆P. Here is the PED
calculation for cars2:
Q1 – Q0
PEDcars =
%∆ in Qd
%∆ in P
Q0
80 – 100
x 100
-20%
12 – 10
P1 – P0
P0
x 100
100
x 100
x 100
+20
%
= 1.0
10
Definition: range of PED values
A price elasticity of demand of less than 1 is called inelastic demand; PED
that is equal to one is unit elastic; PED that is higher than 1 is elastic. (Note
that I have dropped the minus sign, e.g. used absolute values. |x|) ***
PED < |1|; inelastic
PED = |1|; unit elastic PED > |1|; elastic
 Main determinants of PED
1) Availability and closeness of substitutes
PED basically measures how responsive consumers are to a change in the price of a good, and the
closeness/availability of substitutes is doubtlessly the main determinant of price elasticity of demand.
Just like the moving along a PPF induces choice and giving something up, so too does switching from
one good to a comparable good. The choice is based on the ability and willingness of consumers to
give up Good X for Good Y – both of which are determined by whether there is in fact a substitute in
the first place and secondly whether there is a high degree of perceived similarity, or closeness in the
two goods. The rule of thumb is that the closer the perceived substitute, the higher the value of PED,
i.e. high substitutability leads to greater price elasticity of demand.
2) Time frame involved
There are also a goodly number of goods which one can postpone the purchase of, such as sofas and
interior decorations, while other goods are considered necessities, such as electricity and, em, well,
cigars.3 I often say that there is, in fact, only one determinant of demand; the availability of substitutes.
‘Time’ is just another way of saying that one will have the incentive, opportunity and propensity to
search for viable substitutes. Short time-span  lack of adjustment and search time for substitutes 
inelastic demand.
2
In fact, in reality the estimated PED for cars is closer to -2.
3It’s
my book and I’ll define things as I see ‘em.
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3) Proportion of income spent on the good (this is actually NOT TRUE but since it’s in your
syllabus I shall have to bring it up)
‘How many of you bought paper clips this week? None? How about rubber bands? No? How many of
you have never bought paper clips or rubber bands?’ Every hand in the class goes up. What do you
think the PED is for a good which represents a fraction of a fraction of one ’s income?! Yes, highly
inelastic. The overall effect is negligible which means that even if the price were to double, the overall
effect on total consumption capability will be so low that one would buy the good anyhow. In line with
this argument, goods which account for a major proportion of income will be more elastic as an
increase in the price would force household to cut back on outlays to make ends meet. Food and
clothing are standard examples of such goods. Keep in mind though, that different income groups will
have different price elasticities. High income groups and high income countries will spend
proportionately less of income on housing and clothing and therefore have lower PED for these goods
than low income groups and low income countries.
4) Necessity or not
Again, this is really just a re-written way of saying a good has few or many substitutes. Asthma
medicine and petrol could be considered necessities and will have low PED thus. Expensive watches
and cigars are luxury goods and would therefore be elastic in terms of PEd. HOWEVER; it turns out
that many luxury goods are highly price inelastic – since the proportion of income spent by rich people
on such goods is in fact rather small! Also, if we look at such human traits as dependency, a cigarette
would be considered by many smokers as a necessity!
Revision questions:
1. Define PED and give the formula.
2. Why do we in fact say that a PED of -2 is “greater” than a PED of -1?!
3. Why does the price of oil tend to fluctuate more than the price of, say, Nintendo games?
4. What are the main PED determinants of
a. The PED of movies during daytime and night time
b. The PED of gold
c. The PED of flights for a businessman and a university student
5. What might a businessman do to the price in order to increase TR for a good with
a. Low ped
b. High ped
6. Why would governments benefit from having knowledge of the PED for certain goods?