Download PRICE ELASTICITY OF DEMAND

PRICE ELASTICITY OF DEMAND
•
When the price of a good rises, the demand will typically fall; in reverse
manner when the price falls the demand will rise. However the extent
to which demand changes can vary considerably
•
When demand is very responsive to price changes it is defined as
elastic; when demand is unresponsive it is known as inelastic
So for example if the price of DVD players falls by 10% and demand
rises by 30% (i.e. is very responsive to the price change) this constitutes
elastic demand
If however the price of petrol rises by 10% and demand falls by 5% (is
not very responsive to the price change) then demand is inelastic
•
More precisely price elasticity of demand is measured
% change in Qd of a good
% change in its price
PRICE ELASTICITY OF DEMAND (con)
• Thus in the first example it is measured as - 30% = -3
10%
• The measurement is negative because price and
demand move in opposite directions
• In the second case elasticity is measured as - 5% = -.5
10%
• Thus when numerically the measurement is > 1 (in
absolute terms) demand is elastic; when the
measurement is < 1, then demand is inelastic.
Elastic demand between two points
Expenditure falls
as price rises
P(£)
5
b
a
4
0
D
10
20
Q (millions of units per period of time)
Inelastic demand between two points
Expenditure rises
as price rises
8
c
P(£)
a
4
D
0
15
20
Q (millions of units per period of time)
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
Elasticity is determined by a number of factors:
• When goods are close substitutes for each other demand tends
to be very elastic (>1). By contrast demand is inelastic (< 1) for
necessities
• Elasticity also depends on the amount of income spent on a
good. When a small amount of overall income is spent demand
tends to be inelastic
• Elasticity also depends on the time period involved.
In the short term (e.g. immediately after an alcohol price
increase in a budget) demand tends to be very elastic, though
much more inelastic in the long run). In other cases demand is
more inelastic (e.g. for meat products) in the short than in the
long run
• Elasticity also depends on whether goods are durable or nondurable
MEASUREMENT OF ELASTICITY
•
There are two types of measurement of elasticity i.e. arc and point
•
Though point measurements are more accurate they relate to (theoretical)
infinitesmally small changes in price and quantity
Arc measurements are used in practice though there is a degree of arbitrariness
due to two equally valid ways of calculation (which give opposite answers)
So the most correct answer is based on an average of the two other answers
Example: If milk is €1with 100,000 bottles sold and then when the price
goes up to €1.10, 95,000 bottles are sold.
Using old price (P1) and old quantity (Q1) as base,
PED = - 5,000/100,000 divided by 10/100 = -.5
However using new price (P2 ) and new quantity (Q2) as base
PED = - 5,000/95,000 divided by 10/110 = -.58
Best measurement = ∆Q/ (Q1+ Q2) divided by ∆P/(P1+ P2)
= -5,000/195,000 divided by 10/210 = .54
Measuring
elasticity
using
the
arc
method
10
Ped =
m
8
=
DP = –2
7
n
6
P (£)
DQ = 10
Mid P
=
=
=
DQ
mid Q
DP
 mid P
10
-2

15
7
10/15 x -7/2
-70/30
-7/3 = -2.33
4
Demand
2
0
0
10
15
Mid Q
20
30
Q (000s)
40
50
Measuring elasticity at a point
50
Ped = (1 / slope) x P/Q
= -100/50 x 30/40
= -60/40
= -1.5
r
30
P
D
0
100
40
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
(1 / slope) is constant
= -50/10 = -5
8
m
But P/Q varies:
6
at n, P/Q = 8/10
at m, P/Q = 6/20
atl l, P/Q = 4/30
P
4
l
Demand
k
2
0
0
10
20
fig
Q
30
40
50
PRICE ELASTICITY AND CONSUMER
EXPENDITURE
• The basic rule is as follows
If demand is elastic when P increases TR will fall
If demand is inelastic when P rises, TR will increase
If demand is elastic when P falls, TR will increase
If demand is inelastic, when P falls, TR will decrease
• In terms of the demand curve elastic demand leads to a more
horizontal (flat) shape
Inelastic demand leads to a more vertical (steep) curve
• If the demand curve is totally horizontal, this represents totally
elastic demand (i.e. infinite).
If the demand curve is totally vertical, this represents totally
inelastic demand (i.e. 0)
IMPORTANT APPLICATIONS OF ELASTICITY
• Tax increases with respect to excise duties and VAT by a Government
in the budget; for tax revenue to increase demand must be inelastic
• Proposed price increases (or decreases) by a company; in the case of
monopolies like ESB (where demand for electricity is inelastic) price
increases are likely to increase total revenue; in other cases where there
are close substitutes such as budget airlines demand is very price
elastic so that reductions in fares is more likely to increase revenue
• Price elasticity of demand is also very important in both export and
import markets
For example assuming that export markets such as the UK and US are
price competitive (with close substitutes) a rise in the Euro against
sterling and the dollar would (other things being equal) lead to a drop
in export revenues for Irish firms.
INCOME ELASTICITY OF DEMAND
•
Income elasticity of demand is also important. It measures the
responsiveness of demand to a change in income
% change in Qd of a good
% change in income
•
Generally income elasticity is positive. For example an increase in
income will lead to increased demand for a product.
However for inferior goods demand actually falls as income rises so
that income elasticity is negative.
•
The definition of a normal good is one with a positive income elasticity of
demand
•
Demand is very income elastic for luxuries (e.g. foreign holidays)
and income inelastic for necessities (e.g. food).
•
For a wide range of goods and services income would be the most
important determinant of demand; this helps to explain why a recession is
so damaging for business
CROSS ELASTICITY OF DEMAND
• Cross elasticity of demand measures the responsiveness in
demand of one good to a change in price of the other.
% change in Qd of good X
% change in P of good Y
• Cross elasticity is especially important for substitutes and
complements.
For substitutes (i.e. goods that can be used in place of each
other) cross elasticity is measured as positive
In other words if the price of Coca Cola was to rise, then the
demand for a close substitute (Pepsi Cola) will also rise
For complements (i.e. goods that are used jointly) cross
elasticity is negative.
Thus if the price of petrol was to rise, then the demand for cars
will fall (other things remaining equal).
PRICE ELASTICITY OF SUPPLY
•
This measures the responsiveness of supply to a change in demand
% change in Qs of a good
% change in its price
•
If supply changes by more than price (as a %) then supply is elastic. If it
changes by less then it is inelastic
•
Supply differs from demand in that it takes a longer time typically for
supply to react to price. These time periods are divided into 4 periods
as follows
Immediate market period, short run, long run, very long run
•
Thus with respect to oil in the immediate market period supply is
totally fixed. Therefore any increase in demand will lead to an increase
in price. In the short run existing oil wells could be more intensively
worked leading to some increase in supply.
In the long run new oil wells could be opened up leading to a greater
increase in supply.
In the very long run the technology of oil production could change
leading to further possible increases.
Response of supply to an increase in
P
demand
S short-run
S long-run
b
P2
P3
P1
c
a
D2
D1
O
Q1
Q2 Q3
Q
Response of demand to an increase in
P
supply
S1
S2
a
P1
P3
P2
c
b
D long-run
D short-run
O
Q1
Q2 Q3
Q
SPECULATION
• Speculation will tend to have a stabilising effect on price fluctuations when
suppliers or demanders believe that a change in price is only temporary
• Speculation will have a destabilising effect on price fluctuations when
suppliers and/or buyers believe that a change in price heralds similar
changes to come in the future
• Gambling can be of two kinds
- when the odds are known (where it is referred to as risk)
- when the odds are not known (where it is referred to as uncertainty)
The buying of appropriate information can reduce uncertainty
Stockholding can also reduce uncertainty
MAXIMUM AND MINIMUM PRICES
• Government usually set minimum prices above free market prices (setting a
price floor below which prices are not allowed to fall)
• Maximum prices are then set below free market prices (setting a price
ceiling above which prices are not allowed to rise)
• The Common Agricultural Policy is a good example of a minimum price
approach
• Rent controls provide an interesting example of the alternative maximum
price approach
Incidence of tax: inelastic demand
P
S + tax
P2
S
CONSUMERS’
SHARE
P1
P2 - t
PRODUCERS’ SHARE
D
O
Q2
Q1
Q
Incidence of tax: elastic demand
P
P2
S + tax
S
CONSUMERS’
SHARE
P1
D
PRODUCERS’
SHARE
P2 - t
O
Q2
Q1
Q
Incidence of tax: inelastic supply
P
S + tax
S
P2
P1
CONSUMERS’ SHARE
PRODUCERS’ SHARE
D
P2 - t
O
Q2
Q1
Q
Incidence of tax: elastic supply
P
S + tax
P2
S
CONSUMERS’
SHARE
P1
PRODUCERS’
SHARE
P2 - t
D
O
Q2
Q1
Q
Incidence of tax: inelastic demand
P
P
S + tax
P2
P2 - t
S + tax
S
S
P2
CONSUMERS’
SHARE
P1
Incidence of tax: elastic demand
CONSUMERS’
SHARE
P1
PRODUCERS’ SHARE
D
PRODUCERS’
SHARE
P2 - t
D
O
Q2 Q1
Q
Q2
O
Incidence of tax: inelastic supply
P
P2
P1
Q1
Q
Incidence of tax: elastic supply
S + tax
P
S
P2
S + tax
S
CONSUMERS’
SHARE
P1
CONSUMERS’ SHARE
PRODUCERS’
SHARE
P2 - t
PRODUCERS’ SHARE
D
D
P2 - t
O
Q2
Q1
Q
O
Q2
Q1
Q
(UK)
Foodstuff
Price elasticity of
demand (1988–2000)
Income elasticity of
demand (1998–2000)
Bread
–0.40
0.12
Milk
–0.17
–0.17
Cheese
–0.35
0.23
Lamb
–1.29
0.15
Pork
–0.82
0.13
Fresh fish
–0.80
0.31
Eggs
–0.28
–0.01
Fresh potatoes
–0.12
0.09
Fresh green vegetables
–0.66
0.27
Frozen peas
–0.68
0.06
Bananas
–0.32
0.12
Cakes and biscuits
–0.56
0.13
n.a.
0.20
All foods
Source: National Food Survey 2000 (National Statistics, 2001), extracted from Tables 6.1, 6.3, 6.4 and 6.5
Decline in food prices over time
P
S1
S2
Long-term increases in
supply likely to be
greater than long-term
increases in demand.
P1
P2
D1
O
Q1
Q2
D2
Q
Buffer stocks to stabilise incomes
P
Sa
Sa
3
1
Released from buffer stock
P3
P3
e
d
a
P1
Y
D
O
Q3
Q3  Q1
Q
Minimum prices for a product where the EU is self-sufficient
P
e
Intervention price
SEU
d
P
i
Pw
f
NET COST
a
b
c
COST
REVENUE FROM
SALE OF SURPLUS
ON WORLD MARKET
O
Q d2
Qs1
Qd 1
Surplus
DEU
Q s2
Q
Effect of subsidies on foodstuffs
in which the country is self-sufficient
P
S
S + subsidy
Subsidy
Total paid
in subsidy
Pg
Pe
Pm
D
O
Qe
Q1fig
Q
MARKET ADJUSTMENT OVER TIME
• Full adjustment of price demand and supply to a situation of disequilibrium
will not be instantaneous
• As price elasticities of demand vary with the time period under
consideration, the short-term price change can differ from the long-term
• If prices are likely to change in the future this will affect the behaviour of
buyers and sellers now
- a belief that prices will go up (e.g. houses) will cause consumers to buy
now; a belief that prices will come down will cause them to postpone
present expenditure
- a belief that prices will go up will cause producers to postpone selling now;
a belief that prices will go down will cause producers to sell now
Stabilising speculation: initial price fall
P
S2
S1
P1
a
c
P3
P2
D1
b
D2
O
Speculators
believe that the fall
in price to P2 is
only temporary.
D3
Q
Stabilising speculation: initial price rise
P
S1
S2
b
P2
c
P3
P1
Speculators
believe that the
rise in price to P2
is only temporary.
a
D2
D1
O
D3
Q
Destabilising speculation: initial price fall
P
S1
S2
P1
a
P2
b
P3
c
Speculators
believe that the fall
in price to P2
signifies a trend.
D1
D3
O
D2
Q
Destabilising speculation: initial price rise
P
S2
S1
P3
c
P2
b
P1
Speculators
believe that the
rise in price to P2
signifies a trend.
a
D3
D1
O
D2
Q
MARGINAL UTILITY THEORY
•
Total and marginal utility
•
meaning of total utility
– marginal utility: DTU/DQ
•
diminishing marginal utility: as the consumption of a product increases (assuming
no significant time delay as between units) the extra utility or satisfaction
experienced on each additional unit consumed tends to diminish and in extremes
become negative
- marginal utility: DTU/DQ
for example if one consumes four cups of coffee in one session, the utility
of the marginal unit (i.e. each additional cup of coffee) will diminish
- total and marginal utility curves
Ollie's utility from consuming crisps (daily)
16
TU
14
Utility (utils)
12
MU
Packets
TU
of crisps in utils in utils
10
0
1
2
3
4
5
6
8
6
4
7
4
2
1
0
-1
0
7
11
13
14
14
13
2
0
0
1
2
3
4
-2
fig
Packets of crisps consumed
(per day)
5
MU
6
MARGINAL UTILITY THEORY
• The optimum level of consumption:
the one-commodity version
– consumer surplus is the notion that a consumer can gain a surplus of
utility. For example using a previous example if one is willing to pay
€2 for the each of the four cups of coffee consumed then this implies
that the utility from the last cup justifies the price paid. Therefore as the
marginal utility is higher on the 1st, 2nd and 3rd units, then one thereby
obtains surplus utility on the earlier units consumed
• marginal consumer surplus: MU – P
• total consumer surplus: TU – TE
• maximising consumer surplus: P = MU
• Marginal utility and the demand curve
Consumer surplus
MU, P
P1
Total
consumer
surplus
Total
consumer
expenditure
O
MU
Q1
fig
Q