Download File

Price Elasticity of
Demand (PED)
Study of Elasticities
 Examines
the responsiveness of
consumers and producers to a change
in a variable in the marketplace
 Elasticity measures how much one
factor changes in response to a change
in a different factor
Implications for businesses
 Degree
to which consumers respond
to raising or lowering of prices

Producers to be aware of changes in the
prices of other goods to expand their
current market productions
Implications for governments
 Use
elasticities to determine which
goods to place taxes on and whether
or not to raise or lower income tax
 Raising
or lowering income tax
stimulates or reduce overall household
spending on goods and services
Types of Elasticities
 Price
Elasticity of Demand (PED)
 Price Elasticity of Supply (PES)
 Cross-price Elasticity of Demand (XED)
 Income Elasticity of Demand (YED)
Price Elasticity of Demand
 Is
a measure of the responsiveness of
the quantity demanded with respect to
a change in the price of the good.
 “How
much does the quantity
demanded change when the price
changes?”
Price Elasticity of Demand (PED)
% D Quantity Demanded
% D Price
Percent change in quantity demanded / Percent change in price
% Change Calculation




To calculate the % change, take note of this
formula:
N–O
O
x
100
Take the new number minus the old
number, then divide by the old number
% Change Calculation

For Example:
 The
quantity demanded has increased by
30,000 from an original demand of 200,000,
which is a change of 15%. This is calculated
by the equation:
New quantity = 30K + 200K = 230K
change = 230K – 200K / 200K = .15
% change = -.15 x 100 = 15%
% Change Calculation

For Example:
 The
price has fallen by $0.50 from an original
price of $5, which is a change of -10%. This
is calculated by:
New price = 5 - .50 = 4.50
change = 4.50 – 5.00 / 5.00 = -.10
% change = -.10 x 100 = -10%
% Change Calculation
 If
we put the two values into the
equation for PED, we get:

PED = 15% / -10% = -1.5
Calculate PED

If the price of margarine rises by 10% and
households respond by decreasing their
quantity demanded by 20%, PED is equal
to?

PED = -20% / +10% = -2
Calculate PED

If the price of butter falls by 10% and
households respond by increasing their
quantity demanded by 20%, PED is equal
to?

PED = +20% / -10% = -2
The negative value indicates that there
is an inverse relationship between
price and the quantity demanded.
However, in order simplify matters,
economists usually ignore the negative
value that comes from the equation
and simply give the answer as a
positive figure.
Exercises
1. Calculate the PED if a price increase of
50% causes the quantity demanded to fall
by 40%.
1. If P=$8 and Qd=200, calculate the new
Qd resulting from a price increase to $10
if the PED is -1.5
3. Explain why the PED coefficient is always
negative.
Exercises (Answers)
1. Calculate the PED if a price increase of 50%
causes the quantity demanded to fall by 40%.
Answer: PED = -.8
2. If P=$8 and Qd=200, calculate the new Qd
resulting from a price increase to $10 if the PED
is -1.5.
Answer: New Qd = 125
3. Explain why the PED coefficient is always
negative.
Answer: Inverse relationship between price
and quantity demanded
Exercises
A firm producing decorative candles lowers
the price of one of its scented candles from
$4 to $3.60 and finds that the weekly
quantity demanded of the candles goes up
from 600 per week to 630.
1. Calculate the percentage changes in price
and quantity demanded.
2. Calculate the price elasticity of demand
for the scented candles.
Exercises (Answers)
1. Calculate the percentage changes in price
and quantity demanded.
Answers:
Change in Qd = 5%
Change in Price = -10%
2. Calculate the price elasticity of demand
for the scented candles.
Answer: PED = -.5
Range of PED Values

INELASTIC DEMAND:
 Price elasticity of demand of less than 1
(between 0 and 1 in absolute value)
 Inelastic
demand means that the quantity
demanded is not very sensitive to the price
Range of PED Values

ELASTIC:
 Price elasticity of demand greater than 1 in
absolute value
 Elastic
demand means that the quantity
demanded is sensitive to the price
Range of PED Values



UNIT ELASTIC:
 Price elasticity of demand equal to 1
 Percentage change in quantity demanded equals
percentage change in price
PERFECTLY INELASTIC:
 Price elasticity of demand is equal to zero
 When 1% change in the price would result in no change
in quantity demanded
PERFECTLY ELASTIC:
 Price elasticity of demand value of infinity
 When 1% change in the price would result in an infinite
change in quantity demanded
Perfectly inelastic demand curve
P
D
P2
P1
O
Q
Q
Perfectly elastic demand curve
P
P1
D
O
Q
Range of price elasticity along a straight-line curve
PED = Infinity (Perfectly Elastic)
PED > 1 (Elastic)
Price
Unitary PED = 1
PED < 1 (Inelastic)
PED = 0
Perfectly
Inelastic
Q
O
Quantity
Elasticity
Demand curves with
various elasticities
Perfectly inelastic demand (PD = 0)
P
D
P2
b
P1
a
O
Q1
Q
Infinitely (Perfectly) elastic demand (PD = )
P
a
b
D
P1
O
Q1
Q2
Q
P
20
Unit elastic demand (PD = –1)
a
b
8
D
O
40
100
Q
Different elasticities along different portions of a demand curve
P
a
P1
D
O
Q1
Q
Different elasticities along different portions of a demand curve
P
a
P1
Elastic
demand
b
P2
D
O
Q1
Q2
Q
Different elasticities along different portions of a demand curve
P
a
P1
b
P2
Inelastic
demand
c
P3
D
O
Q1
Q2
Q3
Q
INELASTIC DEMAND




Value of PED is less than 1 and greater than 0
If a product has inelastic demand, then a change
in the price of the product leads to a
proportionally smaller change in the quantity
demanded of it – if the price is raised, the
quantity demanded will not fall by much in
comparison
Total revenue gained by the firm will increase
Revenue = the number of units sold x the price
of the product
INELASTIC DEMAND

For example:

When the price of a carton of strawberry
yoghurt is raised from $1 to $1.20 the firm finds
that quantity demanded per week falls from
12,000 cartons to 10,800 cartons. Thus a 20%
increase in price is causing a 10% fall in the
quantity demanded
PED = -10% / 20% = -0.5
(less than 1, inelastic)


Inelastic demand between two points
P($)
Revenue rises
as price rises
c
1.20
Revenue = 10.8 x 1.20 = $12,960
1.00
Revenue = 12 x 1 = $12,000
0
10.8
Q (000s)
If a firm has
inelastic
demand for its
product and
wishes to
a
increase total
revenue, it
should raise
the price of the
D
product.
12
Elasticity Exercise
Inelastic Demand
A firm producing decorative candles lowers
the price of one of its scented candles from
$4 to $3.60 and finds that the weekly
quantity demanded of the candles goes up
from 600 per week to 630.
1.Calculate the percentage changes in price and quantity
demanded.
2.Calculate the price elasticity of demand for the scented
candles.
3.Calculate the change in total revenue that the firm will
experience following the fall in price.
4.Draw a “revenue box” diagram to illustrate the effect on
quantity demanded and total revenue following the price
change for the scented candle.
5.Was the firm sensible to lower the price of the scented
candles? Explain your answer.
ELASTIC DEMAND




Value of PED is greater than 1 and less than
infinity
If a product has elastic demand, then a change in
the price of the product leads to a greater than
proportionate change in the quantity demanded
of it – if price is raised, the quantity demanded
will fall by more in comparison
Total revenue gained by the firm will fall
Revenue = the number of units sold x the price
of the product
ELASTIC DEMAND

For example:
When the price of a hot dog is raised from $2 to
$2.10, a hot dog seller finds that quantity
demanded per week falls from 200 hot dogs to
180 hot dogs.
PED = -10% / 5% = -2
(greater than 1, elastic)
Elastic demand between two points
P($)
Revenue falls
as price rises
2.10
b
R = 180 x $2.1 = $378
a
2.00
Revenue = 200 x $2 = $400
0
200
180
Q
If a firm has
elastic demand
for its product
and wishes to
increase
total
D
revenue, it
should not
raise the price
of the product.
Elasticity Exercise
Elastic Demand
A pizzeria lowers the price of its most
popular takeaway pizza, the Margherita,
from $5 to $4.50 and finds that the weekly
quantity demanded of the pizzas goes up
from 60 per week to 72.
1.Calculate the percentage changes in price and quantity
demanded.
2.Calculate the price elasticity of demand for the pizzas.
3.Calculate the change in total revenue that the firm will
experience following the fall in price.
4.Draw a “revenue box” diagram to illustrate the effect on
quantity demanded and total revenue following the price
change for the Margherita.
5.Was the firm sensible to lower the price of the Margherita?
Explain your answer.
Unit Elastic Demand



Value of PED is equal to one
A change in price of the product leads to a
proportionate, opposite, change in the quantity
demanded of it
If price is raised by a certain percentage, then
the quantity demanded will fall by the same
percentage. Total revenue gained by the firm
will not change
P
20
Unit elastic demand (PD = –1)
a
b
8
D
O
40
100
Q
NOTE about Elasticity

For a straight line, downward-sloping demand
curve, the value of PED falls as price falls.

Low priced products have a more inelastic
demand than high-priced products, because
consumers are less concerned when the price of
an inexpensive product rises than they are when
the price of an expensive product rises.
Determinants of price elasticity of demand

SPLAT
 S: Substitutes
 P: Proportion of Income
 L: Luxury or Necessity
 A: Addictive or Not
 T: Time to respond
Determinants of price elasticity of demand

The number and closeness of substitutes
 Most important determinant of PED
 The more substitutes there are for a
product, the more elastic will be the
demand for it
 The closer the substitutes available, the
more elastic will be the demand
Determinants of price elasticity of demand
 Availability
 If
of substitutes:
a product has close substitutes it is relatively
easy for the consumer to switch demand away
from one product and divert it to another. If
the price of one brand of chocolate bar goes
up consumers may well switch to buying a
rival brand. The substitution effect is strong
in this case and the demand for the particular
bar will be highly elastic. However, if the
prices of all chocolate bars go up then there
are few substitutes for chocolate and so
demand will be less elastic.
Determinants of price elasticity of demand

Proportion of Income
 Demand for goods that make up a large
portion of a consumer’s income tends to
be more elastic since a particular
percentage change in price will appear
much larger to the consumer than the
same percentage change in price of a
good that makes up a very small portion
of income.
Determinants of price elasticity of demand
 Proportion
 Very
of income
cheap items such as matches or salt are likely to
have an inelastic demand. If their prices rise there
will be little impact on the spending power of the
individual and so no need to change spending
patterns. For larger items of expenditure, the
consumer will be more inclined to weigh up the
purchase more carefully. Often consumers can put
off a purchase and do not have to buy, eg. replacing a
hi-fi system can be quite expensive. If a shop cuts its
prices it can have a great influence on buyers and
sales can rake off. Here the income effect is a
powerful influence on demand.
Determinants of price elasticity of demand

The necessity of the product and how widely the
product is defined

It is worth remembering that for many goods,
necessity will change from consumer to consumer,
since different people have different tastes and
necessity

Necessity may go to extremes when individuals
consider products to be very “necessary”, such as
habit-forming goods, like cigarettes, alcohol, or hard
drugs. Such products tend to have inelastic demand.
Determinants of price elasticity of demand
 Number
 If
of uses of a product
the demand for a single use product, such
as lawn mowers, falls there is no other use
which might lessen the impact of the change
in demand. However, a multi-use product
may be protected. The demand for flour may
be relatively inelastic because it is used to
make a wide range of other products.
Determinants of price elasticity of demand

Addictive or Not Addictive Goods
 Addictive goods tend to have relatively
inelastic demand
 Examples: tobacco, drugs, fatty or salty
foods
 Consumers with physical dependence on
a good will be unwilling or unable to
respond to price increases to much
degree.
Determinants of price elasticity of demand
 Addiction
 The
demand for cigarettes is likely to be inelastic. As
price rises the evidence seems to suggest that
smokers will continue to smoke with little change in
their habit. However, even with this product it is
probably the case that if price rose to $15 or $20 for
a packet of 20 cigarettes there would be a greater
impact on demand and demand would become more
elastic. Goods which people regard as necessities are
likely to have an inelastic demand although it is
difficult to define exactly what a ‘necessity’ is,
especially in developed countries. In developing
countries many would agree that rice would, in many
instances, be a necessity.
Determinants of price elasticity of demand

The time period considered

PED tends to be more inelastic in the short term
and then becomes more elastic, the longer the time
period it is measured over.

Example: when heating oil prices rose sharply in
Austria, the demand for oil that winter change by a
proportionately smaller amount than the change in
price.
Determinants of price elasticity of demand
 The
time period
 For
some products it is difficult for
consumers to change their pattern of
consumption in a short time. There may be a
need for time for people to search out
alternatives. In this case demand might be
relatively inelastic in the short term but more
elastic in the long term. This is of particular
importance to importers of goods. If the
prices of foreign goods rise it may take some
time before they can find suppliers to provide
goods at a cheaper price.
Elasticity Exercise
Determinants of PED
What are the major determinants of price
elasticity of demand? Use the determinants
and your own reasoning in judging whether
demand for each of the following products is
elastic or inelastic.
–
–
–
–
–
–
Bottled Water
Toothpaste
Crest Toothpaste
Ketchup
Diamond bracelets
Microsoft Windows operating system
Determinant is how badly the consumer wants the good - whether it
satisfies a basic need, and whether there are substitutes.
– Bottled Water
• Inelastic – at least in the short term, since people are used
to them & will not be able to give them up easily
– Toothpaste
• Generally inelastic – because you have to brush
– Crest Toothpaste
• Being one of many brands, will be very elastic since you just
buy Colgate brand if Crest gets expensive
– Ketchup
• Inelastic – at least in the short term, since people are used
to them & will not be able to give them up easily
– Diamond bracelets
• Are a luxury goods, & hence elastic. You can make do
without them if you cannot afford them.
– Microsoft Windows operating system
• Inelastic – since people need an OS to run a PC, and using
Linux has a switching cost (both installing it & learning to
use it), & cost of OS is small compared to price of
computer.
Price elasticity of demand and taxation

Governments need to be aware of the possible
consequences when they impose indirect taxes,
such as sales taxes, on products. If a
government puts a tax on a product, then its
price will usually rise

If the demand for the product is very elastic,
then a price increase as a result of the imposition
of a tax on the product will lead to a relatively
large fall in the demand for the product.
Price elasticity of demand and taxation

Demand for production workers in the industry
is likely to fall significantly, increasing
unemployment in the economy.

Since governments are not usually keen to
increase unemployment, they normally place
taxes on products where demand is relatively
inelastic, so that the demand for the product will
not fall by a significant amount, and will not
thus lead to high unemployment.
Elasticity Exercise
Price elasticity of demand and
taxation
Exercise
Estimates based on studies of the US
population suggest that a 10% increase in the
price of cigarettes would reduce overall
consumption by adults by 3% to 5%. The
same 10% increase would reduce the
consumption by youths by 13%.
• Calculate the price elasticity of demand for
cigarettes among US adults and among US youths.
• Suggest possible reasons for the different
magnitude of elasticity between the two groups.
• Explain two possible reasons why a government
would place a tax on cigarettes.
Additional
Elasticity Exercise
Apply the correct elasticity term
to each scenario
John must have an appendectomy. Upon arriving
at the hospital he is told that for this week only
they are doing abdominal operations at half price.
Even in the face of a 50% price cut, John insists
that he wants only one operation.
PERFECTLY INELASTIC
John had a perfectly inelastic demand for abdominal surgeries. No
matter what the percentage change in price, the percentage change in
the quantity demanded was zero.
The Dell Corporation announces that it is willing to
sell as many model 3000 computers as are ordered
at a fixed price of $500 per unit
PERFECTLY ELASTIC
The Dell Corporation had a perfectly elastic supply curve of model
3000 computers. No matter what the percentage change in the
quantity it supplied, the percentage change in price was zero.
Northwest Airlines increased all its fares by 25
percent. As a result the number of passengers
declined by 25 percent and the total revenue of
Northwest Airlines remained the same.
UNIT ELASTIC
Northwest Airlines had a unit elastic demand for its flights because
the percentage gain in price was just offset by the percentage decline
in quantity demanded.
Newsweek magazine raised its price to annual
subscribers by 50 percent. As a result annual
subscriptions fell by 30 percent. Although it lost
some readership, Newsweek significantly
increased its revenues.
INELASTIC
Newsweek magazine had an inelastic demand for annual subscriptions
because the percentage loss in subscribers was less than the
percentage gain in price.
The price of movie tickets went down by 60
percent. In response, demand for movie tickets
increased by 70 percent.
ELASTIC
The demand for movie tickets was elastic because the percentage
increase in quantity demanded was greater than the percentage
decrease in price.