Download Price Elasticity of Demand

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Price Elasticity of Demand
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Price elasticity of demand measures the responsiveness of demand after a change in price
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The formula for calculating the co-efficient of elasticity of demand is:
Percentage change in quantity demanded divided by the percentage change in price
Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in
the minus sign. We are more concerned with the co-efficient of elasticity of demand.
Values for price elasticity of demand
1. If Ped = 0 demand is perfectly inelastic - demand does not
change at all when the price changes – the demand curve will
be vertical.
2. If Ped is between 0 and 1 (i.e. the % change in demand from
A to B is smaller than the percentage change in price), then
demand is inelastic.
Demand for rail services
At peak times, the demand for rail
transport becomes inelastic – and
higher prices are charged by rail
companies who can then achieve
higher revenues and profits
3. If Ped = 1 (i.e. the % change in demand is exactly the same as
the % change in price), then demand is unit elastic. A 15%
rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level.
4. If Ped > 1, then demand responds more than proportionately to
a change in price i.e. demand is elastic. For example if a 10%
increase in the price of a good leads to a 30% drop in demand.
The price elasticity of demand for this price change is –3
Factors affecting price elasticity of demand
1. The number of close substitutes – the more close substitutes
there are in the market, the more elastic is demand because
consumers find it easy to switch. E.g. Air travel and train travel
are weak substitutes for inter-continental flights but closer substitutes for journeys of around 200400km e.g. between major cities in a large country.
2. The cost of switching between products – there may be costs involved in switching. In this case,
demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month
contract which has the effect of locking-in some consumers once a choice has been made
3. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic
demand whereas luxuries tend to have a more elastic demand. An example of a necessity is rareearth metals which are an essential raw material in the manufacture of solar cells, batteries. China
produces 97% of total output of rare-earth metals – giving them monopoly power in this market
4. The proportion of a consumer’s income allocated to spending on the good – products that take
up a high % of income will have a more elastic demand
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5. The time period allowed following a price change – demand is more price elastic, the longer that
consumers have to respond to a price change. They have more time to search for cheaper
substitutes and switch their spending.
6. Whether the good is subject to habitual consumption – consumers become less sensitive to the
price of the good of they buy something out of habit (it has become the default choice).
7. Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak
times – this is particularly the case for transport services.
8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more
elastic following a price change.
Demand curves with different price elasticity of demand
Relatively Elastic Demand
Relatively Inelastic Demand
Price
Price
P2
P2
P1
P1
P3
P3
Demand
Demand
Q2 Q1 Q3
Q2 Q1
Q3
Elasticity of demand and total revenue for a producer
The relationship between elasticity of demand and a firm’s total revenue is an important one.
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When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise in price
might cause demand to contract by only 5% (Ped = -0.25)
When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in
price might cause demand to expand by only 25% (Ped = +2.5)
When demand is perfectly inelastic (i.e. Ped = zero), a given price change will result in the same
revenue change, e.g. a 5 % increase in a firm’s prices results in a 5 % increase in its total revenue
Peak and Off-Peak Demand and Prices
Why are prices for package holidays more expensive during school holiday weeks? Why are rail fares more
expensive at peak times? During peak demand periods, market demand is higher and also more price
inelastic. This allows producers to sell their products for higher prices and make increased profits.
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Relatively Inelastic Demand
Relatively Elastic Demand
Price
Price
P2
P1
P1
P2
Demand
Demand
Q2 Q1
Q1
Q2
The table below gives an example of the relationships between prices; quantity demanded and total revenue.
As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of
£12 per unit when 520 units are sold giving total revenue of £6240.
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Price
Quantity
Total Revenue
Marginal Revenue
£ per unit
Units
£s
£s
20
200
4000
18
280
5040
13
16
360
5760
9
14
440
6160
5
12
520
6240
1
10
600
6000
-3
8
680
5440
-7
6
760
4560
-11
Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. The % change
in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly
elastic).
In this situation when demand is price elastic, a fall in price leads to higher total consumer spending /
producer revenue
Consider a price change further down the estimated demand curve – from £10 per unit to £8 per
unit. The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of
elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction
in total revenue.
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CHANGE IN THE MARKET
WHAT HAPPENS TO TOTAL REVENUE?
Ped is inelastic (<1) and a firm raises its price.
Total revenue increases
Ped is elastic (>1) and a firm lowers its price.
Total revenue increases
Ped is elastic (>1) and a firm raises price
Total revenue decreases
Ped is unit elastic (=1) and a firm raises price
Total revenue remains the same
Ped is -1.5 (elastic) and the firm raises price by 4%
Total revenue decreases
Ped is -0.4 (inelastic) and the firm raises price by 30%
Total revenue increases
Ped is -0.2 (inelastic) and the firm lowers price by 20%
Total revenue decreases
Ped is -4.0 (elastic) and the firm lowers price by 15%
Total revenue increases
Elasticity of demand and indirect taxation
Many products are subject to indirect taxes. Good examples include the duty on cigarettes (cigarette taxes
in the UK are among the highest in Europe) alcohol and fuel. Here we consider the effects of indirect taxes
on costs and the importance of elasticity of demand in determining the effects of a tax on price and quantity.
A Tax when Demand is Price Inelastic
Most of the tax is paid by the consumer
A Tax When Demand is Price Elastic
Most of the tax is paid by producer
Price
Price
S + Tax
S + Tax
S1
S1
P2
P2
P1
D1
P1
D1
Q2
Q1
Quantity
Q2 Q1
Quantity
A tax increases the costs of a business causing an inward shift in supply. The vertical distance between the
pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier may be able to
pass on some or all of this tax to the consumer by raising price. This is known as shifting the burden of the
tax and this depends on the elasticity of demand and supply.
Consider the two charts above.
 In the left hand diagram, the demand curve is drawn as price elastic. The producer must absorb the
majority of the tax itself (i.e. accept a lower profit margin on each unit sold). When demand is elastic,
the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium quantity. Output
has fallen from Q to Q1 due to a contraction in demand.
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In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the range of
this demand curve) and therefore the producer is able to pass on most of the tax to the consumer
through a higher price without losing too much in the way of sales. The price rises from P1 to P2 –
but a large rise in price leads only to a small contraction in demand from Q1 to Q2.
The Usefulness of Price Elasticity of Demand for Producers
Firms can use PED estimates to predict:
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The effect of a change in price on total revenue
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The price volatility in a market following changes in supply – this
is important for commodity producers who suffer big price and
revenue shifts from one time period to another.
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The effect of a change in an indirect tax on price and quantity demanded and also whether the
business is able to pass on some or all of the tax onto the consumer.
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Information on the PED can be used by a business for price discrimination. This is where a
supplier decides to charge different prices for the same product to different segments of the
market e.g. peak and off peak rail travel or prices charged by
many of our domestic and international airlines.
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Usually a business will charge a higher price to consumers
whose demand for the product is price inelastic
Price elasticity of demand and changing market prices
The price elasticity of demand will influence the effects of shifts in supply on
price and quantity in a market. This is illustrated in the next two diagrams.
An outward shift of supply when demand is
price inelastic (Ped < 1)
An outward shift of supply when demand is
price elastic (Ped > 1)
Price
Price
S1
S1
S2
S2
P1
P1
P2
D1
P2
D1
Q1
Q2
Quantity
Q1 Q2
Quantity
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In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward
shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively
small change in the market price.
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In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand
curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively
small expansion in the equilibrium quantity.
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Focus on the Price Elasticity of Demand for Cigarettes
The rising real price of tobacco in the UK
1997 = 100
Index of prices, 1997=100
275
275
250
250
225
225
200
200
175
175
150
150
Tobacco
125
125
Consumer Price Index
100
100
75
75
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
Source: Reuters EcoWin
The traditional approach to cutting consumption of cigarettes and other tobacco products has been to raise
the price by lifting the tax (duty) on tobacco each year by more than the annual rate of inflation. As our chart
above shows the index of tobacco prices rises each year immediately after the Budget in April each year.
Since 2005 the average retail price has risen by more than 50 per cent.
Do higher prices cut demand? This is an application of the concept of price elasticity of demand. In the UK:
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21% of adults reported smoking in 2010 compared to 39% in 1980.
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Cigarette smoking is higher among men than women
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Those aged 20-24 and 25-34 reported the highest
prevalence of cigarette smoking (32% and 27%
respectively), while those aged 60 and over reported
the lowest (12%).
Tobacco is now established as a
leading cause of preventable death
worldwide and is expected to claim
nearly a billion lives in the 21st
century (WHO 2008).
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Smokers smoked an average of 13.1 cigarettes per day
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Average weekly household expenditure on cigarettes in
Great Britain in 2008 was £3.90
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£16.3 billion was estimated to be spent on tobacco in 2009, the proportion of total household
expenditure on tobacco has decreased since 1980, from 3.6% to 1.9% in 2009
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Two thirds (67%) of current smokers reported wanting to give up smoking, with three quarters (75%)
reporting having tried to give up smoking at some point in the past
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On the 1st July 2007, smoke free legislation was introduced in England, banning smoking in
enclosed public places
Would you expect the demand for cigarettes to have high or low price elasticity? What factors might help
explain your view?
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