Price Elasticity of Demand (PED)

1. Price Elasticity of Demand (PED)

2. 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

3. 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

4. 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

5. Types of Elasticities • Price Elasticity of Demand (PED) • Price Elasticity of Supply (PES) • Cross-price Elasticity of Demand (XED) • Income Elasticity of Demand (YED)

6. 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?”

7. Price Elasticity of Demand (PED) % D Quantity Demanded FORMULA = % D Price Percent change in quantity demanded / Percent change in price

8. % Change Calculation • To calculate the % change, take note of this formula: • N – O x 100 • O • Take the new number minus the old number, then divide by the old number

9. % 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%

10. % 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%

11. % Change Calculation • If we put the two values into the equation for PED, we get: • PED = 15% / -10% = -1.5

12. 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

13. 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

14. 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.

15. Exercises • Calculate the PED if a price increase of 50% causes the quantity demanded to fall by 40%. • 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.

16. Exercises (Answers) • Calculate the PED if a price increase of 50% causes the quantity demanded to fall by 40%. Answer: PED = -.8 • 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 • Explain why the PED coefficient is always negative. Answer: Inverse relationship between price and quantity demanded

17. 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. • Calculate the percentage changes in price and quantity demanded. • Calculate the price elasticity of demand for the scented candles.

18. Exercises (Answers) • Calculate the percentage changes in price and quantity demanded. Answers: Change in Qd = 5% Change in Price = -10% • Calculate the price elasticity of demand for the scented candles. Answer: PED = -.5

19. 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

20. 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

21. 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

22. Perfectly inelastic demand curve P D P2 P1 O Q Q

23. Perfectly elastic demand curve P P1 D O Q

24. Range of price elasticity along a straight-line curve PED = Infinity (Perfectly Elastic) PED > 1 (Elastic) Unitary PED = 1 Price PED < 1 (Inelastic) PED = 0 Perfectly Inelastic Q O Quantity

25. Elasticity Demand curves with various elasticities

26. Perfectly inelastic demand (PÎD= 0) b P2 P D a P1 Q1 O Q

27. Infinitely (Perfectly) elastic demand (PÎD= ¥) b Q2 P a D P1 Q1 O Q

28. Unit elastic demand (PÎD = –1) b 8 100 P a 20 D 40 O Q

29. Different elasticities along different portions of a demand curve P a P1 D O Q1 Q

30. Different elasticities along different portions of a demand curve Elastic demand P a P1 b P2 D O Q1 Q2 Q

31. Different elasticities along different portions of a demand curve Inelastic demand P a P1 b P2 c P3 D O Q3 Q1 Q2 Q

32. 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

33. 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)

34. Inelastic demand between two points Revenue rises as price rises c 10.8 P($) 1.20 If a firm has inelastic demand for its product and wishes to increase total revenue, it should raise the price of the product. Revenue = 10.8 x 1.20 = $12,960 a 1.00 Revenue = 12 x 1 = $12,000 D 0 12 Q (000s)

35. Elasticity Exercise Inelastic Demand

36. 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. • Calculate the percentage changes in price and quantity demanded. • Calculate the price elasticity of demand for the scented candles. • Calculate the change in total revenue that the firm will experience following the fall in price. • Draw a “revenue box” diagram to illustrate the effect on quantity demanded and total revenue following the price change for the scented candle. • Was the firm sensible to lower the price of the scented candles? Explain your answer.

37. 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

38. 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)

39. Elastic demand between two points Revenue falls as price rises b 180 P($) If a firm has elastic demand for its product and wishes to increase total revenue, it should not raise the price of the product. 2.10 R = 180 x $2.1 = $378 a 2.00 D Revenue = 200 x $2 = $400 0 200 Q

40. Elasticity Exercise Elastic Demand

41. 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. • Calculate the percentage changes in price and quantity demanded. • Calculate the price elasticity of demand for the pizzas. • Calculate the change in total revenue that the firm will experience following the fall in price. • Draw a “revenue box” diagram to illustrate the effect on quantity demanded and total revenue following the price change for the Margherita. • Was the firm sensible to lower the price of the Margherita? Explain your answer.

42. 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

43. Unit elastic demand (PÎD = –1) b 8 100 P a 20 D 40 O Q

44. 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.

45. 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

46. 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

47. Determinants of price elasticity of demand • Availability of substitutes: • If 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.

48. 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.

49. Determinants of price elasticity of demand • Proportion of income • Very 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.

50. 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.