Reading 04 elasticity of demand ped


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Reading 04 elasticity of demand ped

  1. 1. 04 Elasticity of Demand - PEDContentPrice Elasticity of Demand (PED)Learning outcomes G1. Define, price, income and cross elasticity of demand G2. Calculate and interpret price, income and cross elasticity of demand G3. Draw simple but neat and accurate graphs to illustrate various stages of price, income and cross elasticity of demand G4. Explain the factors that determine the level of price elasticity of demand G5. Explain the impact on company revenue of price elasticity of demand REQUIRED READING – Economics 5th Edition by Alain Anderton Unit 9 & 10What is elasticity of demand?Elasticity of Demand is the measurement of how customer demand is affected by achange in price, income, price of substitutes and complementary goodsPrice elasticity of demandPrice Elasticity of Demand measures the effect a change in price has on the quantitydemanded. It is also known as PED and is calculated using the following equation:PED = %∆Qd %∆PPercentage Change = Absolute Change * 100 Original Value• Though the result is always negative, the negative sign is often presented in brackets e.g. (-)0.2. There is vocabulary used to describe the result which are price elastic, price inelastic, unit/unitary elasticity, perfectly elastic and perfectly inelasticPrice elasticIf PED is > 1 the good is relatively elastic (price elastic)This means demand reacts strongly to a change in priceE.g. If a 15% fall in price leads to a 30% increase in quantity demanded, the priceelasticity is 2.0 1
  2. 2. Demand for Cinema Tickets 120 100 80 Original Price Price 60 Demand New Price 40 20 0 1 2 3 4 5 6 7 8 9 10 Quantity• The demand change is 4 So (4/4)*100=100%• Here the change in price is 40 So (40/70)*100=57%• PED is 100/57=1.7 This is a very elastic product, changing the price has a strong effect on its demand• Notice that the gradient of the curve is not steepPrice inelastic• If the PED is less than 1, the product is relatively inelastic (price inelastic). Demand doesn’t react strongly to change• E.g. If a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity is 0.25 Demand New Price 7 6 5 Old Price 4 Price Demand 3 2 1 0 10 20 30 40 50 60 Quantity• The demand change is 10 So (10/50)*100=20%• Here the price change is 3 So (3/3)*100=100% 2
  3. 3. • PED is 20/100=0.2 This product is price inelastic, changing the price doesn’t have strong effect on its demand • Notice that the gradient of the curve is not steep Unit elastic • If PED = 1, it is called unit or unitary elasticity • The percentage change in quantity demanded is the same as the percentage change in price • This results in a ‘traditional’ demand curve shape • In reality, a Unitary elastic product, will have maintain a certain level of income regardless of price e.g. price £100 = demand 1 or price £1 = demand 100 In both cases Total Revenue = £100 Demand CurvePrice D Quantity Perfectly inelastic • If the PED is 0, the good is said to be perfectly inelastic • The percentage change in price will have no effect on the quantity demanded • The demand curve for such a product will be vertical • This shows a product, which is needed to an extent or very rare – hard to find or buy (e.g. rare art) Demand CurvePrice D P1 Q1 Quantity Perfectly elastic • If the PED is almost infinite, then the demand curve is shown as a horizontal line • We call this perfectly elastic • Any change in price will see the quantity demanded fall to zero • Basically buyers are prepared to buy all they need for a limited price (health care or education) 3
  4. 4. • This curve is also important to understand the Market Structure called Perfect Competition Demand CurvePrice P1 D Q1 Quantity PED and revenue • Understanding PED is important when making price changes since PED informs whether total revenue will increase or decrease. • Relatively elastic products will experience a fall in total revenue if they increase their prices. • The opposite is true for relatively inelastic products • Calculate the changes in total revenue (P*Q) for the graphs above and you will be able to see the difference The determinants of PED There are many influences on PED including the availability of substitutes, time, the percentage of income spent on goods and whether or not a good is a luxury or a necessity. Availability of Substitutes: the greater the amount and quality of substitutes available, the more price elastic a good or service will be. E.g. wheat noodles can be replaced with noodles made from other materials, boiled/fried rice or bread Time: the more time passes, the more likely we are to find substitutes or be able to use a product more efficiently – as this occurs the product will be become more price elastic. E.g. In the past, homes in the UK were fueled by coal. Improvements in coal production, allowing less to be used for greater levels of heat affected the quantities bought. Additionally, technological improvements allowed people to have access to other methods of heating their homes, causing coal to become more price elastic. Percentage of income spent on the item: cheap goods that are a relatively small percentage of income, such as cigarettes, tend to be inelastic since high percentage price changes still result in a cheap product. The opposite is true for products that are a high percentage of income, such as HDTVs. Luxuries versus Necessities: it is logical to argue that luxuries will be more price elastic that necessities. However, it can be very difficult to decide which is which, a person needs shelter, but many people live in houses much grander that simply shielding from the elements requires – arguably a luxury. People need clothing and 4
  5. 5. food, yet we have more clothing that we require and often eat food not necessary forour survival.There are many other possible factors which may affect the price elasticity of demand.It is important to use common sense to determine what they may be. One of theexamples discussed above was cigarettes, a low price is not the only factor. Cigarettesare addictive, many smokers feel they ‘need’ to smoke and will not reduce demandeven as the price increases.Summary• PED is concerned with how quantity demanded responds to a price change• Elastic means that the response is great• Inelastic means the response is small• Understanding elasticity can help businesses to effectively plan price strategies and anticipate how changes in the economy and various markets will affect the demand for their products 5