2. Price elasticity of demand (PED)
• Price elasticity of demand (PED) is a
measure of the responsiveness of demand for a
product to a change in its own price.
• PED assumes that as the price of X changes,
other things (the conditions of demand) remain
equal, so it involves movements along the demand
curve (expansioncontraction) rather than shifts
in the demand curve (increase/decrease).
3. PED – Cont.
• The PED for product X is given by the equation:
• the sign of PED for a product is negative, since a
fall in price of X will lead to an expansion of
demand for X (+/- = -).
• For example, if a 2% fall in price of X results in a
6% expansion in demand, then PED is +6/-2 = (-)3
• However, we usually ignore the sign of PED when
expressing the numerical values.
6. Factors affecting PED
• 1 The availability of substitutes in consumption. A
small percentage change in price of X can then lead to
a large percentage change in the quantity demanded of
X as consumers switch towards or away from these
substitutes in consumption.
• 2 The nature of the need satisfied by the product.
The more possible it is to classify the need as being in
the luxury category, the more price sensitive consumers
tend to be and the more elastic the demand.
• 3 The time period. The longer the time period, the
more elastic the demand (consumers take time to
adjust their consumption patterns to a change in price).
7. Factors affecting PED – Cont.
4 The proportion of income spent on the product. The
greater the proportion of income spent on the
product, the more elastic the demand will tend to
be.
5 The number of uses available to the product. The
greater the flexibility of the product in terms of
the number of uses to which it can be put, the
more elastic the demand.
8. Price elasticity of demand (PED) and
revenue
• For a business to make sensible decisions as to the
price it should charge, it will help to be aware of the
linkage between PED and total revenue (turnover).
9. • With the initial price at OP, total revenue (price
*quantity) is shown by area OPVQ.
• A fall in price to OP1 will lead to an expansion of
demand to OQ1 and a new total revenue indicated by
area OP1V1Q1.
• Clearly Area 1 is common to both total revenue
situations, but here Area 2 is lost and Area 3 gained.
The loss of
• Area 2 is due to selling the original OQ units at a now
lower price; the gain of Area 3 is due to the lower price
attracting new (Q–Q1) consumers for the product.
10.
11. Price changes and total revenue
• ■ For price reductions along a unit elastic demand curve (PED
= 1) or segment of a demand curve, there will be no change
in total revenue (Area 3 =Area 2).
• ■ For price reductions along a relatively elastic demand curve
(PED >1 < ∞) or segment of a demand curve, total revenue
will increase as there is a more than proportionate response
of extra consumers to the now lower price (Area 3 > Area 2).
• ■ For price reductions along a relatively inelastic demand curve
(PED > 0 < 1) or segment of a demand curve, total revenue
will decrease as there is a less than proportionate response of
extra consumers to the now lower price (Area 3 <Area 2).
12.
13. 1 When demand is price inelastic:
● a price rise will increase total revenue; consumer
expenditure on the good increases;
● a price fall will decrease total revenue; consumer
expenditure decreases.
inelastic demand
TR changes in same direction as price
2 When demand is price elastic:
● a price rise will decrease total revenue or total
expenditure;
● a price fall will increase total revenue or total
expenditure.
elastic demand
TR changes in same direction as quantity
14. Measuring price elasticity of demand (PED)
• In most cases price elasticity of demand varies
along different segments of the same demand curve
15.
16.
17. Non-linear demand curve
• If the demand curve is not a straight line (i.e. it is
non-linear) then we have a further problem since
the ratio ΔQ/ΔP will no longer be a constant.
19. Demand
(a) GASOLINE: SHORT-RUN AND
LONG-RUN DEMAND CURVES
(a) In the short run, an increase in
price has only a small effect on
the quantity of gasoline
demanded. Motorists may drive
less, but they will not change the
kinds of cars they are driving
overnight.
In the longer run, however,
because they will shift to smaller
and more fuel-efficient cars, the
effect of the price increase will be
larger. Demand, therefore, is more
elastic in the long run than in the
short run.
Short-Run versus Long-Run Elasticities
20. (b) AUTOMOBILES: SHORT-
RUN AND LONG-RUN
DEMAND CURVES
(b) The opposite is true for
automobile demand. If price
increases, consumers initially
defer buying new cars; thus
annual quantity demanded
falls sharply.
In the longer run, however,
old cars wear out and must be
replaced; thus annual quantity
demanded picks up. Demand,
therefore, is less elastic in the
long run than in the short
run.
21. Total, average and marginal revenue
• Total revenue (TR): The firm’s total revenue is its total
earnings from the sale of its product (PRICE
*QUANTITY SOLD). Thus: TR= P*Q
• Average revenue (AR): The firm’s average revenue is
simply total revenue (TR) divided by quantity sold (Q).
AR = TR/Q = P*Q/Q = P
• It follows that in this situation the demand curve of the
firm is the average revenue (AR) curve, since it tells us
the price (AR) consumers are willing to pay for any given
quantity of the product.
• Marginal revenue
• The firm’s marginal revenue is the addition to total revenue
from selling the last unit of output. Marginal revenue can
also be defined as the rate of change of total revenue.
22. PED and tax incidence
Types of Tax
■ Lump-sum tax. This is a constant absolute
amount of tax (e.g. £1 per unit) irrespective of
price. The supply curve shifts vertically upwards
by £1 at all points, i.e. a parallel shift from S to S1
in Figure 2.5(a).
■ Percentage (ad valorem) tax. This is where the
absolute amount of tax varies with the price of
the product. For example, VAT at per cent will
mean more tax is paid as the price of the product
rises.
23.
24. Tax on Perfectly inelastic and Inelastic demand Curves
• Perfectly elastic demand
• Where the demand curve is perfectly inelastic
(D), the equilibrium price rises from P to
P1, i.e. by the full amount of the tax
(equilibrium quantity is unchanged at Q).
• We conclude that all the tax is passed on to
the consumer, i.e.:
• ■ 100% tax incidence on the consumer;
• ■ 0% tax incidence on the producer.
• Perfectly elastic demand
• Where the demand curve is perfectly elastic
(D1), the equilibrium price is unchanged at
• P (equilibrium quantity falls to Q1). We
conclude that none of the tax is passed on
to
• the consumer, i.e.:
• ■ 0% tax incidence on the consumer;
• ■ 100% tax incidence on the producer.
25. Tax on Relatively inelastic demand
• Where the demand curve is
relatively inelastic (Figure
2.6a), the producer is able to
pass on the larger part of the
lump sum tax t to the
consumer in the form of a
higher price. The producer
only needs to absorb a small
part of the tax.
26. Tax on Relatively elastic demand
• Where the demand curve is relatively elastic (Figure
2.6b), then the producer is less able to pass on the tax
t to the consumer and instead the producer must
absorb the larger part of the tax.
27. • We conclude that:
• ■ the more inelastic the demand, the
greater the tax incidence on the consumer,
and the smaller the tax incidence on the
producer;
• ■ the more elastic the demand, the smaller
the tax incidence on the consumer, and the
• greater the tax incidence on the producer.
28. Tax and government revenue
• Price elasticity of demand for the taxed product
will play a key role in determining the impact of
such tax increases on government revenue.
• As we can see from Figure 2.7, the more
inelastic the demand for the product, the smaller
the impact of any given lump-sum tax on the
quantity of the product purchased and therefore
the greater the government tax-take (tax per unit
" quantity purchased).
29. • The tax-take (government revenue) is
indicated by the
The tax-take (government revenue) is indicated by the shaded
rectangle P1VWC, which is clearly greater when demand is relatively
inelastic, as in Figure 2.7(a).
30. Other elasticities of demand
• Cross elasticity of demand (CED):CED is a measure of the
responsiveness of demand for a product (X) to a change in
price of some other product (Y). It involves shifts in a demand
curve
• The CED for product X is given by the equation:
• – Where X and Y are substitutes in consumption, a fall in
PY will result in an expansion of demand for Y and a decrease
in demand for X, i.e. a leftward shift in DX as some consumers
switch to the now relatively cheaper substitute for X.
• Here the sign of CED will be positive (-/-=+).
31. Other elasticities of demand – Cont.
• – Where X and Y are complements in consumption, a fall
in PY will result in an expansion of demand for Y and an
increase in demand for X, i.e. a rightward shift in DX as
consumers require more of X to complement their extra
purchases of Y. Here the sign of CED will be negative (+/-
=-).
• ■ The magnitude of the shift in DX will depend upon how
close X and Y are as substitutes or complements in
consumption. The closer the two products are as substitutes
or complements, the greater will be the numerical value of
cross-elasticity of demand. In other words, a given fall in
price of Y will cause a larger shift to the left of DX for close
substitutes, and a larger shift to the right of DX for close
complements.
32.
33. Income elasticity of demand (IED)
• IED is a measure of the responsiveness of demand
for a product to a change in income (household
income or national income).
• Usually we use real income rather than nominal
income for this measurement. IED involves shifts in
a demand curve (increase/decrease) rather than
movements along a demand curve
(expansion/contraction).
• The IED for product X is given by the equation:
34. Income elasticity of demand (IED) –
Cont.
• ■ For a normal product the sign of IED will be positive: for
example, a rise in incomen increases demand for X, i.e. a
rightward shift in DX, with more of X demanded at any given
price.
• ■ For an inferior product the sign will be negative over certain
ranges of income: for example, a rise in income beyond a certain
‘threshold’ level may decrease demand for X as consumers use
some of the higher income to switch away from the relatively
• cheap but poor-quality product X to a more expensive, better-
quality substitute.
• As a broad rule of thumb, a product is often considered
• a luxury if IED is p 1 and a necessity if IED is significantly ` 1.
