Elasticity of Demand

Price Elasticity of Demand Defining price elasticity of demand (PeD) measures the strength of response of consumer demand to a change in price. Measures our reaction to a change in price

Price Elasticity of Demand and Consumer Expenditure Defining Total consumer Expenditure TE = P × Q Illustrating TE graphically

Total expenditure Consumers’ total expenditure = firms’ total revenue £2 x 3m = £6m D Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure Effects of a price change: elastic demand Price rises Total Expenditure falls See graph

Elastic demand between two points Expenditure falls as price rises P(£) b 5 10 a 4 D 20 Q (millions of units per period of time)

Elastic demand between two points 5 10 revenue gain a 4 D revenue loss 20 Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure Effects of a price change: inelastic demand Price rises: Total Expenditure rises

Q (millions of units per period of time) Inelastic demand Expenditure rises as price rises c 8 15 P(£) revenue gain a 4 revenue loss D 20 Q (millions of units per period of time)

Price Elasticity of Demand Applications to pricing decisions Applications to tax decisions Income Elasticity (at end) Revenue predictions Government revenue changes from taxes on products

Price Elasticity of Demand Measuring price elasticity of demand use of percentage changes the sign: positive or negative? the value: greater or less than 1? % change in QD % change in P

Price Elasticity of Demand Measuring price elasticity of demand greater than -1 then price elastic less than -1 then price inelastic % change in QD % change in P

Price Elasticity of Demand Determinants of price elasticity of demand availability of substitute goods proportion of income spent on the good habit fashion frequency of purchase

Elastic or Inelastic?

Elastic or Inelastic

Elastic or Inelastic

Elastic or Inelastic?

Elastic or Inelastic

Elastic or Inelastic?

Measuring Elasticity ÷ % change in QD % change in P Change in QD Original QD Change in P Original P

Measuring Elasticity m n P (£) Demand Q (000s)

Price elasticity of demand % change in QD % change in P ÷ 10 2 8 = 4

Price Elasticity of Demand and Consumer Expenditure Special cases PeD = 0

Totally inelastic demand (PÎD = 0) b P1 a O Q1 Q

Price Elasticity of Demand and Consumer Expenditure Special cases PeD = 0 PeD = 

Infinitely elastic demand (PÎD = ¥) b P1 D Q2 O Q1 Q

Price Elasticity of Demand and Consumer Expenditure Special cases PeD = 0 PeD =  PeD = –1

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

Price Elasticity of Demand and Consumer Expenditure Special cases PeD = 0 – perfectly inelastic PeD =  - perfectly elastic PeD = –1 – unitary elasticity

Demand Changes with Income Consumers increase the demand for most good when income rises – NORMAL GOODS Demand for a good may fall when income rises and vice versa – INFERIOR GOODS

The London Restaurant market Watch the video clips and comment on the types of goods and their elasticities: Restaurant Food Prepacked sandwiches Sandwich boxes

Goods can be both! Bread NORMAL if you are on a low income INFERIOR for higher income earners

Other Elasticities Income elasticity of demand measurement determinants degree of necessity rate at which people are satisfied level of income Applications – we can work out the effect of a price change/tax change

Income Elasticity If sellers know the income elasticity of their product they can predict what will happen to their revenue when incomes change The Government would also be able to predict changes in revenue from taxes on products % Change in demand % Change in Income

If income rises? Some products are still out of our reach. How much is an Aston Martin? £183,000 Some products we will buy no more of. Eg a newspaper Some we will buy a little more of eg food. (Food is income inelastic in a high-income economy such as ours). Some we will buy more of eg entertainment, meals out. Income elasticity tends to be greater than 1 Some we will buy less of eg no more Tesco Value for me or white bread!

Income Elasticity A normal good will always have a positive income elasticity because quantity demanded and income either both increase (+/+) or both decrease (-/-) An inferior good will always have a negative elasticity - opposite signs each way

Giffen Goods Theory by Sir Robert Giffen! A giffen good is a special sort of inferior good Giffen observed that the consumption of bread increased as the price rose Bread was the staple food of those on low incomes – bread would ‘fill’ empty stomachs! And as its price had risen they could afford less luxuries like meat and so bought more bread

Income Effect If the price of a good rises, the real income of a consumer falls Cannot buy the same basket of goods and services as before.

Substitution Price rises Buy more pears If the price of a good rises, consumers will buy less of that good and more of others because it is relatively more expensive. Price rises Buy more pears

Cross Elasticity The quantity demanded of a good varies according to the price of other goods Eg a rise in the price of beef would increase demand for pork (substitute) A rise in the price of cheese would lead to a fall in demand for macaroni (complement)

% ∆ Price of another good Y Cross Elasticity % ∆ Q demanded good X % ∆ Price of another good Y Two goods which are substitutes will have a positive cross elasticity Two goods which are complements will have a negative cross elasticity The cross elasticity of goods which have little relationship to each other would be zero (independents)

Example – positive cross elasticity A rise in the price of fish may cause demand for chicken to increase (substitutes) What will have happened to the demand curve for chicken? Price of Fish Quantity of Chicken Demanded

Example – negative cross elasticity A rise in the price of air travel causes a fall in the demand for foreign holidays (complementary goods) What will have happened to the demand curve for foreign holidays? Price of air travel Quantity of foreign holidays demanded

Example – zero cross elasticity A rise in the price of apples leaves the demand for gloves unaffected! However we must remember that a change in the price of a product affects our purchasing power and may affect the demand for an unrelated product. Price of apples Quantity of gloves demanded

The significance of cross elasticity Firms may realise that if a product has a high positive cross-elasticity, then a decrease in price will attract more customers. A low positive cross –elasticity gives a firm more power to raise the price. A high negative cross elasticity means lowering the price of the cheaper complement can increase sales of the other product.