Price Elasticity of Demand

Elasticity – the concept The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity – the concept If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity 4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity

Elasticity Price Elasticity of Demand The responsiveness of demand to changes in price Where % change in demand is greater than % change in price – elastic Where % change in demand is less than % change in price - inelastic

Elasticity Price ($) Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity Total Revenue Price $5 D 100 Quantity Demanded (000s) Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. $5 Total Revenue D 100 Quantity Demanded (000s)

Elasticity Total Revenue D Price $5 $3 100 140 If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. $5 $3 Total Revenue D 100 140 Quantity Demanded (000s)

Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20% Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

Elasticity Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 5 20 Quantity Demanded

The Meaning of Price Elasticity of demand Elastic Demand: A strong response to a change in price Unit Elastic demand: A proportional response to a price change (total amount spent by consumers remains unchanged) Inelastic demand : A weak response to a price change

Elasticity If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P)

Total Outlay Method Total Outlay is a way to calculate the price elasticity of demand method by looking at the effect of changes in price on the revenue earned by the producer. If price and revenue move in the same direction, demand is inelastic. If price and revenue move in the opposite direction, demand is elastic If revenue remains unchanged in response to a price change, demand is unit elastic

Elasticity and Total Outlays

Total Outlay Method and slope of a demand curve Look at Pg 85 Perfectly elastic Demand is where consumers are willing to pay any price in order to obtain a given quantity of a good or service. The situation can be represented by a horizontal demand curve. An apple grower sells apples, along with many other apple growers , at a fruit and vegetable market. The grower can sell the entire load at the going market price. If the grower tries to sell the apples at a price above the going rate he will sell none.

Perfectly Inelastic demand is where consumers are willing to pay any price in order to obtain a give quantity of a good or service. This situation can be represented by a vertical demand curve. Example a person with a life threatening illness would be willing to pay almost anything.

Review Question 1 and 2 pg 86

Factors affecting elasticity of demand Whether the good is a luxury or a necessity. -necessities have relative inelastic demand-even if there is an increase in price, the quantity demanded will not fall to a great extent -price elasticity of demand is higher for products that are regarded as luxuries

Factors affecting elasticity of demand Whether the good has any close substitutes. Goods with close substitutes tend to have highly elastic demand. If the price increases the demand is is likely to contract more then proportionately. Goods and Services with few or no close substitutes , such as water supply, would have inelastic demand- even if price increase, people cannot switch to another product

Factors affecting elasticity of demand The expenditure on the product as a proportion of income Items which take up a very small proportion of a person’s income would have a lower price elasticity of demand, whereas the demand for more expensive items would tend to be more elastic.

Factors affecting elasticity of demand The length of time subsequent to a price change If the price falls may take time to become aware and adjust to the price change If it increases, consumers may take time to seek out alternatives and substitute products

Factors affecting elasticity of demand Whether a good is habit forming (addictive) or not Relative inelastic demand. E.G Price rise in Alcho-pops and cigarettes did not lead to a large decrease in demand. REVIEW QUESTION 1-3 pg 87 Chapter Review pg 89