IB Business and Management Elasticity of Demand IB Business and Management

What is Elasticity? Elasticity measures how responsive demand is to a change in a particular variable The IB syllabus includes: Price Elasticity of Demand Income Elasticity of Demand Cross-price Elasticity of Demand Advertising Elasticity of Demand

Price Elasticity of Demand

Elasticity

The relationship between price and demand

Elastic Demand?

Price Elasticity of Demand Price Elasticity of demand is concerned with how responsive the demand for a product is to a change in price How much will the demand change as a result of a change in the price?

Price Inelastic Goods Goods where demand is relatively unresponsive to a change in price Demand will reduce but by a relatively small amount Firms would like their products to be price inelastic.... Why? Can you think of any examples?

Price Elastic Goods Demand for the product is relatively responsive to a change in price Firms will have very little freedom to increase prices as this will result in a large decrease in demand Can you think of any examples?

Calculating Price Elasticity PED = % Change in quantity demanded % change in price Example: The price for a wardrobe is reduced from £50 to £47 and as a result sales rise from 2,000 to 2,240 units. % change in demand = 240/2000 X 100 = 12% % change in price = -£3/£50 X 100 = -6% PED = +12%/-6% = -2

Classifying Price Elasticity Price Elasticity will always have a negative value – Why? PED Value (ignoring minus sign) Negative value less than 1 Price Inelastic Exactly -1 Unit Elasticity Negative Value more than 1 Price Elastic

PED and Revenue for Price Elastic Products Increase in SP Large Decrease in QD Revenue Falls Revenue = Selling Price x Quantity Demanded Decrease in SP Large Increase in QD Revenue Increases Therefore firms who assess their products to be Price Elastic should consider carefully before increasing prices and can be in a difficult position if their costs increase

PED and Revenue for Price Inelastic Products Increase in SP Small Decrease in QD Revenue Increases Revenue = Selling Price x Quantity Demanded Decrease in SP Small Increase in QD Revenue Decreases Therefore firms who assess their products to be Price Inelastic have great freedom with their selling price.

Using PED to calculate changes in revenues PED = % Change in quantity demanded % change in price How could we rearrange this formula to make % change in quantity demanded the subject? % change in quantity demanded = PED X % change in price

E.g. A product costs £100. At this level demand for the product is 60 units What would revenue be at this price level? Total Revenue = £100 X 60 = £6,000 The company are considering increasing the price to £110 % change in quantity demanded = PED X % change in price The product is Price Inelastic – PED -0.5 What will the % change in demand be? If PED is -0.5 a 10% increase in price will result only in a 5% decrease in demand So the new level of demand will be? 60 ÷ 100 x 95 = 57 So what will the new revenue be? New Total Revenue = £110 X 57 = £6,270

Answer: The product is Price Elastic – PED -2 What will the % change in demand be? If PED is -2 a 10% increase in price will result in a 20% decrease in demand So the new level of demand will be? 60 ÷ 100 x 80 = 48 So what will the new revenue be? New Total Revenue = £110 X 48 = £5,280

Exam Question (b) (i)

Exam Question (b) (ii)

Factors influencing Price Elasticity Necessity or luxury Availability of substitutes Income of customers Brand Loyalty

Questions Why do firms prefer to sell products that are price inelastic? How can firms reduce the price elasticity of their products?

Implications of Price Elasticity of Demand Helps firms decide on their pricing policy Helps predict the effect of exchange rate fluctuations on exported goods Helps governments to work out optimum levels of taxation on goods to maximise tax revenues

What do the following graphs show?

Exam Question (b) (i)

Exam Question (b) (ii)

Income Elasticity of Demand

Income Elasticity of Demand Income elasticity of demand is concerned with how responsive the demand for a product is to a change in income How much does the demand for a product increase or decrease with a change in consumer’s incomes?

Calculating Income Elasticity IED = % change in demand % change in income Whereas an increase in price will always lead to a fall in demand (negative correlation) an increase in demand can lead to either a fall or a rise in demand depending on the type of product. Therefore IED can be negative or positive

Interpreting Income Elasticity of Demand An IED with a value < 1 is income inelastic and a value of > 1 are income elastic (regardless of whether they are negative or positive) Products can be split into one of three categories: Normal Goods, Luxury goods or Inferior goods

Inferior Products Inferior products are those where an increase in income leads to a decrease in demand Inferior products have a negative IED Inferior products can be income elastic or inelastic Demand falls as incomes rise and people tend to buy more luxury products E.g. A 10% increase in income leads to a 5% decrease in demand for Tesco Value white bread. IED = -5%/10% = -0.5

Luxury Goods Luxury goods are products where an increase in income will lead to a large increase in demand and vice versa. Luxury goods are therefor income elastic Luxury goods have a positive IED >1 E.g. An increase in income of 10% leads to a 20% increase in demand for cruise holidays. IED = 20%/10% = +2

Normal goods Normal goods are products where an increase in income leads to a small increase in demand and vice versa These products have a positive income elasticity < 1 Normal goods are therefore income inelastic These products are normally ‘everyday’ items E.g. A 10% increase in income leads to a 6% increase in the demand for jammy dodgers. IED = 6%/10% = +0.6

Normal, Inferior or Luxury

Issues with income elasticity Can help a firm to predict sales if they know the economic forecast Goods can fall into different categories to different groups of people. What is considered a necessity is subjective Goods can move between categories over time

Question Product A Product B Price Elasticity -3.5 -0.5 Income Elasticity +0.4 +2.5 What products can be drawn about the nature of the two products A and B?

Cross-price Elasticity of demand

Cross-price elasticity Measures how responsive the demand for a product is to a change of price of another product These other products can be: Substitutes Complements Not-related

Calculating Cross-price elasticity CED = % change in demand for Good A % change price of Good B

Substitutes Substitute products compete for demand as they can be used in place of each other These products can be competitor products or other products that fulfill the same needs

Suggest some substitutes for these products….. Train travel

Elasticity of demand and substitute products What is likely to happen to the demand for a product if the price of it’s substitute increases? There is a positive relationship between the demand for a product and the price of it’s substitutes The cross-price elasticity will be a positive number The higher the value the greater the elasticity

Complements Complements are products that are joint in demand as they are related products

Suggest some complements for these products…..

Elasticity of demand and complement products What is likely to happen to the demand for a product if the price of it’s complement increases? There is an inverse relationship between the demand for a product and the price of it’s complements The cross-price elasticity will be a negative number The more negative the value the greater the elasticity

Other considerations with cross-price elasticity What would it mean if the calculation returned a result of zero? Knowledge of cross-price elasticity can help businesses forecast the impact on revenues if competitors implement a price change

Advertising Elasticity of demand

Advertising elasticity of demand Advertising elasticity of demand (AED) measures the degree of responsiveness of demand for a product following a change in the advertising expenditure for the product

Calculating Advertising Elasticity of demand AED = % change in demand % change in advertising expenditure Can the results be positive or negative? What would a large figure suggest? How might a firm use this information in planning it’s marketing strategy?

Considerations with AED Is very difficult to determine in reality as it is difficult to determine whether advertising expenditure or another factor lead to a change in demand Also, AED is dependent on the effectiveness of the advertising rather than just the amount of expenditure