Elasticities of Demand

Includes different types of goods

What is price elasticity of demand (PED)?

Measures the responsiveness of quantity demanded to a change in price

What is the formula for PED?

%change in quantity demand / %change in price

What is the value of PED > 1?

Elastic

What is the value of PED 0 < 1?

Inelastic

What is the value of PED = 1?

Unit elastic

What is the value of PED = 0?

Perfectly inelastic

What is the value of PED = infinity?

Perfectly elastic

What does price elastic mean?

The percentage change in QD is more than proportional to the percentage change in price (eg luxury goods)

What does price inelastic mean?

The percentage change in QD is less than proportional to the percentage change in price (eg addictive products)

What does unitary elastic mean?

The percentage change in QD is exactly equal to the percentage change in price

What does perfectly inelastic mean?

QD is completely unresponsive to a change in price (theoretical)

What does perfectly elastic mean?

The percentage change in QD will fall to zero with any percentage change in price (theoretical)

What are the determinants of PED?

• Availability of substitutes

• Necessities vs luxury

• Proportion of income spent on the good

• Time period (more elastic over time)

• Addictiveness

What is the relationship between total revenue and PED?

• Elastic demand: price increase → total revenue decrease (vice versa)

• Inelastic demand: price increase → total revenue increase

• Unit elastic: price changes don’t have an affect on revenue

What are the implications of PED for firms?

• Knowledge of PED helps firms maximise revenue

  • Demand is price inelastic = raise prices to increase TR

  • Demand is price elastic = lower prices to increase TR

• Price discrimination

  • Firms can change different prices to different groups based on PED

  • Lower prices for more elastic segments, higher prices for inelastic segments

What are the implications of PED for governments?

• Taxation

  • Taxing goods with price inelastic demand = higher tax revenue with less impact on QD

  • Firms pass the tax onto consumers since demand is not very responsive

• Subsidies

  • Subsidising goods with price elastic demand = large increase in QD

  • Effective for encouraging consumption of merit goods (eg. electric vehicles, public transport)

Why is PED for primary commodities lower than manufactured products?

• Fewer substitutes of raw materials

• Proportion of income: each raw material component tends to be much smaller compared to overall cost of product → demand inelastic

• Necessity: commodities are necessities as they are raw materials used in production of goods

• Addictiveness: although not addictive, some raw materials are highly sought after by manufacturers (eg. iridium is a rare earth metal used to make the shell of Macbooks)

• Time period: time period to grow or extract primary commodities is much longer compared to manufactured goods

What sign should PED always be?

Negative - but you don’t have to write it with a negative sign

What is the income elasticity of demand (YED)?

Measures the responsiveness of quantity demanded to a change in income

What is the formula for YED?

%change in QD / %change in income

What is the value of YED > 0?

Normal goods

What is the value of 0 < YED < 1?

Necessities (income inelastic)

What is the value of YED > 1?

Luxuries

What is the value of YED < 0?

Inferior goods

What does it mean for YED to be a necessity?

• Normal good: quantity demanded increases when income increases

• Income inelastic which means that it is relatively unresponsive to a change in income

What does it mean for YED to be luxury?

• Normal good: quantity demanded increases when income increases

• Income elastic which means that it is relatively responsive to a change in income

What does it mean to be an inferior good?

• Quantity demanded decreases when income increases

What are the factors that influence YED?

• Recession

  • Wages tend to fall, demand for inferior goods increase and demand for luxury goods decrease

• Economic growth

  • Wages tend to rise, demand for luxury goods increase, demand for inferior goods decrease

• Minimum wage legislation

• Taxation

• Increased international trade

Why is YED important?

• Understand consumer behaviour → firms understand how changes in income levels affect consumer demand for their product or services. Firms can identify which sectors are more sensitive to changes in income

• Adapt to changes in the sectoral structure of the economy → indicates shifts in consumer preferences and patterns of consumption, firms need to adapt to these changes to remind competitive.

  • Sector declining due to low income elasticity → firms consider diversifying their product offerings or exploring new markets to sustain growth

  • Sectors with high income elasticity can provide opportunities for firms to specialise and cater to the growing demand

What are normal goods?

Demand increases as income increases

• Necessities: 0 < YED < 1

  • Eg. bread

• Luxury: YED > 1

  • Eg: designer clothes

What are inferior goods?

Demand decreases as income increases

Eg: Instant noodles, bus rides