Price Elasticity

price elasticity

the measure of the responsiveness or sensitivity of quantity (demand or supply) to a change in price.

price elasticity of demand

the responsiveness of quantity demanded to a change in the price of the good or service

• we can conclude how responsive the demand for certain goods and services are to a change in price.

• along any normal downward sloping demand curve, price elasticity decreases as we move down the demand curve. In other words, price elasticity falls as price falls

• generally consumers are not that price sensitive to relatively inexpensive goods and are more price sensitive to expensive luxury goods

perfectly inelastic (demand)

• quantity demanded does not change, the demand curve is vertical

• goods with no substitutes

• For example, the demand for insulin by a diabetic person is perfectly inelastic. A perfectly inelastic demand curve is vertical

• the law of demand in this case stops working as there is no quantity change when price increases

inelastic (demand)

• when the value is less than 1, it means that the law of demand is relatively weak - quantity demanded is not very responsive to a price change. This is usually determined by the substitution effect.

• goods that are necessitates (such as basic food productions, petrol, etc) will have few close substitutes and will therefore be inelastic

• quantity demanded decreases by less than 1%, relatively steep demand curve

unitary elastic (demand)

• quantity demanded decreases proportional to the decrease in price

• equally proportional demand curve

• goods with some close substitutes

elastic (demand)

• when the value of Ed is greater than 1, it means that the law of demand is relatively strong, quantity demanded is relatively responsive to change in price. In this case, demand is said to be relatively elastic.

• the larger the elasticity coefficient the more responsive demand is to price which indicates that there is likely to be many close substitutes

• goods and services that have relatively close substitutes are expected to be more sensitive to a price change.

perfectly elastic

• if price elasticity equals infinity demand is said to be perfectly elastic. An example of this would be a good that has a perfect substitute. If the price of the good increases, consumers would stop buying it and switch to the perfect substitutes

• the graph for perfectly elastic goods is horizontal

determinants of price elasticity of demand: availability of substitutes

• the greater the number of close subsitutes a good has, the more price elastic its demand.

• if the price of good X rises and it has many close subsitutes, then consumers will be sensitive of the price change because they can easily switch to other products

• the demand for goods that have few substitutes such as good or water would be inelastic

determinants of price elasticity of demand: whether the good is a necessity or luxury

• necessity type goods such as basic items of food will be more price inelastic than luxury type goods such as jewellery, designer hand bags and french champagne

• goods that are considered necessities (such as petrol, water, electricity) will be relatively insensitive to price changes

• habit forming and addictive goods such as tobacco and alcohol are highly inelastic because they are perceived as necessities by people who use them

determinants of price elasticity of demand: definition of the market

• the demand for a good in a broadly defined market will be more inelastic than the demand for a good in a narrowly defined market.

• for example, petrol is a broadly defined market whereas a particular brand of petrol is a narrowly defined market. The demand for specific brands such as BP, Coles Express or caltex, would be very elastic because each brand acts as a very clost substitute

• for all goods, the price elasticity of a single brand is greater than the price elasticity of the good in general

determinants of price elasticity of demand: the proportion of income spent

• expensive goods are likely to be relatively price elastic because they take up a large proportion of a consumers income or budget.

• cheaper, inexpensive goods, will be realtively price inelastic

• for example, if the price of coffee went to increase from $4-$5 (25% increase), it is unlikely to caue a signficicant decrease in quantity demanded. However, if the price of a large screen tv went up by 25% (from $3000-$3750) this price increases would have a greater proportional effect on quantity demanded as it now takes up a much larger portion of a consumers income.

time

• if consumers have time to respond to price change, then demand will be more price elastic

• in the immediate run, demand for most commodities will be realtively inelastic because consumers do not have time to adjust their consumption to find subsitute goods

• as the time period increases, it becomes easier to change consumption patterns and so demand becomes more elastic

• short run: the period when consumers can partially adjust their behaviour - they have some time to search for a substitute good

• long run: the period when consumers can fully adjust to the change in market conditions

determinants of price elasticity of demand: is consumption a habit?

• if consumption is a habit the demand is likely to be inelastic as the consumer will view that good as more of a necessity and will therefore be less responsive to price changes

price elasticity and total revenue

elastic demand curve: price and total revenue move in opposite directions

inelastic demand curve: price and total revenue move in the same direction

unitary demand curve: change in price does not change total revenue.

elasticity on linear demand curves

• as you move down along a linear demand curve, price elasticity falls

• At the top of the demand curve, where quantity is zero, elasticity is infinite. At the midpoint of the demand curve, elasticity is 1. At the bottom of the demand curve, where quantity is full, elasticity is 0

• the demand curve can be dived into the elastic segment (the top half) and the inelastic segment (the bottom half). If a firm is located on the top half of the demand curve it can increase revenue by lowering price, while if it is located in the bottom hald, it could raise revenue by raising price

• total revenue is maximised at the midpoint of the demand curve, where it is unitary elastic

price elasticity of supply

measures the responsiveness of quantity supplied to a change in price.

price elasticity of supply: elastic

• the price elasticity coefficient is more than 1.

• These would be products that are easy to produce and therefore suppliers can easily respond to changes in price by increase quantity.

• For example, technology, clothes, etc

price elasticity of supply: inelastic

the price elasticity is less than 1. These are products that only really have one supplier and therefore changes in price don’t really affect supply. This would be utilities for example.

• this could also be goods that are not easy to produce and therefore suppliers cant respond to the change in price as quickly. Necessity and goods with limited supply

price elasticity of supply: perfectly elastic

an increase in demand can be met without any increase in price. E.g. water

price elasticity of supply: perfectly inelastic

supply is fixed and cannot respond to a change in price. The same amount of good is supplied for every price

determinants of price elasticity of supply: time

• if the producer can respond quickly to a price change then supply will be price elastic

• in the immediate run, it may be difficult for a producer to suddenly increase output, especially if inventories are low. Supply could even be perfectly inelastic.

• as time increases, producers will be able to obtain more inputs and expand output more easily and so supply will become more price elastic.

• In the long run, the firm has a much greater flexibility and can increase the capacity of production. As time increases, the supply curve will become flatter and ‘swivels’ from a steep curve to a flatter curve

• the supply for all goods and services becomes more elastic as time increases

determinants of price elasticity of supply: nature of the industry

• the supply of agricultural goods tends to be more inelastic while the supply on manufactured goods tends to be more price elastic

• agricultural products such as wheat, wool or meat require a reasonable amount of time to produce therefore if the price of wheat suddenly increases, farmers cannot quickly respond, they must wait for the next growing seasons

• on the other hand, manufactured goods are relatively easy to produce. Firms can quickly respond and expand the output of goods that are manufactured as a response to an increase in price.

determinants of price elasticity of supply: availability of store inventories

• inventories refers to stocks that a producer keeps stored for future sale

• if a producer has the ability to store or warehouse goods, then it can respond relatively quickly to a change in demand due to price and therefore supply would be elastic

• supermarkets are bale to store non-perishable goods in large warehouses and ship them whenever a store runs out of a product

• goods that are perishable, such as fresh fruit and vegetables cannot be stored and therefore their supply would be relatively inelastic.

price discrimination

• the concept of elasticity plays an important role in a firms pricing policy

• different consumer goods have a different price elasticity of demand and therefore firms can increase revenue by segmenting customers into separate groups according to their elasticity.

• higher prices for those who have an inelastic demand, because the increase in revenue from the increase in price will outweigh the revenue lost from only the small amount of consumers that will stop buying

• lower price for those with an elastic demand because the revenue from the influx of demand will outweigh the revenue lost from the price decrease.

market for agricultural goods

• relatively inelastic demand (necessity)

• over time, supply increases due to technology, therefore price decreases and quantity increases

• due to inelastic demand, total revenue falls

• this is because when demand is inelastic, an increase in production results in a large decrease in price, but only a small increases in quantity

• farming communities have tended to decrease overtime due to inelastic demand

market for housing

• inelastic supply because it takes a long time to construct houses

• over time, demand for housing increases due to higher incomes and population growth

• due to inelastic supply, price increases much more than quantity

• price elasticity can be useful in predicting price and quantity changes over time.