elasticity of demand

elasticity of demand

Price Elasticity of Demand measures the responsiveness of the quantity of a good demanded to a change in its price.

Elastic Demand

If the elasticity is >1, then this shows that the good in question has an elastic demand. This means that demand for this good responds well to a change in its price:

 If price rises, demand will fall proportionately more then the price rise.

• If price falls, demand will rise proportionately more than this.

Elastic Demand and Total Revenue

If a business has an elastic product they need to reduce price to increase their total revenue:

- The increase in sales will be proportionately larger than the fall in price.

The quantity demanded will change MORE than the price change. A small percentage change in price will lead to a relatively large percentage change in quantity demanded. Relatively elastic goods normally have a large number of substitutes, and so when price increases consumers switch to the consumption of the substitute good.

INELASTIC DEMAND

If the elasticity <1, then this shows that the good has an inelastic demand.

This means that demand for this good does not respond as much to a change in its price:

 If price rises, demand will fall, but proportionately not as much as the price rose.

 If price falls, demand will rise proportionately less than the price fell.

When demand is relatively inelastic it takes a large percentage change in price to cause a relatively small change in quantity demanded. Relatively inelastic goods are normally addictive or have few substitutes e.g. cigarettes. Therefore when the price increases consumers continue to purchase these products.

Elastic Demand and TR

If a firm knows that the Demand for their product is price elastic Whatever they do with P, the OPPOSITE will happen with TR

If P Increases, TR is going to Fall.

Reason – Because of the increase in P, QD is going to significantly fall, so they are selling a lot less at a slightly higher price, overall TR will fall.

Whereas, if Demand is Price Elastic and price is decreased, QD is going to increase significantly, therefore as they are selling loads more at a slightly lower Price, TR will increase for the firm.

Inelastic Demand and TR

Whereas, if Demand is Price Inelastic, Whatever the firm does with P will be the SAME is going to happen to TR.

If the firm increases P, QD will fall but only slightly, therefore they are selling a little bit less but at a much higher price, this will therefore increase TR

Whereas if the firm decreases their P, TR is going to fall. It is going to do the same thing. As the firm decreases their P, yes QD will increase but only slightly, therefore they are selling a little bit more but at a much lower price, TR is going to fall.

pricing decisions for firms

Relationship between PED (Price Changes) and TR

Overall, if demand is price elastic, the firm should DECREASE their price to increase TR

And

If demand is price inelastic, the firm should INCREASE their price to increase TR This helps firms with Pricing Decisions

uses of PED

• PED is important to firms in determining their pricing strategy

• useful generally for employment, stocks and output purposes.

  For example, If a business knows that the demand for their good is price elastic and price is going to fall in the future, then they need to be prepared for the increase in the QD, such as they need to make sure they can produce that by maybe needing to employ more people, maybe by increasing their level of stocks maybe by increasing the productivity of their workers. But, overall they need to ensure that they can find a way to increase output.

• A firm can use knowledge of PED to forecast the effect on sales of any planned price

  changes.

• It can help to decide whether a price change is wise and plan future output.

Income Elasticity of Demand (YED)

Income elasticity of demand is concerned with the relationship between changes in income and changes in demand

goods

 Normal goods are any items for which demand increases when income increases. A good is normal when an individual consumes or demands more of it because their income has increased. demand of between 0 and +1

Superior/luxury goods- For example, high definition TV’s would be luxury. When income rises, people spend a higher % of their income on the luxury good. Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25.

An inferior good means an increase in income causes a fall in demand. It has a negative YED (income elasticity of demand). An example, of an inferior good is Tesco value bread. When your income rises you buy less Tesco value bread and more high quality, organic bread.

Examples of different types of goods in relation to income elasticity of demand

Fine wines and spirits, high quality chocolates and luxury holidays overseas.

 Sports cars

 Consumer durables - smart-phones

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect on sales.

 Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle.

 Income elasticity and the pattern of consumer demand

 As we become better off, we can afford to increase our spending on different goods and services. The income elasticity of demand will also affect the pattern of demand over time.

 For superior goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumers income spent on that product will go up.

 For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall

 For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.