Elasticity of Demand

Price elasticity of demand formula

PED = New - Original

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Original

PED definition

• Measures the responsiveness quantity demanded to a change in price for a good or service

Elastic goods

• Elastic goods - demand changes a lot when price changes

• PED value greater than 1

Inelastic goods

• Demand changes a little when price changes

• Value less than 1

Elastic demand diagram

Inelastic demand diagram

Factors that influence Elasticity

Essential - essential goods are inelastic

Substitutes - the more substitutes the more elastic

Percentage of income - if the price increases by a small bit, demand will be elastic as it doesn’t have a significant change like 10% increase in coffee price

Perfectly inelastic demand

PED = 0

Essential goods like water and electricity

Perfectly elastic demand

PED = infinity

Price of good is always the same, demand is infinite

Good, oil

When the good is elastic:

• increasing price will decrease total revenue

• decreasing price will increase total revenue

When the good is inelastic:

• increasing price will increase total revenue

• decreasing price will decrease total revenue

Revenue boxes

• used to work out revenue at price points

• price x quantity

Why is PED important?

• Firms will know how to maximise revenue

• Governments know which goods to tax

• Taxes on inelastic goods won’t change consumption, but will increase tax revenue

• Taxes on elastic goods will reduce consumption and lead to structural unemployment

PED for primary vs manufactured goods

Primary - inelastic goods as they are necessities, no substitutes

Manufactured - elastic demand, lots of substitutes,

Income elasticity of demand

A measure of the responsiveness of quantity demanded to a change in consumer income

YED formula

YED = percentage change in Qd

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Percentage change in income

Luxury goods

Goods which have a high income elasticity of demand

YED > 1

Necessity good

Goods which have a low income elasticity of demand

-1<YED<1

YED a positive value

Normal good

YED a negative value

Inferior good

Why is YED important for firms?

During a recession:

• incomes typically fall

• demand for inferior goods increase

• firms will increase production of inferior goods

During a boom:

• incomes typically rise

• demand for luxury and normal goods increase

• firms will increase production of luxury and normal goods

Sectoral changes in structure of economy:

• As incomes rise proportion of GDP from primary sector decreases, so firms will produce tertiary services as they have a higher proportion of GDP coming from them

Engel curve

As incomes rise, people buy more potatoes so demand for them increases. Demand then falls as people begin to buy superior goods, therefore potatoes become inferior