Price Elasticity of Demand (PED)
Theme 2.1.3 Responsiveness of consumers and/or producers
1.1 Price elasticity of demand (PED)
1.2 Income elasticity of demand (YED)
1.3 Cross elasticity of demand (CED)
1.4 Price elasticity of supply (PES)
2.1 Price Mechanism and its Applications
2.1.1 Price mechanism and its functions
Resource allocation in a free market
2.1.2 Interaction of demand and supply
Determinants of demand and supply
Equilibrium price and equilibrium quantity
Changes in demand and supply leading to changes in market equilibrium
2.1.3 Applications of demand and supply analysis to real-world markets
Responsiveness of consumers and/or producers
Price, income and cross elasticities of demand - determinants and significance
Price elasticity of supply - determinants and significance
Impact of market outcomes on consumers and producers
Consumer expenditure and producer revenue
Consumer and producer surplus
Rationale and impact of government intervention on consumers and producers
Taxes and subsidies
Price controls - maximum and minimum prices
Quantity controls - quotas
Possible A Level Question
GCE 2016 H2 P2 The price of a pair of jeans can be as little as S$20 or as much as S$500.
Explain what might cause price elasticity of demand and cross elasticity of demand to be different for different products. [10]
Assess the likely effects of a rise in price of one brand of jeans on the revenue earned by both retailers of that brand of jeans and those who sell other related goods. [15]
Introduction to PED
PED measures the extent of change in quantity demanded when the price of a good changes.
In the graph:
DD1: Initial demand curve.
DD2: New demand curve after a change in price.
∆P: Change in price.
Qd: Quantity demanded.
Example: For a given change in price, if the quantity demanded rises by a larger extent (DD2), this responsiveness of quantity demanded to the change in price is known as PED.
Why Study PED?
To determine whether a producer should reduce the price.
Scenario A: Price falls from $5 to $4, quantity increases from 100 to 110 units.
Scenario B: Price falls from $5 to $4, quantity increases from 100 to 150 units.
Answer:
(A) – should not reduce because total revenue (TR) = P X Q
Before P reduction, TR = $5 \times 100 = $500
After P reduction, TR = $4 \times 110 = $440 (worse off)
(B) – should reduce because after P reduction,
TR=$4 \times 150=$600 (better off)
Theory of Demand: Determinants of Demand
Price of the good itself
Prices of related goods
Income of consumers
Why Study Elasticity?
To understand by how much the quantity demanded of the good or the demand for the good will change when a given factor changes.
For example, when the price of a good rises by 10%, would the quantity demanded of the good fall by:
10%?
More than 10%?
Less than 10%?
1.1 Price Elasticity of Demand (PED)
1.1.1 Definition
1.1.2 Formula
1.1.3 Sign of PED (+ or -?)
1.1.4 Magnitude of PED (small or big?)
1.1.5 Determinants of PED
Concept of Price Elasticity of Demand
1.1.1 Definition:
Measures the degree of responsiveness of quantity demanded (Qd) due to a change in the price of the same good, ceteris paribus.
1.1.2 Formula:
PED = \frac{\% \text{ change in the Qd of good X}}{\% \text{ change in the price of good X}}
\% \text{ change formula } = \frac{\text{new } – \text{ old}}{\text{old}} \times 100\%
Example Calculation of PED
When P decreases from $10/unit to $9.50/unit,
Calculate the PED
DP = 9.5-10
DQ = 22-20
PED = \frac{\% \text{ change in the quantity demanded of good X}}{\% \text{ change in the price of good X}}
PED Calculation
PED = \frac{\frac{22 – 20}{20} \times 100\%}{\frac{9.50 – 10}{10} \times 100\%} = \frac{10\%}{-5\%} = -2
1.1.3: Interpret Sign of PED
PED is always negative
Due to the inverse relationship between price and quantity demanded (Law of Demand)
By convention, when we interpret the PED value, we leave out the sign and just take the absolute value.
PED = -2 \implies PED = 2
1.1.4 The Magnitude of PED
Elastic Demand
Inelastic Demand
Unitary Elasticity of Demand
Perfectly Elastic Demand
Perfectly Inelastic Demand
PED > 1: Demand is Price Elastic
A change in price results in a more than proportionate change in quantity demanded, ceteris paribus
Example: A 5% increase in the price of the good causes a 10% fall in the quantity demanded.
(a) Price Elastic Demand
Value of PED: PED > 1
\% \text{ change in Qd for good X} > \% \text{ change in P of good X}
A 5% increase in the price of the good causes a 10% fall in the quantity demanded.
Figure: Elastic Demand
PED = \frac{\% \text{ change in the Qd of good X}}{\% \text{ change in the price of good X}} > 1
A Change in Price causes a more than proportionate change in quantity demanded, ceteris paribus
PED=2= \frac{10\% \text{ change in the Qd of good X}}{5\% \text{ change in the price of good X}}
Flatter curve/ Gentler slope
PED < 1: Demand is Price Inelastic
A change in price results in a less than proportionate change in quantity demanded, ceteris paribus
Example: A 20% increase in the price of the good causes a 10% fall in the quantity demanded.
(b) Price Inelastic Demand
Value of PED: PED < 1
\% \text{ change in Qd for good X} < \% \text{ change in P of good X}
A 20% change in the price of the good causes a 10% change in the quantity demanded
Figure: Inelastic Demand
PED = \frac{\text{% change in the Qd of good X}}{\text{% change in the price of good X}} < 1
a Change in Price causes a less than proportionate change in quantity demanded, ceteris paribus
PED=0.5 = \frac{10\% \text{ change in the Qd of good X}}{20\% \text{ change in the price of good X}}
Steeper slope
PED = 1: Demand is Unitary Elastic
A change in price results in the same proportionate change in quantity demanded, ceteris paribus
(e) Unitary Elastic Demand Example: A 10% change in the price of the good causes a 10% change in the quantity demanded.
(e) Unitary Elasticity of Demand
Value of PED: – PED = 1
\% \text{ change in Qd for good X} = \% \text{ change in P of good X}
A 10% change in the price of the good causes a 10% change in the quantity demanded.
Figure: Unitary Elasticity
PED = \frac{\% \text{ change in the Qd of good X}}{\% \text{ change in the price of good X}} = 1
a change in price causes a proportionate change in quantity demanded, ceteris paribus
PED=1= \frac{10\% \text{ change in the Qd of good X}}{10\% \text{ change in the price of good X}}
Rectangular hyperbola
PED = ∞: Demand is Perfectly Price Elastic
a change in price causes an infinite change in the quantity demanded, ceteris paribus
Example: A 10% change in the price of theyt good causes an infinity change in the quantity demanded.
Applies to a good with homogeneous substitutes (H2 market structures – perfect competition)
(d) Perfectly Price Elastic Demand
Value of PED: – PED= ∞
PED = \frac{\% \text{ change in the Qd of good X}}{\% \text{ change in the price of good X}} = ∞
a change in price causes an infinite change in quantity demanded, ceteris paribus
PED=∞ = \frac{\text{infinite change in the Qd of good X}}{10\% \text{ change in the price of good X}}
Figure : Perfectly Elastic Demand
Horizontal D curve
Can also say for no change in P, a firm can sell infinite amt à denominator = 0 à PED =∞
PED = 0: Demand is Perfectly Price Inelastic
a change in price will result in NO change in quantity demanded, ceteris paribus.
Example: A 10% change in the price of the good causes zero change in the quantity demanded.
Example: Insulin
(c) Perfectly Price Inelastic Demand
Value of PED: – PED = 0
Figure: Perfectly Inelastic Demand
PED = \frac{\% \text{ change in the Qd of good X}}{\% \text{ change in the price of good X}} = 0
a change in price causes no change in quantity demanded, ceteris paribus
PED= 0 = \frac{0\% \text{ change in the Qd of good X}}{10\% \text{ change in the price of good X}}
Vertical D curve
1.1.5 Determinants of PED
(i) Availability of Substitutes (*)
(a) Definition of the good
(b) Time period (*)
(ii) Need for the good e.g. Whether the good is addictive or not (*)
(iii) Proportion of Income Spent on the Good (*)
(i) Availability of Close of Substitutes
A good that has many close substitutes è Price-elastic demand (a given change in price will lead to a more than proportionate change in quantity demanded)
Presence of close substitutes enables consumers to switch to other substitutes when price of the good rises
Thus quantity demanded falls significantly when price rises
(i) Availability of Close Substitutes
A good with few close substitutes to switch to è Price inelastic demand
(i) Availability of Close Substitutes
The availability of substitutes can be affected by:
(a) Definition of the good
Broadly defined -> demand more price inelastic
Drinking water is broadly defined good
Few/almost no substitute to drinking water
Narrowly defined -> demand more price elastic
Pepsi
Many substitutes (Coca-Cola, 100plus, Sprite)
Bread vs Food
Which demand is more price inelastic?
bread vs food?
(i) Availability of Close Substitutes
The availability of substitutes can be affected by:
(b) Time period
Over a longer time period -> demand more price elastic
Time needed for substitutes to be found
Consumer habits/preference also takes time to change
Eg. Price of petrol ↑
SR: continue to use petrol to fuel car
LR: found alternatives like electricity to fuel car switch to carpooling, public transport
(ii) Need for the Good e.g. Whether the Good is Addictive
Good is very addictive-> demand is price inelastic
Eg. Cigarettes, alcohol
Significant increase in price of cigarettes will not greatly deter consumers from buying cigarettes due to their addiction
(iii) Proportion of Income Spent on the Good
The larger the proportion of income spent on a good è Demand is more price elastic
E.g. car, house:
Expensive / takes up a large proportion of income
even if price increases only by 10%, it would substantially affect its affordability for many households.
Quantity demanded will fall more than proportionately
(iii) The Proportion of Income Spent on the Good
The smaller the proportion of income spent on a good è Demand is more price inelastic
E.g. sugar:
Inexpensive / takes up a very small proportion of income
Even if price rises a lot, the increase in expenditure does not have much impact
Consumers unlikely to cut down consumption of sugar significantly
Qty demanded will fall less than proportionately
Determinants of Price Elasticity of Demand
Determinants
P – Proportion of income spent
A – Availability of substitutes
N – Need for the good (e.g. addictiveness, basic necessities)
T – Time Period
Luxury Car Example
Is demand for luxury car price elastic or price inelastic?
Which factor is this?
P – Proportion of Income Spent
Movie Ticket Example
Is demand for Cathay movie tickets price elastic or price inelastic?
Which factor is this?
A – Availability of Substitutes
White Rice Example
Is demand for white rice price elastic or price inelastic for Asians?
Which factor is this?
N – Need for the Good
Film Camera Example
Is demand for film camera price elastic or inelastic?
Which factor is this?
T-Time Period
1.1 Price Elasticity of Demand (PED)
Degree of responsiveness of quantity demanded to a change in price
quantity demanded is very responsive to P ∆
quantity demanded is not very responsive to P ∆
More than proportionate change in quantity demanded
Less than proportionate change in quantity demanded
Say price increase by 10%, quantity demanded decreases by 20%
Say price increase by 10%, quantity demanded decreases by 5%
PED = \frac{20\%}{10\%} = 2
PED = \frac{5\%}{10\%} = 0.5
PED > 1
0 < PED < 1
Summary (PED)
(PED<1)
inelastic
1
unitary elasticity
(PED>1)
elastic
perfectly inelastic
perfectly elastic