Price Elasticity Demand

LO:

• Explain the meaning and significance of price elasticity demand (PED)

• Illustrate the difference between relatively price elastic demand and relatively price inelastic demand using diagrams

• calculate PED using the mid-point formula

• Describe & apply a range of factor that may influence PED

• law of demand states that there is an inverse relationship between P & Qd

  • If P increases, Qd falls (vice versa)

• How much will fall/increase in P of product affect quantity demand for a product?

  • concept of price elasticity of dd (PED) used

• PED: ratio of % change in Qd of product to % of its price

Inelastic dd

• consumers not sensitive to P changes

• changes in P doesn’t significantly affect Qd

  • e.g. 10% fall in P leads to only 5% increase in Qd

• PED < 1

• Firms should increase P to increase revenue

• dd curve relatively steep

  

elastic dd

• consumer sensitive to P changes

• changes in P significantly affect Qd

  • 10% fall in P leads to a 30% increase in Qd

• PED > 1

• Firms should reduce P to increase revenue

• dd curve relatively flat

Measurement to determine category of elasticity

• mid-point method

  • ‘average elasticity’ between 2 price points 

• Total Revenue = P * Qty

• Profit = Total Revenue  - Total Cost

PLEASE NOTE: WE IGNORE ANY NEGATIVE SIGNS IN THIS CALCULATION AS THE NEGATIVE SIGN IS IRRELEVANT - THE FORMULA WILL ALWAYS PROVIDE US WITH A NEGATIVE ANSWER DUE TO THE NEGATIVE SLOPE OF THE DEMAND CURVE. IN ECONOMICS, WE USUALLY EXPRESS A 'PED' VALUE WITHOUT ITS NEGATIVE SIGN.

Purpose 

• demand is price elastic

  • reduce P → increase revenue

  • consumers sensitive to P, fall in P significantly increase Qd

  • increase in qty sold more than makes up for a smaller decrease in price

• demand is price inelastic

Rules to Remember (TR & PED)

1. Inelastic (PED < 1) → ↑P = ↑TR

2. Inelastic (PED < 1) → ↓P = ↓TR

3. Elastic (PED > 1) → ↑P = ↓TR

4. Elastic (PED > 1) → ↓P = ↑TR

Factors affecting PED

1. S = Substitutes

• More substitutes → more elastic demand (consumers can switch).

• Fewer substitutes → more inelastic.

• Example: Ford cars (elastic) vs cars in general (inelastic).

2. P = Proportion of Income

• Expensive items (big % of income) → elastic (price change matters).

• Cheap items (small % of income) → inelastic.

• Example: Cars (elastic) vs Bread (inelastic).

3. L = Luxury or Necessity

• Necessities → inelastic (must buy even if price rises).

• Luxuries → elastic (easy to cut back).

• Example: Rice (inelastic) vs Party hats (elastic).

4. A = Addictiveness

• Addictive → inelastic (people buy no matter what).

• Non-addictive → elastic.

• Example: Cigarettes (inelastic) vs Orange juice (elastic).

5. T = Time

• Short run → inelastic (no time to adjust).

• Long run → elastic (can find substitutes, change habits).

• Example: Petrol today (inelastic) vs Petrol in long run with electric cars (elastic).