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Chapter 2.7 - Price Elasticity of Demand

Price elasticity of demand (PED) measures how quantity demanded responds to price changes, with classifications of elastic, inelastic, and unitary demand. Factors influencing PED include the nature of the good, availability of substitutes, proportion of income spent, and consumer habits. Understanding PED is significant for firms and governments as it affects pricing strategies, revenue predictions, and tax implications.

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5 views16 pages

Chapter 2.7 - Price Elasticity of Demand

Price elasticity of demand (PED) measures how quantity demanded responds to price changes, with classifications of elastic, inelastic, and unitary demand. Factors influencing PED include the nature of the good, availability of substitutes, proportion of income spent, and consumer habits. Understanding PED is significant for firms and governments as it affects pricing strategies, revenue predictions, and tax implications.

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abirami.s
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© © All Rights Reserved
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UNIT 2

CHAPTER 2.7

PRICE ELASTICITY OF DEMAND


DEFINITION AND FORMULA

Price elasticity of demand (PED) measures the responsiveness


of quantity demanded to a change in price.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅


PED =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
TYPES OF
Elastic
ELASTICITIES demand

Unitary
Inelastic
elastic
demand
demand
Types

Perfectly Perfectly
Inelastic Elastic
demand demand
ELASTIC DEMAND

• A small % change in price results in P


larger % change in quantity demanded R
I
C
• The percentage change in quantity E
demanded is greater than
the percentage change in price

• The demand curve is flatter

PED > 1 QUANTITY DEMANDED


INELASTIC DEMAND
• The change in quantity demanded for a P
commodity is less than the change in R
price. I
C
• A larger % change in price results in a E
smaller % change in quantity
demanded.

• The demand curve is relatively steeper.

PED < 1 QUANTITY DEMANDED


UNITARY ELASTIC DEMAND
• A % change in price results in the
same % change in quantity demanded

• The change in quantity demanded for


a good is equal to the change in price.

• The demand curve is neither steep


nor flat

PED = 1
PERFECTLY INELASTIC DEMAND
• A change in price causes no change in
quantity demanded
• The demand curve is a vertical
straight line

PED = 0
PERFECTLY ELASTIC DEMAND
• There is change in the quantity
demanded even when there is no
change in price.

• The demand curve becomes horizontal


line parallel to the X axis.

PED = ∞
NATURE OF THE GOOD
• If the good is a necessity, the demand for the good is price inelastic as these
goods are essential for survival.
• Luxury goods have elastic demand as these goods are not essential for survival.

DEGREE OF SUBSTITUTION
• The greater the number and availability of close substitutes a good has, the
demand for the good is elastic as it makes people more willing to switch to
other products
• The less substitutes a good has, the demand for the good is inelastic as
consumers cannot switch to other goods easily

PROPORTION OF INCOME SPENT


• The larger the proportion of income spent on a product, higher the elasticity of
the product (demand is elastic) as consumers notice the price changes more
quickly
• The smaller the proportion of income spent on a product, lower the elasticity of
the product (demand is inelastic) as consumers will not notice the price changes
HABITS/ADDICTIONS
If consumers are addicted or habituated to using a product (such as tobacco) its demand tends to be
price inelastic as people find it difficult to stop consuming it
If consumers are less addicted, people can stop consuming it and will become more willing to alter
their demand. Hence, demand is elastic.

DELAYING THE PURCHASE


If purchase of a good can be postponed, its demand is elastic as the good may not be a necessity
and hence need not be purchased.
If purchase of a good cannot be postponed, its demand is inelastic as the good may be a necessity
and hence need to be purchased.

TIME PERIOD
Longer the time period available, more price-elastic the demand is as consumers have more time to
find substitutes
Shorter the time period available, less price-elastic (inelastic) the demand is as consumers have
less/no time to find substitutes

DEFINITION OF THE PRODUCT


Broader the definition, lower the elasticity (demand is inelastic).
Narrow the definition, higher the elasticity (demand is elastic).
RELATIONSHIP BETWEEN PRICE ELASTICITY
OF DEMAND AND TOTAL REVENUE
❑ Sales revenue (or total revenue) is the sum of money
received from the sale of a good or service. It is calculated
by the formula: Price × Quantity
❑ Profit is the difference between a firm’s total revenues and
its total costs. It is calculated using the formula: TR − TC
For inelastic demand, price and total revenue move in the same direction
For elastic demand, price and total revenue move in the opposite direction

✓ If demand is perfectly inelastic:


• a rise in price will cause an equally proportionate rise in revenue because
the quantity demanded will not change
• a fall in price will cause an equally proportionate fall in revenue because
the quantity demanded will not change

✓ If demand is perfectly elastic:


• a rise in price will cause revenue to fall to zero because people will stop
buying the product
• a fall in price will cause revenue to rise exponentially because people will
increase the consumption of the product significantly
SIGNIFICANCE OF PED TO FIRMS
A firm can use PED to predict how demand for its products will be influenced by a change in price.
Information on PED can influence a firm’s pricing strategy. Elastic demand may indicate that the
firms face close substitutes for its products and inelastic demand may indicate that firms have
considerable market power.
✓ If PED is elastic
• If firms reduce the price, it will cause a greater percentage rise in demand (quantity demanded will
increase more than proportionately) leading to an increase in revenue
• If firms increase the price, it will cause a greater percentage fall in demand (quantity demanded will
decrease more than proportionately) leading to a fall in revenue

✓ If PED is inelastic,
• If firms reduce the price, it will cause a smaller percentage rise in demand (quantity demanded will
increase less than proportionately) leading to a decrease in revenue
• If firms increase the price, it will cause a smaller percentage fall in demand (quantity demanded will
decrease less than proportionately) leading to an increase in revenue
However, PED might not be useful because:
• Price is only one of a number of factors affecting demand.
Other factors such as changes in the prices of other
products and income can be significant.
• Price Elasticity of Supply (PES) should also be
considered e.g. demand may be elastic but may not be
able to take advantage of a lower price, if PES is
inelastic
• It is difficult to determine PED as it may change over
time
SIGNIFICANCE OF PED TO GOVERNMENT
❖ Knowledge of PED would help a government to estimate how much tax revenue it may earn
from changes in indirect taxes
✓ If PED is inelastic,
• If government reduces the tax on the good, it will cause a smaller percentage rise in demand (quantity
demanded will increase less than proportionately) leading to a decrease in tax revenue
• If government increases the tax on the good, it will cause a smaller percentage fall in demand (quantity
demanded will decrease less than proportionately) leading to an increase in tax revenue
✓ If PED is elastic
• If government reduces the tax on the good, it will cause a greater percentage rise in demand (quantity
demanded will increase more than proportionately) leading to an increase in tax revenue
• If government increases the tax on the good, it will cause a greater percentage fall in demand (quantity
demanded will decrease more than proportionately) leading to a fall in tax revenue
❖ Knowledge of PED may help a government to estimate how much of a subsidy to give .
✓ A subsidy will have more of an impact on quantity if demand is elastic and less impact if demand is
inelastic.
❖ Knowledge of PED will help a government to estimate how successful it may be in reducing
consumption of a product. For example, cigarettes consumption is more likely to be reduced by
increasing taxes on it if demand is elastic.
❖ Knowledge of PED may influence the price the government charges for the products it
supplies

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