Price Elasticity

• Price elasticity of demand

  A measure of the responsiveness or sensitivity of quantity to a change in price
• Price elasticity of demand

  • Good to know how responsive consumers and producers are to a change in price
  • Useful to know whether the law of demand and supply are relatively strong or weak
• Price elasticity of demand


  The responsiveness of quantity demanded to a change in the price of the good or service
• Price elastic demand


  Ed > 1: Demand is price elastic and buyers are sensitive to a price change. Law of demand is relatively strong.
• Price inelastic demand


  Ed < 1: Demand is price inelastic and buyers are not sensitive to a price change. Law of demand is relatively weak.
• Unitary elastic demand


  Ed = 1: Demand is unitary elastic. Price and quantity change in exactly the same proportion.
• The answer is known as the elasticity coefficient.
• A 1% change in price will cause a 0.3% change in quantity demanded
• Inelastic demand


  Law of demand is relatively weak as the value of the coefficient is less than one
• A 1% change in price will cause a 2% change in quantity demanded
• Elastic demand


  Law of demand relatively strong – quantity demanded is relatively responsive to a price change
• Elastic vs Inelastic demand

  • Elastic demand has a relatively flat curve
  • Inelastic demand has a relatively steep curve
• Point method


  The formula used to calculate elasticity from a specific point or price on the demand curve
• The point method gives different answers depending on whether the price is increasing or decreasing
• Midpoint method


  An averaging technique used to calculate elasticity along the same segment of the demand curve
• The midpoint method is usually the preferred method used by economists
• Along any normal downward sloping demand curve, price elasticity decreases as we move down the demand curve
• Perfectly inelastic demand


  If price elasticity = 0, then a change in price will have no effect on quantity demanded. Demand is said to be perfectly inelastic.
• Perfectly inelastic demand


  • Insulin for a diabetic
• Perfectly elastic demand


  The demand curve is horizontal. An example would be a perfect substitute.
• Determinants of price elasticity of demand

  • Availability of substitutes
  • Whether the good is a necessity or a luxury
  • Definition of the market
  • The proportion of income spent
  • Time
• Availability of substitutes


  • The greater number of close substitutes a good has, the more price elastic its demand
  • If price of good X rises and it has many close substitutes, consumers will be sensitive to change as they can easily switch to another product
  • Few substitutes would be inelastic (water, petrol)
  • Brand of petrol would be elastic as many substitutes (BP, Coles express, Caltex, united, puma)
• Necessity or a luxury


  • Necessity goods like food are more price inelastic
  • Luxury goods like jewellery and French champagne are elastic
• Definition of the market

  • Demand for a good in a broadly defined market will be more inelastic than the demand for a good in a narrowly defined market
  • Example – petrol is a broadly defined market whereas a particular brand of petrol is a narrowly defined market
  • Demand for specific brand such as BP, Coles Express, Caltex is elastic as each brand is a relatively close substitute
• Proportion of income spent

  • Expensive goods more likely to be price elastic as they take up a larger proportion of consumers income
  • Cheaper goods more price inelastic
  • Coffee increase from $3 to $4 (25% increase) unlikely to cause significant decrease
  • TV increase from $2000 to $2500 (25% increase) cause great effect on quantity demanded
• Time


  • If consumers have time to respond to a price change, demand is more price elastic
  • In very short run, demand for most commodities is relatively inelastic as they don't have time to adjust consumption or find substitutes
  • When oil prices increased in 2008 causing petrol prices to rise to $1.50, consumers could do little except pay extra
  • As time progressed, they could alter their consumption by using public transport or switching to diesel/electric
  • COVID was a prime example
• Total revenue


  Total revenue or total expenditure = P X Q
• If price falls from P1 to P2, quantity demanded will increase from Q1 to Q2


  Effect on total revenue is different
• When demand is elastic

  Total revenue has increased because change in quantity demanded is greater than change in price
• When demand is inelastic

  Total revenue will decrease because the change in quantity demanded is smaller than the change in price
• When demand is unitary elastic


  A change in price does not change total revenue
• Price discrimination


  Firms can boost their revenue by segmenting their customers into separate groups according to their elasticity
• Price discrimination


  • Why do some firms (cinemas) charge children and students a lower price than adults?
  • Students and seniors have a more elastic demand as they have lower income than adults (cinemas)
• Price elasticity of demand

  Measures the responsiveness of quantity demanded to a change in price
• If we know the price elasticity of a good

  We can accurately predict what will happen to a firm's revenue when it changes the price of its product
• Elastic demand


  Firm's revenue will increase when they have sales and lower prices
• When demand is elastic


  Price and total revenue move in opposite directions
• When demand is inelastic


  Price and total revenue move in the same direction
• Elasticity


  • Plays an important role in firm's pricing policy
• Firms charge children and students a lower price than adults


  Different consumer groups have different price elasticity of demand