ECO - 2.7 Price elasticity of demand

• Price Elasticity of Demand (PED)

  Measures the responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus
• PED


  • Always negative due to inverse relationship between price and quantity demanded (i.e. law of demand)
  • The negative sign is often ignored
• Magnitude of PED coefficient


  • PED > 1 (Demand is price elastic) gradual
  • 0 < PED < 1 (Demand is price inelastic) steep
  • PED = 1 (Demand is unitary price elastic) banana
  • PED = ∞ (Demand is perfectly price elastic) flat
  • PED = 0 (Demand is perfectly price inelastic) straight
• Determinants of PED


  • If the product is a necessity
  • The number of close substitutes
  • The amount of time consumers have to search for substitutes
  • The cost of switching to a different suppliers
  • The proportion of income spent
• Why PED < 1 (Price Inelastic)?

  
  

  The good does not have many close substitutes.

  Reason for lack of substitutes:

  • unique product
  • brand loyalty
• PED > 1 (Price Elastic)


  If the good has many close substitutes available that consumers can turn to, then consumers are more responsive to changes in its price
• PED < 1 (Price Inelastic) - Example


  • Demand for petrol is price inelastic because there are very few alternatives that consumers (drivers) can turn to
• PED > 1 (Price Elastic) - Example


  • Demand for apples likely to be price elastic because it has many substitutes (other types of fruits) that consumers can turn to when price of apple increases
• PED < 1 (Price Inelastic)

  If the good is a low-cost & cheap product, it only takes up a small fraction of the consumers' income, so consumers are less responsive to slight changes in its price
• PED > 1 (Price Elastic)


  If the good is expensive, it takes up a large fraction of consumers' income to buy the good, so consumers are more responsive to slight changes in its price
• PED < 1 (Price Inelastic)


  If the good is a basic necessity/essential or addictive, most people will still have to consume it even if price rises
• PED > 1 (Price Elastic)


  If the good is a non-essential or luxury item, many consumers will likely decide not to buy now if the price increases
• PED < 1 (Price Inelastic)


  If the period of time is too short for consumers to respond (known as short run), then they are not able to find other substitutes to turn to when price of the good rises
• PED > 1 (Price Elastic)


  In the long run, consumers have more time to adjust & find relatively cheaper substitutes when price of good increases
• PED < 1 (Price Inelastic)


  Some products (e.g., telephone, broadband & electricity services) usually come with long term contracts, the penalty fee for terminating the contract early & switching to another supplier may be high
• PED > 1 (Price Elastic)


  If the cost of switching to another supplier is low, demand will tend to be more price elastic
• PED is closely linked to the total consumer expenditure (TE) & the firm's total revenue (TR)


  A change in price will have a different impact on TR/TE depending on the PED
• Impact of PED on TE/TR

  • If elastic (PED > 1): When price increases, quantity demanded decreases more than proportionately, so total expenditure/revenue decreases
  • If inelastic (PED < 1): When price increases, quantity demanded decreases less than proportionately, so total expenditure/revenue increases
  • If unitary elasticity (PED = 1): When price increases, quantity demanded decreases proportionately, so total expenditure/revenue remains unchanged
• Total revenue (TR)


  TR = P x Q
• Change in price


  Different impact on TR/TE depending on PED
• Price elasticity of demand (PED)


  Useful/relevant to consumers, producers & government in their decision-making
• PED


  1. Change in price of the good

  2. Impact on quantity demanded (Qd)

  3. Impact on TE/TR
• If elastic (PED > 1)

  • When price increases, Qd decreases more than proportionately, TR/TE decreases
  • When price decreases, Qd increases more than proportionately, TR/TE increases
• If inelastic (PED < 1)


  • When price increases, Qd decreases less than proportionately, TR/TE increases
  • When price decreases, Qd increases less than proportionately, TR/TE decreases
• If unitary elasticity (PED = 1)


  • When price increases, Qd decreases proportionately, no change in TR/TE
  • When price decreases, Qd increases proportionately, no change in TR/TE
• Consumer Expenditure (CE)

  The amount of money that consumers spend on goods and services. A measure of demand in an economy.
• Total Revenue (TR)

  The amount of money that a firm earns from selling its goods or services. A measure of supply in an economy.
• PED (Price Elasticity of Demand)

  A measure of how sensitive the quantity demanded of a good or service is to changes in its price.
• Elastic PED


  Consumers are sensitive to changes in price, so a decrease in price leads to a larger increase in CE and TR.
• Inelastic PED


  Consumers are not sensitive to changes in price, so a decrease in price leads to a smaller increase in CE and TR.