Elasticity of demand

Price elasticity of demand

Price elasticity of demand (PED) is the responsiveness in the demand for a good, due to a change in price. The formula to calculate it is:

where %ΔD is the percentage change in demand, and %ΔP is the percentage change in price.

In most circumstances a negative answer is obtained, indicting that the two variables of price and demand move in opposite directions  – there is a negative gradient.

Types of price elasticity of demand

If PED is greater than 1, the good is price elastic: that is , the percentage change in demand is greater than the percentage change in price. For example, a 10% rise in the price of holidays to Florida may cause a 20% decrease in the quantity demanded. A good with an infinite PED is perfectly elastic – a rise in price causes demand to fall to 0. The demand curve is horizontal.

[1st diagram pg 20]

If PED is less than 1, the good is price inelastic, that is: the percentage change in demand is less than the percentage change in price. For example, a 10% fall in price of coffee might cause a 5% increase in the quantity demanded. If PED is 0, the good is perfectly inelastic, and a change in price has no effect in quantity demanded. The demand curve is vertical. This could be heroin to a drug addict.

[2nd diagram on page 20]

If PED is exactly 1, the good has unit elasticity: that is the percentage change in price is equal to the percentage change in demand.

[3rd diagram on page 20]

The relationship between price elasticity of demand and total revenue

Elasticity varies along a straight-line demand curve, as shown in the flowing diagram. Elasticity falls as you move along the curve from the top left to the bottom right. At the mid-point, demand has unitary elasticity.

[diagram on page 21]

Total revenue

Total revenue refers to the total payments a form receives from selling a given quantity of goods or services. It is the price per unit of a good multiplied by the quantity sold. THe total revenue a firm receives from selling a good will be equal to the total spending by consumers on that good.

A firm’s total revenue will increase as long as price is moving towards the mid-position of the demand curve, where PED is unitary. It is important for firms to know the PED of their output when making pricing decisions, because this affects revenue and profitability.

If demand is elastic, then a cut in price increased total consumer spending an hence revenue to the firm. On the other hand, a rise in price causes total consumer spending to fall and so forms loose revenue.

If demand is inelastic, then an increase in price increases total consumer spending and hence revenue to the forum. On the other hand, a fall in price causes total consumer spending to fall so the firm looses revenue.

Once unit price elasticity has been reached, the firm is maximizing its total revenue. Note the relationship between PED and marginal revenue, which falls during a move down the demand curve. As long as marginal revenue is positive, demand is price elastic. When marginal revenue is zero demand is unit elastic, when marginal revenue is negative, demand is inelastic.

Determinants of price elasticity of demand

  • Availability of substitutes. The more narrowly a good is defined, the more substitutes it tends to have, and so its demand is elastic. For example, cod, a type of fish, has many substitutes such as plaice, rock, salmon and haddock. However, the more broadly a good is defined, the fewer substitutes it tends to have, and so demand is less elastic. For example, there are few close substitutes for fish as a whole.
  • Luxury and necessity goods. Luxury goods, such as racing cars and caviar, tend to have an elastic demand, whereas necessity goods, like bread and underwear tend to have inelastic demand.
  • Proportion of income spent on the good. If a high percentage of income is spend on the good, as with a new car or boat, demand tends to be price elastic. However, for goods that take up a mall percentage of income, such as newspapers and tomato sauce, demand will tend to be price inelastic.
  • Addictive and habit-forming goods. Tobacco, alcohol and coffee are the type pf goods that tend to be price inelastic in demand.
  • The time period. For most goods demand is less elastic in the short run that it is in the long run. For example, a rise in the price of household electricity is likely to have only a minor effect on consumption in the short tun. In the long run, household can cut back on consumption by switching to gas or their cooking and heating. This means demand eventually becomes more responsive to changes in price.

Income elasticity of demand

Income elasticity of demand (YED) is the responsiveness of demand for a good or service to a change in real income. Real income refers to the spending power of money income – the amount of goods and services that can be purchased with one’s nominal income. The formula to calculate YED is:

Normal goods

In most circumstances, YED is positive, which means the two variables of income and demand moe in the same direction. In other words, a rise in income causes arise in the quantity demanded.

Inferior goods

Occasionally, YED is negative, which meas the two variables of income and demand move in opposite directions. This is because people tend to demand higher quality goods as their incomes rises, substituting them for lower-quality products. The next diagram shows the demand curve for an inferior good compared to that of a normal good in relation to income.

[diagram on page 23]

Cross elasticity of demand

Criss elasticity of demand (XED) is the responsiveness of demand for food B to a change in price of good A. The formula to calculate XED is:

– change in demand for good B over change in price for good A.

Cross elasticity of demand is used to determine whether goods are compliments or substitutes for each other.

Substitute goods

Substitute goods are competitive in demand. For example, a rise in price of coffee may cause an increase in demand for tea. XED is positive for substitutes, as the two variables of price and demand move in the same direction – there is a positive gradient.

Complimentary goods

Complimentary goods are in joint demand, They tend to be consumed together. For example, a fall in price of tennis rackets may cause an increase in demand for tennis balls. XED is negative for complimentary goods, as the two variables of price and demand move in opposite directions – there is a negative gradient.

Note: a cross elasticity of demand of zero means there is no relationship between the goods, such as chocolate and beef.

The following diagram demonstrates cross elasticity demand for complimentary goods and substitute goods.

[diagram on page 24]

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