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Tutor2u - Price Elasticity of Demand

Normal laws of demand suggest that as prices increase demand decreases whilst firms attempt to supply more (with the opposite happening as prices decrease). The concept of elasticities asks the question ‘by how much does demand and supply change?’ Recent examination reports have made it clear that “price elasticity is an important topic and students should be prepared to apply it to the examination context as well as quote the formulas.” There is a lot to learn in this section – start with a good understanding of what elasticity it and how it is measured. Then consider why it matters for businesses to have a working knowledge / estimate of the coefficient of price elasticity of demand.

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Tutor2u - Price Elasticity of Demand

  1. 1. How Markets Work – Price Elasticity of Demand (PED)
  2. 2. How Markets Work Price Elasticity of Demand
  3. 3. What is Price Elasticity of Demand? • Price elasticity of demand (PED) measures the responsiveness of demand after a change in the good’s own price • The basic formula for calculating the co-efficient of price elasticity of demand is: – Percentage change in quantity demanded divided by the percentage change in price • All normal goods with downward sloping demand curves will have a negative price elasticity of demand • Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign • We are more concerned with the co-efficient of elasticity Elasticity - responsiveness of X to a change in another variable
  4. 4. Price Elasticity of Demand in Action WH Smith have recently reduced the price of its Kobo Mini E- reader from £60 to £40. They predict that sales of the E-reader will increase from 15,000 units a month to 25,000 a month (nationwide). What is the price elasticity of demand for this price change for the Kobo Mini-reader? % change in price = -33% % change in demand = +66% Coefficient of PED = 2 I.e. demand is price elastic A business that makes suitcases aimed at holidaying tourists has increased its prices by 5%. As a consequence, they have seen a drop in sales between January and March by 15% (compared to the same time last year) Calculate the price elasticity of demand and comment on the effect on total revenue % change in price = +5% % change in demand = -15% Coefficient of PED = 3 Total revenue will fall
  5. 5. Numerical Values for Coefficient of Price Elasticity 1. If Ped = 0 demand is perfectly inelastic - demand does not change when the price changes – the demand curve is vertical 2. If Ped is between 0 and 1 (% change in demand is smaller than the percentage change in price), then demand is inelastic 3. If Ped = 1 (% change in demand is the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level 4. If Ped > 1 then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in price leads to a 30% drop in demand. The price elasticity of demand for this price change is –3 Be careful when discussing ‘food’ or ‘electrical goods’ – different classifications within these groups will have different values of elasticity of demand and / or supply
  6. 6. What factors determine the PED of a product? Number of close substitutes available for consumers • The more close substitutes there are, the more price elastic the demand e.g. many brands of breakfast cereal Price of the product in relation to total income • When the % of budget is high, demand is usually more price sensitive i.e. price elastic Cost of substituting between different products • When substitution/switching costs are high, demand will tend to be price inelastic Brand loyalty and habitual consumption • High levels of brand loyalty makes demand less price elastic • Persuasive advertising can make demand price inelastic Degree of necessity / luxury • Standard assumption is that necessities have a lower price elasticity of demand whereas luxuries are an optional spend
  7. 7. Inelastic Demand (Ped < 1) • Following a change in price, the total revenue earned by the producing firm will depend on the PED for its product. • If the coefficient of PED is <1, a rise in market price (e.g. from P1 to P2) will lead to an increase in total revenue for the seller of the product. If the co-efficient of price elasticity of demand <1, then demand is said to be price inelastic i.e. unresponsive to a change in price Price Quantity P1 P2 Q1 Q2 Demand Increased revenue from selling at a higher price Lost revenue from the contraction in quantity sold
  8. 8. Example of Inelastic Demand – Rare Earths • China is the dominant supplier of rare earths – producing over 90% of world output • The lack of close substitutes makes demand price inelastic • Low PED provides China with a source of monopoly power and creates conditions in which China can restrict exports of rare-earth metals causing price to rise and increase their total revenue Rare-earth metals are an essential raw material in the manufacture of solar cells and batteries and car catalysts Projected global demand for products containing rare earths in 2014 (% change) Magnets 42 Batteries 13 Displays (containing phosphor) 10 Polish 10 FCC (molecule splitting) 9 Others 5 Extractive metallurgy 5 Car catalysts 4 Vitrious additives 3
  9. 9. Elastic Demand (Ped > 1) • If demand for a product is price elastic, a supplier stands to gain extra revenue if they reduce their prices. • The change in quantity demanded will be proportionately higher than the reduction in price. This is shown in the diagram opposite. If the co-efficient of price elasticity of demand >1, then demand is said to be price elastic i.e. highly responsive to a change in price Price Qty P2 P1 Q1 Q2 Demand Increased revenue from selling more at a lower price Lost revenue from selling at a lower price
  10. 10. Perfectly Inelastic Demand (Ped = 0) • A perfectly inelastic demand curve is an extreme case. • It implies that consumers are willing and able to pay any price for the product. • If supply falls, equilibrium market price can rise without any contraction in quantity demanded. If the co-efficient of price elasticity of demand = zero, demand is perfectly inelastic i.e. demand does not vary with a change in price Price Qty P2 P3 Demand P1 Q1 S1 S2 S3
  11. 11. Perfectly Elastic Demand (Ped = infinity) • If demand is perfectly elastic, a change in market supply (shown on the right as an outward shift of supply) will not lead to any change in the equilibrium price. • This demand curve applies to highly competitive markets where no supplier has any “pricing power” If the co-efficient of PED = infinity, then demand is perfectly elastic – there is one price at which consumers are prepared to pay Price Qty P1 Demand S1 S2 Q1 Q2
  12. 12. Unitary Elastic Demand (Ped = 1) • With a demand curve of unitary price elasticity, a change in price is met with a proportionate change in demand • This means that total spending by consumers on the product will remain the same at each price level A demand curve with unitary price elasticity has a coefficient of PED equal to 1 (unity) throughout Price Qty P1 Q1 Q2 P2 Demand
  13. 13. Co-Efficient of PED along a linear demand curve • Price elasticity of demand along a straight line demand curve will vary • At high prices, a reduction in price will have an elastic price response – i.e. lower prices cause total revenue to rise • Demand is price inelastic towards the bottom of the demand curve – a fall in price causes total revenue to drop For a straight-lined demand curve, the PED varies along the curve Price Qty P1 D Q1 P2 Q2 A fall in market price from P1 to P2 causes total spending to rise, therefore PED >1 P3 P4 Q3 Q4 A fall in price from P3 to P4 causes total spending to fall, therefore PED <1
  14. 14. Usefulness of Price Elasticity of Demand for Producers Firms can use PED estimates to predict: 1. The effect of a change in price on total revenue of sellers 2. The price volatility in a market following changes in supply – this is important for commodity producers who suffer big price and revenue shifts from one time period to another. 3. The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer. PED can be used by a business for price discrimination. • This is where a supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines. • Usually a business will charge a higher price to consumers whose demand is price inelastic
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