Price Elasticity of Demand

transcript

DP Economics

The concept of elasticity

Elasticity is the measure of responsiveness in one variable to a change in another

Elasticity was coined from the properties of rubber i.e. stretchiness

Cut-throat competition?*#

Gillette – the manufacturers of the Mach 3 razor - controls over 70 per cent of the world's wet shave razor market and takes 90 per cent of the $1.5 billion annual global profits

If the price of Mach3 razors went up by 20% - would you still buy them?

Definition of Price Elasticity

Price elasticity of demand (PED) measures responsiveness of demand to change in the price of the good.#

The basic formula for calculating PED is:

PED = percentage change* in quantity demanded

percentage change in price

= %ΔQd

(i) Price falls; expansion of demand (ii) Price rises contraction of demand Hence an inverse relationship between price and demand (giving

a negative value for PED) As results are always negative or zero we ignore the sign

Values for elasticity of demand*

If PED = 0; demand is perfectly inelastic - demand does not change when the price changes

If PED is between 0 and 1; demand is inelastic

If PED = 1 then demand is said to be unitary elastic

If PED > 1, then demand responds more than proportionately to a change in price – i.e. demand is elastic

An inelastic demand

Quantity Demanded

An inelastic demand

Quantity Demanded

An inelastic demand

Quantity Demanded

P1 = $200

Q1 = 400

An inelastic demand

Quantity Demanded

400350

$400P1 = $200

Q1 = 400

P2 = $400

Q2 = 350

An inelastic demand

Quantity Demanded

% change in demand

= Q2 – Q1 x 100

(Ignoring the sign)

An inelastic demand

Quantity Demanded

% change in demand

= 12.5%

% change in price

An inelastic demand

Quantity Demanded

% change in demand

= 12.5%

% change in price

= 100%

An inelastic demand

Quantity Demanded

% change in demand

= 12.5%

% change in price

= 100%

Price elasticity of demand

= 12.5 / 100.0

= 0.125 (< 1)

An inelastic demand

Quantity Demanded

PED is inelastic

An elastic demand curve

Quantity Demanded

P1 $200

Q1 400

An elastic demand

P1 = $200

Q1 = 400

P2 = $100

Q2 = 1200

Quantity Demanded

% change in demand =

% change in price =

*ignoring the sign

Quantity Demanded

% change in demand = 200%

% change in price = 50%

PED = 4 (elastic)

% change in demand = 200%

% change in price = 50%

Quantity Demanded

Plot the following demand schedule for a liquid commodity.

Price ($)

Quantity demanded

(litres)

Plot the following demand schedule

Price ($)

Quantity demanded

(litres)

0 5 10 15 20

Quantity DemandedPr

Calculate the PEDs at each point of the schedule

Price ($)

Quantity demanded

(litres)

0 5 10 15 20

Quantity DemandedPr

PEDS for the demand schedule

Point 1 (0,15)

Q(ignoring the sign)

Point 4 (30,6)

Point 5 (40,3)

Point 6 (50,0)

PEDS for the demand schedule*

Point 1 (0,15)

Point 2 (10,12)

Point 3 (20,9)

25.010

undefinedP

67.010

PED will go from infinity to zero for all straight line curves as you move down from left to right with a PED of 1 in the middle of the demand curve.

Do not be taken in by the slope steepness as this depends on the scales chosen and points chosen

Moving from A to B along a demand curve will have a different PED then B to A

(Try it)

The above is solved by mid-point PED calculation (p139) Pure maths students will notice that a more

sophisticated method of calculating PED for curves will involve calculus namely differentiation.#

Look at the following graphs A & B: do they contradict?*

Quantity Demanded

Price Price

Quantity Demanded

Elastic

PED > 1

Price Inelastic PED < 1

Unit Elasticity PED = 1

Relatively inelastic Curve

Relatively elastic curve

Quantity Demanded

Price Price

Quantity Demanded

Elastic

PED > 1

Quantity Demanded

Price Price

Quantity Demanded

Price Elastic

PED > 1

The extremes of elasticity

Perfectly Inelastic Perfectly Elastic Unitary Elastic

These rarely exist but behave as good benchmarks for comparison

Perfectly inelastic demand curve

Quantity Demanded

£400PED is always 0

Perfectly elastic demand curve

400 1200

Quantity Demanded

PED is always ∞

Unitary elastic demand curve

Quantity Demanded

PED is always 1 at every point

Hyperbolic curve

Factors that Determine PED Read p 142/145

(1) Number of close substitutes for a good and the uniqueness of the product in the

market (2) Degree of necessity of consumption (e.g. absolute luxury to addiction) (3) The % of a consumer’s income allocated to

consumers’ spending on the good (4) The time period allowed following a price change

Elastic or inelastic demand?

A Sony portable PlayStation

Household electricity

Elastic or inelastic demand?

A tall latte from Costa Coffee from a railway station vendor

A pound of pork sausages from a local market

Time Frame and Price Elasticity: Oil Price Shocks*

Two World oil price shocks of the 1970s Response to higher prices was modest in the immediate

period As time passed, people found ways to consume less

petroleum and other oil products Better mileage from their cars (switch to smaller

vehicles) Higher spending on insulation in homes and factories Car pooling for commuters

Car manufacturers invested enormous sums in more fuel efficient vehicles seeing a long term market opportunity

Development of oil substitutes in the long run natural gas, solar heating, nuclear energy

Short Term Demand for Oil

Demand for Oil

Price $ per barrel

Oil Demand

The demand for oil is inelastic in response to price changes in the short run

This is mainly because it is an essential input into many production processes

D short-run

Longer Term Demand for Oil – More Price Elastic

Demand for Oil

Price $ per barrel

Oil Demand

Longer run demand is relatively more elastic if non-oil substitutes develop

D short-run

D long-run

Price Elasticity of Demand

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