Price Elasticity of Demand (PED) Defning elasticity odemand PED measures the responsiveness odemandfor a product following a change in its own price. The formula for c alculating the co-ecient of e lasticity of demand is: % change in quantity demanded% change in price Since changes in price and uantity nearly always mo!e in opposite directions" economists usually do not #other to put in the minus sign. $e are con cer ned with the co-ecientofelasticity of demand. Understanding values or price elasticity odemand • IPED = 0then demand is said to #e perectly inelastic. This means that demand does not change at all when the price changes % the demand cur!e will #e !ertical. • IPED is etween 0 and !(i.e. the percentage change in demand is smaller than the percentage change in price)" the n demand is inelastic. Producers &now that the change in demand will #e proportionately smaller than the percentage change in price. The amount consumed does not vary very much with price. • I PED = !(i .e. the percentage change in demand is e'ac tl y the same as the percentage change in price)" then demand is said to unit elastic. *+ rise in price would lead to a *+ contraction in demand lea!ing total spending #y the same at each price le!el.A change in price will lead to t he same change in the amount demanded. • IPED " !" then demand responds more than proportionately to a change in price i.e. demand is elastic. ,or e'ample a + increase in the price of a good might lead to a /+ drop in demand. The price elasticity of demand for this price change is %.*. Even small changes in prices lead to big changes in demand. #$%$ &or normal goods' the price goes up' demand goes down$ It is how much i t goes down' not does it go down$ (hat Determines Price Elasticity oDemand) *n e+ample, Demand or rail services t pea& times" the demand for rail trans por t #ec omes inelastic% and high er prices ar e charged #y rail companies who can then achie!e higher re!enues and pro0ts. • he numer oclose sustitutes or a good . uni/ueness othe product % the more close su#stitutes in the mar&et" the more elastic is the demand for a product #ecause consumers can more eas ily switc h the ir demand if the price of one product cha nge s relativeto others in the mar&et. People 1ha!e2 to get to wor& for e'ample" a latter train is not a good su#stitute as you get there late" so the demand is inela stic. The huge range of p ac&age holiday to urs and destinations ma&e this a highly competiti!e mar&et in terms ofpri cing % man y hol ida y ma&e rs are pri ce sen sit i!e" so demand is elastic. 3 ou can always go somewhere else on holiday4 • he cost oswitch ing etween dierent products % there may #e sig ni0can t transac tions costs in!ol !ed in swi tchin g #etween di5erent goods and ser!ices. 6n this case" you would need to #uy a car for e'ample" 0nd a par&ing space near wor& and so on" therefore demand tends to #e relati!ely inelastic. • he degree onecessity or whether the good is a lu+ury % goods and ser!ices deemed #y consumers to #e necessities tend to ha!e an inelastic demand whereas lu'uries will tend to ha!e a more elastic demand #ecause consumers can ma&e do 67 Economics notes Price Elasticity of Demand #eil$elric12tes$tw$edu$tp
Defning elasticity o demandPED measures the responsiveness o demand for a product following a change in its ownprice. The formula for calculating the co-ecient of elasticity of demand is:
% change in quantity demanded % change in price
Since changes in price and uantity nearly always mo!e in opposite directions" economistsusually do not #other to put in the minus sign. $e are concerned with the co-ecient of elasticity of demand.
Understanding values or price elasticity o demand
• I PED = 0 then demand is said to #e perectly inelastic. This means that demand
does not change at all when the price changes % the demand cur!e will #e !ertical.
• I PED is etween 0 and ! (i.e. the percentage change in demand is smaller than the
percentage change in price)" then demand is inelastic. Producers &now that thechange in demand will #e proportionately smaller than the percentage change in price.The amount consumed does not vary very much with price.
• I PED = ! (i.e. the percentage change in demand is e'actly the same as the
percentage change in price)" then demand is said to unit elastic. *+ rise in pricewould lead to a *+ contraction in demand lea!ing total spending #y the same at eachprice le!el. A change in price will lead to the same change in the amount demanded.
• I PED " !" then demand responds more than proportionately to a change in price i.e.
demand is elastic. ,or e'ample a + increase in the price of a good might lead to a/+ drop in demand. The price elasticity of demand for this price change is %.*. Evensmall changes in prices lead to big changes in demand.
#$%$ &or normal goods' the price goes up' demand goes down$ It is how much itgoes down' not does it go down$
(hat Determines Price Elasticity o Demand)
*n e+ample, Demand or rail servicest pea& times" the demand for rail transport #ecomes inelastic % and higher prices arecharged #y rail companies who can then achie!e higher re!enues and pro0ts.
• he numer o close sustitutes or a good . uni/ueness o
the product % the more close su#stitutes in the mar&et" the moreelastic is the demand for a product #ecause consumers can more
easily switch their demand if the price of one product changesrelative to others in the mar&et. People 1ha!e2 to get to wor& fore'ample" a latter train is not a good su#stitute as you get there late"so the demand is inelastic. The huge range of pac&age holiday toursand destinations ma&e this a highly competiti!e mar&et in terms of pricing % many holiday ma&ers are price sensiti!e" so demand iselastic. 3ou can always go somewhere else on holiday4
• he cost o switching etween dierent products % there may
#e signi0cant transactions costs in!ol!ed in switching #etweendi5erent goods and ser!ices. 6n this case" you would need to #uy acar for e'ample" 0nd a par&ing space near wor& and so on" therefore
demand tends to #e relati!ely inelastic.
• he degree o necessity or whether the good is a lu+ury % goods and ser!icesdeemed #y consumers to #e necessities tend to ha!e an inelastic demand whereaslu'uries will tend to ha!e a more elastic demand #ecause consumers can ma&e do
without lu'uries when their #udgets are stretched. 6.e. in an economic recession we cancut #ac& on discretionary items of spending. gain" you 189E2 to get to wor& so 1ha!e2to pay the higher price. Train companies &now this and so put the price up withouta5ecting the le!els of demand.
• he 3 o a consumer4s income allocated to spending on the good % goods and
ser!ices that ta&e up a high proportion of a household2s income will tend to ha!e amore elastic demand than products where large price changes ma&es little or nodi5erence to someone2s a#ility to purchase the product. The e!idence for this is largelyanecdotal4
• he time period allowed ollowing a price change % demand tends to #e moreprice elastic" the longer that we allow consumers to respond to a price change #y!arying their purchasing decisions. 6n the short run" the demand may #e inelastic"#ecause it ta&es time for consumers #oth to notice and then to respond to priceuctuations. 7ac& to the train e'ample" it ta&es time to #uy a car and so on. They puttheir prices up and o!er time people would drift to cars away from trains.
• (hether the good is su5ect to haitual consumption % when this occurs" theconsumer #ecomes much less sensiti!e to the price of the good in uestion. E'amplessuch as cigarettes and alcohol and other drugs come into this category. This is also why0rms spend !ast amounts on #uilding #rand images.
• Pea1 and o-pea1 demand - demand tends to #e price inelastic at pea& times % a
feature that suppliers can ta&e ad!antage of when setting higher prices. Demand ismore elastic at o5-pea& times" leading to lower prices for consumers. ;onsider fore'ample the charges made #y car rental 0rms during the course of a wee&" or thecheaper deals a!aila#le at hotels at wee&ends and away from the high-season. Trainfares are also higher on ,ridays (a pea& day for tra!elling #etween cities) and also atpea& times during the day
• he readth o defnition o a good or service % if a good is #roadly de0ned" i.e.
the demand for petrol or meat" demand is often fairly inelastic. 7ut speci0c #rands of petrol or #eef are li&ely to #e more elastic following a price change
(i-f prices and price elasticity o demand
,rom airports to hotels to conference centres. ,rom inter-city rail ser!ices to sports stadiumsand li#raries" more and more people are demanding wireless internet connections for personaland #usiness use. 7ut demand is #eing constrained #y the limited a!aila#ility of ser!ices and"in places" high user charges. 8owe!er the price of connecting to the internet through wi-0ser!ices is set to fall as competition in the sector heats up. <early = per cent of laptops nowcome with wi-0 connections as standard and many pu#lic areas are #eing euipped withhotspots" #ut users often complain a#out the high price of accessing the internet. t presentairports and hotels can charge high prices #ecause in many cases a wi-0 ser!ice pro!ider hase'clusi!ity on the area. 8owe!er the supply of wi-0 ser!ices is more competiti!e on the highstreet and prices are falling rapidly as restaurants and co5ee shops are using low-priced wi-0access as a means of attracting customers. The more wi-0 pro!iders there are in the mar&et-place" the higher is the price elasticity of demand for wi-0 connections.$ireless usage is growing across the >? with sales of /@ cards growing #y AB*+C these are
mostly through #usiness channels. 6n the consumer mar&et" sales of $i-,i routers for the homeha!e grown #y BB+ many #road#and pro!iders are now pro!iding free wireless routers witheach new #road#and su#scription.<ote: $i,i stands for $ireless ,idelity
Source: The Cloud and GFK K Technology !arometer" #$$%
$hen demand is inelastic % a rise in price leads to a rise in total re!enue % for e'ample a +rise in price might cause demand to contract #y only *+ (PED -.*)$hen demand is elastic % a fall in price leads to a rise in total re!enue - for e'ample a + fallin price might cause demand to e'pand #y only *+ (PED .*).
The ta#le #elow gi!es a simple e'ample of the relationships #etween mar&et pricesC uantitydemanded and total re!enue for a supplier. s price falls" the total re!enue initially increases"
in our e'ample the ma'imum re!enue occurs at a price of F per unit when * units are soldgi!ing total re!enue of FGA.
;onsider the price elasticity of demand of a price change from H per unit to HI per unit. The + change in demand is A+ following a + change in price % gi!ing an elasticity of demand of -A (i.e. highly elastic). 6n this situation when demand is price elastic" a fall in priceleads to higher total consumer spending J producer re!enue
;onsider a price change further down the estimated demand cur!e % from H per unit to HIper unit. The + change in demand /./+ following a + fall in price % gi!ing a co-ecientof elasticity of % .GG* (i.e. inelastic). fall in price when demand is price inelastic leads to areduction in total re!enue.
6hange in the mar1et (hat happens to total revenue)
PED is inelastic and a 0rm raises its price. Total re!enue increases
PED is elastic and a 0rm lowers its price. Total re!enue increases
PED is elastic and a 0rm raises price. Total re!enue decreases
PED is -.* and the 0rm raises price #y A+ Total re!enue decreases
PED is -.A and the 0rm raises price #y /+ Total re!enue increases
PED is -. and the 0rm lowers price #y + Total re!enue decreases
PED is -A. and the 0rm lowers price #y *+ Total re!enue increases
Elasticity o demand and indirect ta+ationKany products are su#Lect to indirect ta'ation imposed #y the go!ernment. @ood e'amples
include the e'cise duty on cigarettes (cigarette ta'es in the >? are among the highest inEurope) alcohol and fuels. 8ere we consider the e5ects of indirect ta'es on a producers costsand the importance of price elasticity of demand in determining the e5ects of a ta' on mar&etprice and uantity.
ta' increases the costs of a #usiness causing an inward shift in the supply cur!e (see supplycur!e notes). The !ertical distance #etween the pre-ta' and the post-ta' supply cur!e showsthe ta' per unit. $ith an indirect ta'" the supplier may #e a#le to pass on some or all of thista' onto the consumer through a higher price. This is &nown as shiting the urden o theta+ and the a#ility of #usinesses to do this depends on the price elasticity of demand andsupply.
;onsider the two charts a#o!e. 6n the left hand diagram" the demand cur!e is drawn as priceelastic. The producer must a#sor# the maLority of the ta' itself (i.e. accept a lower pro0tmargin on each unit sold). $hen demand is elastic" the e5ect of a ta' is still to raise the price %#ut we see a #igger fall in euili#rium uantity. Mutput has fallen from N to N due to acontraction in demand.6n the right hand diagram" demand is drawn as price inelastic (i.e. PED O o!er most of therange of this demand cur!e) and therefore the producer is a#le to pass on most of the ta' tothe consumer through a higher price without losing too much in the way of sales. The pricerises from P to P % #ut a large rise in price leads only to a small contraction in demand fromN to N.6n the 0rst diagram producers pay through lost sales" consumers pay only a little #it more forthe product. 6n the second" consumers pay a much higher price" #ut mostly continue to #uythe thing therefore manufacturers continue to ma&e and sell more or less the same amount.
he useulness o price elasticity or producers
,irms can use price elasticity of demand estimates to predict:
• The e5ect of a change in price on the total re!enue e'penditure on a product.• The li&ely price volatility in a mar&et following une'pected changes in supply % this is
important for commodity producers who may su5er #ig price mo!ements from time totime.
• The e5ect of a change in a government indirect ta+ on price and uantitydemanded and also whether the #usiness is a#le to pass on some or all of the ta' ontothe consumer.
• 6nformation on the price elasticity of demand can #e used #y a #usiness as part of a
policy of price discrimination (also &nown as yield management). This is where amonopoly supplier decides to charge di5erent prices for the same product to di5erentsegments of the mar&et e.g. pea& and o5 pea& rail tra!el or yield management #y manyof our domestic and international airlines.
:aitual spending on cigarettes remains high ut sales are allingSales of cigarettes are falling #y the impact of higher ta'es mean that smo&ers must spendmore to 0nance their ha#its according to new research from the mar&et analyst Kintel. Totalsales of indi!idual stic&s for the >? in G are forecast to #e GI #illion" ele!en #illion lowerthan in . M!er a uarter of cigarettes are #rought into the >? either duty free or throughthe #lac& mar&et. Total consumer spending on duty-paid cigarettes is li&ely to e'ceed F/#illion" /+ higher than in . 6n the past" increases in the real !alue of duty (ta'ation) oncigarettes has had had little eect on demand from smo&ers #ecause demand has #eeninelastic. 7ut there are signs that a tipping point may ha!e #een reached. Sales of nicotinereplacement therapies such as patches" loQenges and gums ha!e #oomed #y nearly *+ o!erthe past 0!e years to around F=B million. 7ut for e!ery F spent on nicotine replacement" o!erF/ is spent on cigarette stic&s.<early half of smo&ers tried to &ic& the ha#it last year. ccording to the Kintel research"smo&ers under the age of /A are the most li&ely to stop smo&ing" with people aged G* ando!er the least li&ely to try uitting. #an on smo&ing in pu#lic places comes into force inEngland" <orthern 6reland and $ales in the spring of B" the same #an #ecame law inScotland in Karch G.
Sources: Adapted &rom 'intel (esearch" the Guardian and the )ress Association
