PRICE ELASTICITY OF DEMAND
Elasticity measures the strength of relationship between one variable and another, eg if there is a change in one variable what effect will have it have on another variable.
Elastic: strong relationship between variables
Inelastic: weak relationship
PRICE ELASTICITY OF DEMAND (PED)
Definition: PED measures the the effect of a price change on quantity demanded of the good.
The law of demand identifies an inverse relationship between P and Qd. PED can be used to measure the strength of the relationship
Formula: % change in Qd/%change in Price
example one: as a result of prices rising from 10p to 12p, quantity demanded fell from 40 units per week to 30 units per week
% change in Qd: 2/10 * 100 = 20% % change in price: 10/40 * 100 = 25%
PED = 20/25 = 0.8
Example two: a price fall from 25p to 23p led to quantity increasing from 35units to 45 units
% change in Qd: 10/35 * 100 = 28.6% % change in price 2/25 * 100 = 8%
PED = 28.6/8 = 3.6
Analysis of the results
If PED is less than one, demand is said to be price inelastic.
The proportionate change in Qd is less than the proportionate change in price.
In example one demand is price inelastic (PED is less than one). If prices rise
by 1%, quantity demanded falls by 0.8%.
If PEd is more than one, demand is said to be price elastic. The
proportionate change in Qd is greater than the proportionate change in price.
In example two demand is price elastic (PEd is greater than one). A fall in
price of 1% will lead to quantity demanded rising by 3.6%
Unitary elastic: a situation where the proportionate change in Qd is the same as the proportionate change in price. Hence PED = 1
Looking at this site will give estimates for the PED for cocoa in different countries.
INFLUENCES ON PED
Availability of substitutes: the more substitutes which exist for a product, the greater will be its PED. If prices rise, consumers will have other goods to choose from. Petrol has very substitutes, so demand is very inelastic, whereas the demand for oranges might be considered to be more elastic, because it has a wider range of substitute goods available. If the price of petrol went up, consumption would be little affected, whilst if orange prices went up, quantity demanded of oranges might fall as we switch consumption to alternative fruits.
Amount of income spent on the good: the smaller the proportion of income spent on a good, the more price inelastic demand for that good becomes as consumers will be able to afford price increases, eg if the price of a box of matches doubled from 15p to 30p, the price increase represents a small proportion of income. The more income spent on a good the more elastic demand becomes, eg if interest rates went up from 5% to 15%, the demand for housing would fall considerably as householders would not be able to afford the increased mortgage payments.
Addictiveness of a product: the more we like to consume a good, the more inelastic demand becomes. Once addicted, we would be prepared to pay that little bit extra to satisfy our craving. The demand for cigarettes is very price inelastic, and the demand for watching Birmingham City play at the moment is also very price inelastic.
Time: Demand generally becomes more price elastic over time. If electricity prices rise, consumers have to accept the price increase in the short term, since there are few alternatives to switch to, but in the longer term consumers might switch over to gas, oil or solar power.
The width of definition of a product: The demand for cars is very inelastic, since there are few alternatives, but the demand for individual makes of cars will be more elastic. Car users can switch to alternative makes if the price of one make goes up too much.
APPLICATIONS OF PED
Government taxation policy
Firm's pricing policy
Effect of price changes on a firm's revenue