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Price Elasticity

of Demand

What do you know


already?

The Law of demand states what?


As prices change, do some products QD
change by more/less than other
products?
For which products is QD most/least
sensitive to price changes? Why?
What is revenue? If the price per unit is
$5 and QD and QS is 7units, what is the
revenue?

Price Elasticity of demand


the concept
The responsiveness of quantity demanded to
changes in price
When price rises, what happens
to demand?
Demand falls
BUT, by how much does demand fall?

PED
If price rises by 10% - what happens to quantity
demanded?
We know QD will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which QD
will change
Why is it important for managers to know
the PED of their products?

PED
Price Elasticity of Demand
o Def. The responsiveness of quantity
demanded to changes in price
o Where % change in quantity demanded
is greater than % change in price
elastic
o Where % change in quantity demanded
is less than % change in price inelastic

Determinants of Price Elasticity of


Demand
1. Closeness of substitutes
2. Proportion of Income
3. Luxuries Versus Necessities (nature of
good)
4. Time

Price Elastic or inelastic


demand?
1. Cornflakes (breakfast
cereal)
2. Rice
3. Billingtons rice
4. JIS short run and
long run
5. Toothpaste
6. Bus travel

Determinants of PED
Closeness of
substitutes
Proportion of Income
Luxuries Versus
Necessities
Time

Price Elasticity of Demand


The Formula:
Ped =

% Change in Quantity Demanded


___________________________
% Change in Price

If answer is between 0 and -1: the relationship is inelastic


If the answer is between -1 and infinity: the relationship is elastic
Note: PED has sign in front of it; because as price rises
Quantity demanded falls and vice-versa (inverse relationship between
price and quantity demanded). However, because its always negative,
the sign is usually ignored.

Calculate the price elasticity of


demand for these products
Product

Old price

New price Old QD

New QD

Coke

5,000

6,000

100

90

Cookies

4,000

3,000

50

80

Water

2,000

4,000

90

80

Sandwich

10,000

12,000

20

10

Fried rice

7,000

6,000

60

80

Elasticity and Revenue


Price

Total revenue is price x


The importance of elasticity
quantity sold. In this
is the information it
example,
TRthe
= 5
x 100,000
provides on
effect
on
=
500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.

Total Revenue

D
100

Quantity Demanded (000s)

Activity
1. For the previous table, draw the linear demand
curves.
2. Calculate the revenue, before and after the
change in price.
3. What are the rules regarding price changes,
elasticity, and revenue?

Elasticity and revenue (summary)


If demand is price
elastic:
Increasing price would
reduce TR
Reducing price would
increase TR

If demand is price
inelastic:
Increasing price would
increase TR
Reducing price would
reduce TR

PED and a straight line


1. Draw the linear demand curve. If price = $20, QD = 0. If
price is = $0, QD = 20
2. Calculate the PED as the price drops from, $19 to $18, $17
to $16, $12 to $11, $8 to $7, and $3 to $2.
3.
4. Which portion of the curve is elastic, inelastic, unitary
elastic?
5. Will this rule change if the gradient of the curve changes?
6. Will this rule change if different scaling is used?
7. Therefore, why are elastic demand curves often shown as
relatively shallow, and inelastic relatively steep?

Perfectly price elastic

Perfectly price inelastic

Unitary elasticity

PED and commodities


Commodities tend to be price inelastic as there
are often limited substitutes. E.g. Gold, oil).
As a result, prices of commodities often fluctuate
significantly as supply changes.
Manufactured goods tend to have more and
closer substitutes.

PED and indirect tax


If a Govt wants to reduce consumption of a good,
is it better for demand to be price elastic or
inelastic?
If a Govt wants to raise revenue, is it better for
the good to be price elastic or inelastic?

Activity
Answer TYU 3.1 3.4

Income Elasticity of
Demand
o The responsiveness of quantity demanded
to changes in incomes
Normal Good quantity demanded rises
as income rises
Inferior Good quantity demanded falls
as income rises

Income Elasticity of
Demand
The Formula:
Yed =

% Change in Quantity Demanded


___________________________
% Change in Income

If answer is between 0 and +/-1: the relationship is inelastic

If the answer is between +/-1 and +/-infinity: the relationship is elasti

Income Elasticity of
Demand
A positive sign denotes a normal good
A negative sign denotes an inferior good

Income Elasticity of Demand (Yed)


E.g. Average incomes rise from $1,000 per month
to $1,200 per month.
Over the same period sales of new motor bikes
rise from 400 per month to 560 per month
Yed =
Normal/inferior? Elastic/inelastic?

Application of YED
Commodities = low YED
Manufactured goods = medium YED
Services = high YED
What impact does this have on rich and poor
countries as the world global GDP increases

Activity
Read pg 62-66
Answer TYU 3.6

Cross Price Elasticity of


Demand
The responsiveness of quantity demanded
of one good to changes in the price of a related
good either
a substitute or a complement

% QD of good X
__________________
Xed =
% Price of good Y

Cross Price Elasticity of


Demand
Goods which are complements:

o Cross Elasticity will have negative sign


(inverse relationship)
Goods which are substitutes:

o Cross Elasticity will have a positive sign


(positive relationship)

Example
Calculate Xed
Complement or
substitute?
Elastic or inelastic?

QD of CDs

Old

New

10

P of CD players $80 $100


Old

New

QD of Tea

10

20

P of Coffee

$4

$5

Activity
TYU 3.5

Price Elasticity of Supply


(PES)
Price Elasticity of Supply:
o The responsiveness of quantity supplied to changes
in price
o If Pes is inelastic - it will be difficult for suppliers to
react swiftly to changes in price
o If Pes is elastic quantity supplied can react quickly
to changes in price

%
Quantity Supplied
____________________
Pes =
% Price

Example
If prices increase from $5 to $6, suppliers are
willing to increase quantity supplied from 10 units
to 11 units.
PES = ?
Elastic or inelastic?

Determinants of PES
1.

Time
o
o

2.

Short run
Long run

How much will costs rise with rising QS?


o
o

Transferability of resources
Unused capacity

Price Elastic Supply Curve

Price Inelastic Supply


Curve

Unitary Price Elasticity of Supply

Perfectly elastic and inelastic PES

Application
PES of primary commodities is low.
Why is this? How does this impact world
commodity prices? How in turn does this impact
the incomes in developing countries?
PES of manufactured goods in relatively high
Why is this? How does this impact prices? How in
turn does this impact the incomes in developed
countries?

Activity
TYU 3.7, 3.8