Price elasticity of demand
Formula for coefficient of PED
%Change in Quantity demanded/ %Change in Price %Change in price= (Price new- Price old/ Price old) X100
If PED is between 0-1
(% change in demand is smaller than the percentage change in price), then demand is inelastic
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
Practice questions: 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
Practice questions: WH Smith has recently reduced the price of its Kobo Mini Ereader 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. 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
PED basic rules
-All normal goods with downward sloping demand curves will have a negative coefficient of 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 coefficient of elasticity
Limitations of elasticities
-Problems with inaccurate or incomplete data -Consumer price sensitivity changes over time e.g a consumer may be more willing to pay for organic food if they think it is better for them -Elasticity varies by region -Not all businesses are only focused on maximising profit -Elasticity will vary within product ranges -Substitutes will change their market strategies on occasion
Firms use PED to predict:
-The effect of a change in price on total revenue of sellers -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 -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 airlines. -Usually, a business will charge a higher price to consumers whose demand is price inelastic e.g water companies
Price elasticity example: Uber surge pricing
-Uber engages in surge pricing - also known as dynamic pricing -When market demand out-strips available supply e.g. at peak times, then Uber raises the average fare on their app -The aim is to encourage more drivers to take to the roads to expand the supply -The business is taking advantage of low price elasticity of demand at busy times -Some economists have criticised this policy especially during emergencies e.g after a terrorist attack people have to pay more for an uber
If PED=0
Demand is perfectly inelastic - demand does not change when the price changes - the demand curve is vertical
Coefficient of PED along a linear demand curve
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Elastic demand (PED is <1)
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Inelastic demand (PED is less than 1)
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Perfectly elastic demand (PED=infinity)
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Perfectly inelastic demand (PED=0)
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Unitary elastic demand (PED=1)
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Factors affecting the PED of a product: Subsitutes
If there is greater availability of substitutes, then the good is likely to be more elastic. For example, if the price of one soda brand goes up, people can turn to other brands. So, a small change in price is likely to cause a greater fall in quantity demanded.
Factors affecting the PED of a product: Necessities
If a good is a necessity, then the demand tends to be inelastic. For example, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity.
Price elasticity of demand
Price elasticity of demand (PED) measures the responsiveness of demand after a change in the good's own price
Factors affecting the PED of a product: Time
Over time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes. For example, if the price of gasoline goes up, over time people will adjust for the change, i.e., they may drive less or use public transportation or form carpools.
Formula for coefficient of price elasticity of demand
Percentage change in quantity demanded divided by the percentage change in price %Change in price= (Price new- Price old/ Price old) X100
Factors affecting the PED of a product: Habit
The demand for addictive or habitual products is usually inelastic. This is because the consumer has no choice but to pay whatever the producer is demanding. For example, if the price for a pack of cigarettes goes up, it will likely not have any effect on demand.
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
