ELASTICITY AND PRICE ELASTICITY OF DEMAND
Elasticity
Elasticity refers to the responsiveness
of change in quantity demanded due to change in any factor which affects the
demand such as price or income etc...
Price Elasticity of Demand
Price elasticity of demand measures the
responsiveness of change the quantity demanded in response to change in price.
Elasticity of demand (PED) can be
calculated as follows.
PED = % change in quantity demanded
% change in price
OR
Degree of Elasticity
Elastic: Elastic demand is where price elasticity of demand is
greater than 1. Elastic demand signifies that for a small change in price there
will be more than proportionate change in quantity demanded. In other words, if
price increases a little, the quantity demanded will decrease more than the
increase in price. Here the demand for the product is very sensitive to change
in price. An elastic demand curve will be more horizontal and flat in shape and
more steeper to the quantity demanded side.
Inelastic: Inelastic demand is where price elasticity of demand
is less than 1. Its where a large change in price causes only a small change in
quantity demanded. In this case quantity demanded is very insensitive to change
in price of the good. As inelastic demand curve is more vertical and steeper to
the price line. The following diagram shows an inelastic demand curve
Unit Elastic: Unit elastic demand is where price elasticity of
demand is equal to 1. When the PED is unit elastic percentage change in
quantity demanded will be equal to price. In other words, change in quantity
demanded will be exactly equal to change in price. The following diagram shows
unit elasticity of demand.
Perfectly Elastic: Perfectly elastic demand is where price
elasticity of demand is equal to infinity. When the PED is perfectly elastic,
the buyers will buy at the current market price, but if the price is increased
no one will buy that good, therefore the quantity demanded will fall to zero.
The curve for perfectly elastic demand curve will be fully horizontal. It is
shown by the below diagram.
Perfectly Inelastic: Perfectly inelastic demand is where
price elasticity of demand is equal to Zero. When the PED is perfectly
inelastic, the quantity demanded does not change at all as the price change.
The demand curve for perfectly inelastic demand will be vertical. It is shown
by the below diagram.
Example, in the market for Oranges the price
declined from $3.15 per Kg to $2.88 per Kg. As a result, the demand increased
from 350 units to 452 units. Calculate the price elasticity of demand.
%Change in quantity demanded = (452-350)/350 X 100
=
102/350X100 = 29.14%
%Change in price =(2.88-3.15)/3.15 X 100 =
-0.27/3.50X100 = -7.71%
PED = 29.14/7.71
= 3.78 (Elastic)
Determinant of Price Elasticity of
Demand
The PED of demand for a good is elastic
or inelastic or unit elastic or perfectly elastic or inelastic depends on
following factors:
The number of close substitutes for a
good / uniqueness of the product: The more close substitutes in the market, the more elastic is the demand
for a product because consumers can more easily switch their demand if the
price of one product changes relative to other in the market. The huge range of
package holiday tours and destinations make this a highly competitive market in
terms of pricing. Many holiday makers are price sensitive
The cost of switching between different
products: There may be significant transactions
cost involved in switching between different goods and services. In this case,
demand tends to be relatively inelastic. For example, mobile phone service
providers may include penalty clauses in contracts or insist on 12 month
contracts being taken out
The degree of necessity or whether the
good is a luxury: Goods and
services deemed by consumer to be necessities tend to have an inelastic demand
whereas luxuries will tend to have a more elastic demand because consumers can
make do without luxuries when their budgets are stretched. i.e. in an economic
recession we can cut back on discretionary items of spending.
The % of a consumer’s income allocated
to spending on the good:
Goods and services that take up a high proportion of a household’s income will
tend to have a more elastic demand than products where large price changes
makes little or no difference to someone’s ability to purchase the product.
The time period allowed following a
price change: Demand tends to be more price elastic,
the longer that we allow consumers to respond to a price change by varying their
purchasing decisions. In this short run, the demand may be inelastic, because
it takes time for consumers both to notice and then to respond to price
fluctuations.
Weather the good is subject to habitual
consumption: When this occurs, the consumer becomes
much less sensitive to the price of the good in question. Examples such as
cigarettes and alcohol and other drugs come into this category.
Peak and off peak demand: Demand tends to be price inelastic at
peak times. A feature that supplier can take advantage of when setting higher
prices. Demand is more elastic at off peak times, leading to lower prices for
consumer. Consider for example the charges made by car rental firms during the
course of a week, or the cheaper deals available at hotels at weekends and away
from the high season. Train fares are also higher on Fridays ( a peak day for
travelling between cities) and also at peak times during the day.
The breadth of definition of a good or
service: If a good is broadly defined, i.e. the
demand for petrol or meat, demand is often fairly inelastic. But specific
brands of petrol or beef are likely to be more elastic following a price
change.
Elasticity and Total Revenue.
Total Revenue is the total income received from
selling a particular good.
Total revenue is calculated by multiplying price with the quantity demanded
TR =
P X Q
Elastic Demand and Total Revenue.
When the price elasticity of demand is
elastic, an increase in price will lead to fall in total revenue because fall
in quantity demanded will be greater than increase in price. In this case more
customers will switch to substitute goods due to rise in price leading to fall
in total revenue.
On the other hand if the price is
decreased, total revenue will increase. This is because the increase in
quantity demanded will be higher than the decrease in price. More customer will
buy the product. The following two diagrams shows the effect on total revenue
when price increase and decrease if the PED is elastic.
Total revenue when P
is 10 = 10 X 100 = $1000 Total revenue when P is 15 = 15
X 150 = $2250
Total Revenue when P
is 12 = 12 X 80 = $960 Total Revenue when P is 10 = 10
X 300 = $3000
Change in Total
Revenue = Tr2 –Tr1 Change in Total Revenue = Tr2
–Tr1
=960-1000 =3000-2250
=$40 =$750
Due to increase in the
price from $10 to $12, total revenue Due to decrease in the price
from $15 to $10, total revenue
Has decreased by $40
as shown in the shaded rectangle. Has increased by $750 as shown
in the shaded rectangle.
The total revenue fell
from $1000 to $960 The total revenue increased from
$2250 to $3000
Inelastic Demand and
Total Revenue.
When
the price elasticity of demand is inelastic, total revenue will increase if the
price of the product has increased. This is because consumers are insensitive
to change in price. A large change in price will only cause a small change in
quantity demanded.
On
the other hand if the price is decreased, total revenue will decrease. This is
because for a large decrease in price there will be only small reduction in
quantity demanded.
Following
diagrams shows the effect.
Total revenue when P
is 10 = 10 X 100 = $1000 Total
revenue when P is 10 = 10 X 75 = $750
Total Revenue when P
is 20 = 20 X 85 = $1700 Total
Revenue when P is 5 = 5 X 95 = $475
Change in Total
Revenue = Tr2 –Tr1 Change
in Total Revenue = Tr2 –Tr1
=1700-1000 =475-750
=$700 =$275
Due to increase in the
price from $10 to $20, total revenue Due
to decrease in the price from $10 to $5, total revenue
Has increased by $700 Has decreased by
$275.
The total revenue rose
from $1000 to $1700 The
total revenue fell from $750 to $475
Unit Elastic Demand
and Total Revenue.
When the price
elasticity of demand is unit elastic, total revenue will be unchanged due to
increase or decrease in price. If the price increase or decrease the total
revenue will be constant.
Perfectly Elastic
Demand and Total Revenue.
When the price elasticity
of demand is perfectly elastic, an increase in price will cause total revenue
to fall into zero. A decrease in price will cause PED to increase.
Perfectly Inelastic
Demand and Total Revenue.
When the price
elasticity of demand is perfectly inelastic, the total revenue will increase if
the price increase and total revenue will decrease when the price decrease.
Total Expenditure and Elasticity
The
following figure shows that as price falls there is a range over which.
- · Demand rises and expenditure rises
- · Demand rises and expenditure stays the same
- · Demand rises and expenditure falls
Many
firms around the world have gone bankrupt because they do not understand this
relationship. Ask a person in a business how they will improve profitability.
‘sell more’ is usually the answer. How will you sell more? ‘lower the price’
may be the answer. As we can see, there is a price range over which this is
exactly the right answer and price range over which this is exactly wrong
answer.
Another
interesting point is illustrated by the unitary demand curve: whatever the price,
the expenditure on the product remains unchanged. In below figure, multiply the
price by the quantity sold.