04: A closer look at demand : elasticity of demand Flashcards
What is the price elasticity of demand?
Price elasticity of demand (PED) is a measure of the responsiveness of quantity demanded to a change in price. If demand is highly responsive, it is referred to as highly elastic. Unresponsive demand is inelastic.
How do you calculate PED?
PED= %change in Qd/%change in price
What is the range of values for PED?
- If PED is between zero and one, then a change in price will have a small effect on Qd. This is said to be inelastic.
- If PED is greater than one, it is said to be elastic.
What is mean by ‘perfectly elastic or inelastic’ and ‘unit elastic’?
-If PED is exactly zero, then a change in price will have no change is quantity demanded. This is said to be perfectly inelastic.
- If PED is infinity, the Qd at P1 is infinite, however, any price rise above P1 will reduce the quantity demanded to zero. This is said to be perfectly elastic.
- If PED = 1, a product has unit elastic demand. A change in price will see a proportional change in Qd.
What are the determinants of price elasticity of demand.
1) Necessities vs luxuries
2) The number and closeness of substitutes.
3) Proportion of income spent on good.
4) The time period considered
Necessities vs luxuries.
- If a product is a necessity, for example food and medicine, we would expect the demand to be very inelastic. (In this category we also include habit-forming and addictive food, like cigarettes, alcohol or chocolate)
- If it’s a luxury, for example diamonds, we would expect demand to be elastic.
The number and closeness of substitutes.
- It is said to be the most important determinant of PED. The more substitutes there are for a product the more elastic its demand will be. Also, the closer the substitutes available, the more elastic the demand will be. (i.e different brands of toothpaste)
- Products with few substitutes such as oil, will tend to have relative inelastic demand, with the quantity demanded falling relatively little as the price goes up.
Proportion of income spent on a good.
If a good costs very little and constitutes a very small part of a person’s budget, then a change in price may cause very little change in quantity demanded, so the demand will be quite inelastic.
The time period considered.
As the price of a product changes, it often takes time for consumers to change their buying and consumption habits. PED thus tends to be more inelastic in the short term and then becomes more elastic, the longer the time period it is measured over.
Why is this important for firms?
The main use is to predict the effects of their pricing decisions on quantity demanded.
Why is it important for the government?
- They need to be aware of possible consequences when they impose indirect taxes on goods.
- The government needs to be aware of the impact on their expected tax revenues and on employment / unemployment.
- Since governments generally don’t want to cause unemployment, they will put taxes on goods where demand is relatively inelastic. Therefore demand won’t fall too much.
What is the income elasticity of demand, and how do we measure it?
It is a measure of the responsiveness in quantity demanded of a good to a change in consumers income.
YED= %change in Qd/&change in income of consumer
If YED is + its a normal good. If it’s - its an inferior good.
Normal good
A normal good is a product for which quantity demanded increases as income rises.
Inferior good
An inferior good is a product for which quantity demanded falls as income rises.
YED range
YED<0 → inferior good→ rise in income → fall in demand.
0<YED<1→ necessity→ rise in income → small fall in demand.
YED>1→ luxury product → rise in income→ rise in demand
