2.2.1 Price elasticity of Demand Flashcards
Price elasticity of demand
Measures the response of the quantity demanded to changes in price, and extent of the changes of both variables
Price elastic demand
Small changes in price cause relatively large changes in QD → Quantity demanded changes by a higher percentage than the price
Price inelastic demand
Large changes in price cause relatively small changes in QD → Quantity demanded changes by a lower percentage than price
PED
Demand for most things is higher at low prices and lower and high prices.
- The term for the responsiveness of quantity demanded to price changes is price elasticity of demand
- Demand is responsive → price elastic
- Price has little impact on quantity bought → price inelastic
how to calculate PED and answer
percentage change in QD/percentage change in price
As quantity demanded falls when price rises and vice versa, the answer should be negative (negative correlation on the graph)
interpreting PED
- Any figure for PED between 0 and -1 shows price inelastic demand → quantity changed less than price
- Smaller relative change in demand means less price elastic demand so the number is closer to 0
- Any figure beyond -1 shows price elastic demand and the further the figure moves beyond -1, the more price elastic demand will be
describe a product being perfectly inelastic
PED = O
- prices has no effect on quantity
describe a product being inelastic
PED = 0 to -1
- Quantity demanded changes by a smaller percentage as a result of price changes
eg necessities, giffen goods, water
describe unit elasticity
PED = -1
- Quantity demanded changes by the same % as price
- At any given price + quantity the area under the curve is equal at any other points
describe a product being elastic
PED = -1 to -infinity
- Price changes lead to a bigger percentage change in QD
Eg luxury
describe a product being perfectly elastic
PED = -infinity
- Any price increase causes demand to fall to 0, and a price cut leads to more demand than the firm can cope with
Eg commodity markets (only ever one price at any one point in time)
name 5 influences on PED
- necessity
- substitutes
- time
- share of income a product takes
- number of uses a product has
necessity and PED
- If we need it to survive or cannot deal without it, price hardly influences whether we buy it or not (eg energy, necessities like food) → customer perception
- If something is more casual/impulse buy (minor luxury) demand should be more price elastic
- The product or market makes the difference: food vs meat (eg beef), rail travel and peak times
substitutes
how do firms combat close substitutes
- Availability and closeness of substitutes influence PED → habit, tastes and limited suitability of substitutes should make price inelastic (eg water)
- Close substitutes: advertising and other marketing tries to differentiate products: demand increases and price sensitivity is limited so substitutes become less attractive in comparison → more INELASTIC
- Firms producing undifferentiated items (cheap unbranded clothes) → the demand curve facing an individual producer is very price elastic so any price increase makes their product unsaleable
- There are many other options so the seller has to accept the market price
time
takes time to adjust to price changes –> longer time = more elastic it will be
share of income
- Expensive items taking a high share of income can have a higher P elasticity → more ELASTIC
- PED will be low if the product only takes a small share of income → more INELASTIC
relationship between PED and total rev
why not always true
- When supplier increases price:
Higher price increases the revenue per unit but reduces the number of units sold
Price inelastic → quantity changes more than price
With an elastic demand curve (horizontal) much bigger change in demand → revenue = p x q on diagrams
where demand is price inelastic
- Increasing price increases total revenue
- Decreasing price would decrease total revenue
Where demand is price elastic
- Increasing price reduces total revenue
- Reducing price would increase total revenue
Increase in sales does not always equal an increase in revenue
- increase in sales = increase in production and costs
- Extra sales could lead to producing more and higher costs, total costs will rise as well as total revenue
Costs > revenue → falling profits
problems for firms in markets with many suitable substitutes
In a competitive mass market (rivals and similar products), we can expect price elastic demand
- Most will not increase price as revenue and sales will fall but can only control costs for profit
- Price cut could increase sales increase but could reduce/destroy profit margin - - in competive market
Not essential products → price elastic
firms with few close subs –> small businesses in niche markets
- Demand is less price sensitive: in niche markets successful differentiation from the few markets can give a firm market power
- Confident firms in their price inelasticity of demand may have a small drop in sales if price increases and higher prices can increase sales revenue and profit → attractive so firms want less price elastic D curves
how do firms gain market power
Firms have more market power and are stronger when their demand is price inelastic
- Firms strive to differentiate their products and build strong brand images
- Use market research to target specific groups of customers with what they want
When successful, PED of their product falls, becomes more inelastic → price and profit can increase
