Chapter 3 Flashcards
Common sense tells us that when prices change, so too will the quantities bought. However,……..
…….businesses need to have more precise information than this - they need to have a clear measure of
how the quantity demanded will change as a result of a price change.
What does PED stand for?
Price elasticity of demand
What is price elasticity of demand?
A very useful measure of the relationship between price and quantity demanded .
Price elasticity of demand is a measure of the percentage change in the quantity of a good demanded divided by the percentage change in its price. It effectively is a measure of how price
sensitive demand for a product i
What is the simple formula for PED?
PED = ((Q2-Q1)/Q1) / ((P2-P1)/P1)
This is also called a point PED calculation as it considers the PED at a particular point on the demand curve.
What are the N factors affecting the PED
-The number of close substitutes for a good / uniqueness of the product
-The cost of switching between different products
-The degree of necessity or whether the good is a luxury
-The % of a consumers income allocated to spending on the good
-The time period allowed following a price change
-Whether the good is subject to habitual consumption
-Peak and off-peak demand
-The breadth of definition of a good or service
Explain “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. This is because consumers can more easily switch their demand if the price of one product changes relative to others 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, and will switch to a cheaper provider as there are no barriers (elasticity has increased further with the
advent of price comparison websites).
Explain “The cost of switching between different products”
There may be significant transactions costs 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
Explain “The degree of necessity or whether the good is a luxury”
Goods and services deemed by consumers 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
Explain “The % of a consumers 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 make little or no difference to
someone’s ability to purchase the product.
Explain “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 the short run, the demand may be inelastic, because it takes time for consumers both to notice and then to respond to price
fluctuations.
Explain “whether the good is subject to habitual consumption”
When this occurs demand tends to be more inelastic as 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.
Explain “peak and off-peak demand”
Demand tends to be price inelastic at peak times – a feature that suppliers can take advantage of when setting higher prices. Demand is more elastic at off-peak times, leading to lower prices for consumers. 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
Explain “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
Define Perfectly inelastic demand
An extreme situation where a change in price will have no effect on quantity demands
GRAPH
Define Perfectly inelastic demand
An extreme situation where a market participant is a price taker and has to accept the market price. If
they raise their price they will sell nothing.
GRAPH
Define Elastic Demand
A change in price leads to a greater % change in quantity. Revenue generally increases if prices are lowered. See note below on PED changing along the
demand curve. GRAPH
Define Inelastic Demand
A change in price leads to a smaller % change in quantity demanded. Revenue increases if price is
increased GRAPH
Define Unitary Elastic Demand
The elasticity of demand is 1 at any point on the demand curve (known as a rectangular hyperbola). A change in price will have no effect on revenue i.e.
Price × Quantity = constant. GRAPH
What does an ARC PED look at?
An arc ped looks at an average PED between two points on a demand curve
What is the ARC PED formula
= (Q2-Q1/(Q1+Q2)/2) OVER (P2-P1/(P1+P2)/2)
From a business point of view, it is important to understand what will happen to demand if you raise or lower price. There are clearly many advantages to be gained if people buy a lot more of our goods
when (as a producer) we lower price.
What is elastic demand
In business we use the term ‘elastic demand’ to describe a position where the quantity demanded changes by a bigger percentage than the price change (i.e. the
PED > 1)
What is inelastic demand
We use the term ‘inelastic demand’ where the demand change is a smaller percentage than the price change (i.e. the PED < 1).
If a demand is elastic, what do you do to the price
It makes sense to lower the price of goods from the previous price if demand is elastic and it is relatively cheap to expand production.
A lowering of price for a product that has elastic demand will lead to an overall increase in revenue since the % increase in quantity will be greater than the %
decrease in price.
If a demand is inelastic, what do you do to the price?
It makes sense to raise the price of goods from the previous price if demand is inelastic. This will increase the revenue since the quantity demanded will not drop by as large a % as the % increase in
price
What is the relationship between elasticity and revenue
The elasticity of demand can be seen in the movements of total revenue.
-If total revenue increases after a price cut, demand is elastic
-If total revenue increases after a price rise, demand is inelastic
What is PES?
Price elasticity of supply (PES) measures the relationship between change in quantity supplied and a change in price of that good.
What is the equation for PES
PES =
% change in Qty supplied
OVER
% change in price
The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa.
What factors determine elasticity of supply?
SETS
Spare Capacity
Ease of factor substitution
Time period
Spare capacity
Explain ‘Spare Capacity’ (PES factor)
How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic
Explain ‘Ease of factor substitution’ (PES factor)
If capital and labour resources are occupationally mobile, then the elasticity of supply for a product is likely to be higher than if capital equipment and labour cannot easily be switched and the production
process is fairly inflexible in response to changes in the pattern of demand for goods and services.
Consider the sudden and dramatic increase in demand for petrol canisters during the fuel shortage. Could manufacturers of cool-boxes or producers of other types of canister have switched their
production processes quickly and easily to meet the high demand for fuel containers?
Explain ‘Time Period’ (PES factor)
Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and determined by planting decisions made months before, and climatic conditions, which affect the production, yield.
Economists sometimes refer to the momentary time period - a time period that is short enough for
supply to be fixed i.e. supply cannot respond at all to a change in demand
Explain ‘Stocks’ (PES factor)
The level of stocks or inventories ─ if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the
market - supply will be elastic
