Elasticity

Question 1

What does price elasticity of demand (PED) measure?

Answer 1

The responsiveness of demand after a change in the good’s own price

Question 2

What is the basic formula for calculating the co-efficient of price elasticity of demand?

Answer 2

Percentage change in quantity demanded divided by percentage change in price

Question 3

When do normal goods have a negative price elasticity of demand?

Answer 3

When they have a downward sloping demand curve

Question 4

What does it mean when the PED=0?

Answer 4

Demand is perfectly inelastic - demand does not change when the price changes - the demand curve is vertical

Question 5

What does it mean when the PED is between 0 and 1

Answer 5

% change in demand is smaller than the percentage change in price, then demand is inelastic

Question 6

What does it mean is PED=1?

Answer 6

% change in demand is the same as the % change in price, then demand in unit elastic
A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level

Question 7

What does it mean when PED>1?

Answer 7

Demand responds more than proportionately to a change in price i.e. Demand is elastic
A 10% increase in price leads to a 30% drop in demand. The price elasticity of demand for this price change is -3

Question 8

What factors determine the PED of a product?

Answer 8

• Number of close substitutes available for consumers - the more close substitutes there are, the more price elastic the demand
• Price of the product in relation to total income - when the % of the budget is high, demand is usually more price sensitive
• Cost of substituting between different products - when substitution/switching costs are high, demand will tend to be price inelastic
• Brand loyalty and habitual consumption - high levels of brand loyalty makes banks less price elastic, persuasive advertising can make demand price inelastic
• Degree of necessity / luxury - standard assumption is that necessities have a lower price elasticity of demand whereas luxuries are an optional spend

Question 9

What can firms predict with PED estimates?

Answer 9

• The effects 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 effects of a change in an indirect tax on price and quantity demanded also whether the business is able to pass on some or all of the tax onto the customer

Question 10

What is price discrimination and how do businesses use PED for this?

Answer 10

• Where a supplier decides to charge different prices for the same product at different segments of the market e.g. Peak and off peak rail travel or prices charged by many of our domestic and international airlines
• usually a business will charge a higher price to consumers whose demand is price inelastic

Question 11

What is elasticity?

Answer 11

Responsiveness of X to a change in another variable