Price Elasticity of Demand Flashcards
What is price elasticity?
The concept that measures the sensitivity or responsiveness of quantity demanded to a change in the price of a good or service
What are the main types of elasticity?
- Price Elasticity of Demand
- Price Elasticity of Supply
Describe the law of demand
There is a negative relationship between price and demand. An increase in price will cause quantity demanded to contract and vice versa.
What is elasticity concerned with?
Elasticity is concerned with the question of how much.
What does elasticity allow us to consider?
Real-life examples which illustrate the relationship between price and quantity demanded. This information is useful to firms, economists, consumers and the government.
How do you calculate the price elasticity of demand?
Change in quantity divided by original quantity x original price divided by the change in price
What does it mean if the elasticity coefficient is greater than 1?
It means demand is price elastic. In other words, the buyers of the good are responsive to a change in price. The quantity demanded will change by a greater proportion than the price change
Provide an example of an elastic good.
Motor cars, chinaware and jewellery.
What does it mean if the elasticity coefficient is less than 1?
This means the demand is price inelastic. In other words, the buyers of the good are not very responsive to a change in price. The quantity demanded will change by a smaller proportion than the price change.
What does it mean if the elasticity coefficient is equal to 1?
This means the demand is unitary elastic. In other words, price and the quantity change are in exactly the same proportion.
What does it mean if the elasticity coefficient is equal to 0?
This means that demand is perfectly inelastic. In other words, price changes have no effect on demand whatsoever, the demand curve is a vertical line.
Provide an example of a perfectly inelastic good
The demand for heroin to a drug addict.
What does it mean if the elasticity coefficient is perfectly elastic?
This means price changes have an infinite effect on demand, the demand curve is a horizontal line. In reality, there are no goods that fit this description.
What are the factors affecting the elasticity of demand?
- The availability of substitutes
- Neccesary/Luxury goods
- Definition of the market
- Proportion of Income Spent
- Time
How does the availability of substitutes affect the elasticity of demand?
The greater the number of substitutes a good has, the more price elastic its demand
Goods with many close substitutes will be relatively elastic, while goods with few substitutes will be relatively inelastic
How does whether the good is a necessity or luxury affect the elasticity of demand?
Necessities, such as bread or milk, tend to have inelastic demand because consumers need them regardless of price changes, meaning demand doesn’t decrease much when prices rise.
In contrast, luxury goods like designer handbags or high-end cars are more price elastic, as consumers can withhold these items or choose alternatives if prices increase.
Essentially, demand for necessities is less sensitive to price changes, while demand for luxury goods is more responsive.
What is the definition of the market?
This refers to how the demand for a broad category of goods will always be more inelastic than the demand for a single brand
- e.g. the demand for petrol overall (broad) is inelastic, but the demand for a single brand of petrol (BP) will be elastic because there are close substitutes
What is the proportion of income spent?
Expensive items tend to be relatively price elastic because they take up a larger proportion of a consumer’s income. Cheap, inexpensive items tend to be price inelastic items on the other hand.
If a good takes up a higher proportion of income, demand will likely change when price changes.
What is time?
If consumers have time to respond to a price change, then demand will be more price elastic.
In the short run, demand for most commodities will be relatively inelastic because consumers do not have much time to adjust their consumption or find substitute products.
Why is price elasticity of demand an important concept?
Because of its link with the concepts of total revenue of business firms and total expenditure of households. It plays an important role in a firm’s pricing policy
What is total revenue?
Total revenue is simply price multiplied by quantity
Describe the relationship between price elasticity of demand and total revenue when total revenue moves in the opposite direction to the price change.
This means that demand is elastic. A rise in price decreases total revenue, while a fall in price increases total revenue.
Describe the relationship between price elasticity of demand and total revenue when total revenue moves in the same direction to the price change.
This means demand is inelastic. A rise in price increases total revenue, while a fall in price decreases total revenue
Describe the relationship between price elasticity of demand and total revenue when total revenue and price does not change.
Demand is unitary elastic.
What is price discrimination?
A common pricing practice where different consumer groups have a different price elasticity of demand and firms can use this information to charge different prices and increase their total revenue.
How can firms boost their revenue?
By segmenting their customers into separate groups according to their elasticity.
What happens if demand is ELASTIC and PRICE increases?
Then QUANTITY demanded will fall by a bigger proportion meaning that total revenue must decrease
What happens if demand is ELASTIC and PRICE decreases?
Then QUANTITY demanded will increase by a bigger proportion meaning that total revenue must increase
What happens if demand is INELASTIC and PRICE increases?
Then QUANTITY demanded will fall by a smaller proportion meaning that total revenue must increase.
What happens if demand is INELASTIC and PRICE decreases?
Then QUANTITY demanded will increase by a smaller proportion meaning that total revenue must decrease
Define price discrimination
Price discrimination is the practice where firms sell the same good/service to different customers based on their price elasticity
How can a firm practice price discrimination?
A firm must be able to separate different types of customers – by age (children, adults, seniors); by sex (males, females); by income (low income, high income); or some other category.
The different groups of buyers must have a different price elasticity of demand
How do firms react to price discrimination?
- The firm will charge a higher price to the group with the more inelastic demand and a lower price to the group with the more elastic demand
What happens as you move down along a linear demand curve?
Price elasticity of demand falls.
Where is elasticity infinite on the demand curve?
At the top
Where is the elasticity = 0 on the demand curve?
At the bottom
Where is the elasticity = 1 on the demand curve?
At the midpoint
Where is demand elastic on the demand curve?
Along the top half of a linear demand curve, demand is everywhere elastic.
Where is demand inelastic on the demand curve?
Along the bottom half of a linear demand curve, demand is everywhere inelastic.
What happens when demand is elastic?
A cut in price will increase total revenue
What happens when demand is inelastic?
A rise in price will increase total revenue.
