Price Elasticity of Demand

Question 1

Define Elasticity

Answer 1

Elasticity is the responsiveness or sensitivity of consumer demand to a change in a variable.

Question 2

Define PED

Answer 2

Price Elasticity of Demand is the responsiveness of demand for a product to a change in its price.

Question 3

Give the general formula for PED

Learn other formulas

Answer 3

PED = %change in quantity demanded / %change in price

Question 4

What is the value of PED at the point where the demand curve cuts the price axis?
Explain why this is the case.

Answer 4

At the point where the demand curve cuts the price axis, PED = infinity. This is because at this point QD = 0 so the bottom line of the equation which is demand will be 0. Therefore the final answer is divided by 0, so equals infinity.

Question 5

What is the value of PED at the point where the DC cuts the quantity axis?
Why is this the case?

Answer 5

At the point where the demand curve cuts the quantity axis, price = 0. This means that the top line of the equation is zero, so the whole equation would equal zero.

Question 6

Give a verbal description of inelastic.

How is this shown on a graph?

Answer 6

A fall in price leads to a proportionally smaller fall in quantity demanded.
This is shown by a steep gradient.

Question 7

Give a verbal description of elastic.

Answer 7

A fall in price leads to a proportionally larger rise in quantity demanded.
This is shown by a shallow gradient.

Question 8

Describe a perfectly inelastic demand curve.
Describe a perfectly elastic demand curve.
Describe a demand curve with unitary elasticity.

Answer 8

1) Vertical
2) Horizontal
3) A curve with unitary elasticity is a rectangular hyperbola with the formula PQ = k, where p is price, q is quantity demanded and k is a constant value.

Question 9

Give 7 factors that determine the PED of a product.

Answer 9

1) Number of close substitutes available for consumers
2) Time
3) Width of market definition
4) Degree of necessity
5) Price of the product in relation to total income
6) Brand loyalty and habitual consumption
7) Cost of substituting between different products

Question 10

Explain how the availability of substitutes can affect PED for a product using examples.

Answer 10

The better the substitutes available for a product are, the higher the price elasticity of demand will tend to be. Salt has few good substitutes, when the price of salt increases, the demand for salt will change little and there fore the PED of salt is low.
On the other hand spaghetti has many good substitutes, such as other types of pasta, rice, bread and potatoes. So a rise in the price of spaghetti, all other food prices remaining the same, is likely to have a significant affect on the demand for spaghetti; its PED is high.

Question 11

Explain how the width of market definition can affect PED using examples.

Answer 11

The more widely, the product is defined, the fewer substitutes it is likely to have. For example, spaghetti has many substitutes but food in general has none. So the PED for spaghetti is likely to be higher than that for food.

A 5% increase in the price of boiled sweets, all other prices remaining the same, is likely to lead to a much larger fall in demand for boiled sweets, than a 5% increase in the price of all confectionary.

Question 12

Explain how time can affect PED.

Use an example.

Answer 12

The longer the period of time, the more price elastic the demand for a product is. For instance in 1973-74, when the price of oil quadrupled the demand for oil was, in the short term inelastic. Oil has few good substitutes, so consumers had no choice but to pay the higher prices. However in the long term consumers were able to fin and use substitutes for oil, so the demand for oil fell from what it would otherwise have been. Estimates suggest that the demand for oil was slightly elastic.

Question 13

Why is it argued that in the short term, consumers can be locked into spending?
What is different about the long term?

Answer 13

It is argued, that in the short term consumers are locked into spending through habit, lack of information or because of durable goods which have already been purchased, in the long term they have time to change these habits.

Question 14

How does degree of luxury affect PED?

Answer 14

It is generally assumed that necessities have a lower PED than than luxuries. This is because by definition necessities are essential to everyday life, whereas luxuries are an optional spend.

Question 15

What is argued about goods that form a relatively low percentage of total expenditure?

Answer 15

It is also sometimes argued that goods which form a relatively low proportion of total expenditure have lower elasticities than those which form a more significant proportion.

Question 16

How does brand loyalty and habitual consumption affect PED?

Answer 16

High levels of brand loyalty makes demand less price elastic, persuasive advertising can also make demand price inelastic.

Question 17

What is total revenue and how is it calculated?

Answer 17

Total revenue is the total payment a producer gets from selling a given quantity of a product.
Total revenue is calculated by: Price per unit of product sold x Quantity of product sold.

Question 18

What is the relationship between TR and the amount of spending by consumers on the product?

Answer 18

The total revenue a firm gets from selling a product is identical to the amount of spending by consumers on the product.

Question 19

What can be said about demand if the co-efficient of PED is less than one?
In this instance what can be said about the affect of increasing price?

Answer 19

If the co-efficient of PED is less than one, demand is said to be price inelastic, i.e unresponsive to a change in price.
In this instance the additional revenue gained from increasing price, more than offsets the revenue lost due to a fall in demand, after the price increase.

Question 20

What can be said about demand if the co-efficient of PED is greater than one?
In this instance what can be said about the affect of lowering price?

Answer 20

If the co-efficient is greater than one, demand is said to be price elastic, i.e highly responsive to a change in price.
The revenue lost due to the fall in price is more than made up for by the rise in quantity demanded at the lower price. This is because the change in quantity demanded will be proportionally larger than the change in price.

Question 21

What can be said about demand if the co-efficient of PED is zero?
What does this type of curve imply?
What happens if supply falls?

Answer 21

If the co-efficient of PED is zero, then demand is perfectly inelastic, i.e demand does not vary with a change in price.
A perfectly inelastic demand curve implies that consumers are willing and able to pay any price for the product.
If supply falls, equilibrium market price can rise without any contraction in quantity demanded.

Question 22

What can be said about demand if the co-efficient of PED is infinity?
In this instance what will happen if there is a rise in supply, therefore on what does TR depend?
What would happen if price rises?
What would happen if the price were to fall?

Answer 22

If the co-efficient of PED is infinity, then demand is perfectly elastic, i.e there is one price at which consumers are prepared to pay.
When demand is perfectly elastic, if supply increases there will be no change in price and therefore TR will depend on the quantity of units bought or sold.
However if price rises, total revenue will fall to 0, as there will be no buyers at the higher price.
Similarly if price were to fall, the producer would be committing economic suicide because he/she would be receiving less revenue than at the prevailing market price.

Question 23

What is the co-efficient of PED for a demand curve with unitary elasticity?
What is the relationship between price and demand on a demand curve with unitary elasticity?
What does this mean about consumers spending at each price level?

Answer 23

A demand curve with unitary elasticity, has a co-efficient of PED is one.
With a demand curve of unitary price elasticity, a change in price is met with a proportionate change in demand.
This means that total spending by consumers on the product will remain the same at each price level.