PRICE ELASTICITY OF DEMAND

Price elasticity of demand (PED) measures the responsiveness of demand after a change in price.

Price elasticity of demand (PED): % change in quantity demand

                                                     % change in price

Price Elastic Demand

Definition: Demand is price elastic if a change in price leads to a bigger % change in demand; therefore the PED will therefore be greater than 1.

Goods which are elastic, tend to have some or all of the following characteristics.

1.      They are luxury goods, e.g. sports cars

2.      They are expensive and a big % of income e.g. sports cars and holidays

3.      Goods with many substitutes and a very competitive market. E.g. if Sainsbury’s put up the price of its bread there are many alternatives, so people would be price sensitive.

4.      Bought frequently

Price Inelastic Demand

These are goods where a change in price leads to a smaller % change in demand; therefore PED <1 e.g. – 0.5

·         Inelastic demand PED <1 – Perfectly inelastic PED =0

Goods which are inelastic tend to have some or all of the following features:

1.      They have few or no close substitutes, e.g. petrol, cigarettes.

2.      They are necessities, e.g. if you have a car, you need to keep buying petrol, even if price of petrol increases

3.      They are addictive, e.g. cigarettes.

4.      They cost a small % of income or are bought infrequently.

·         In the short term demand is usually more inelastic because it takes time to find alternatives

·         If the price of chocolate increased demand would be inelastic because there are no alternatives, however if the price of Mars increased there are close substitutes in the form of other chocolate therefore demand will be more elastic.

Unitary Elastic Demand

Where PED is =1, i.e the change in quantity demanded is in the same proportion as the change in price.

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase in revenue. This is why OPEC try to increase the price of oil.

2. If demand is elastic, firms would be unlikely to increase revenue as this could lead to a fall in revenue. Instead they could try advertising to increase brand loyalty and make demand more inelastic

3. Price Discrimination. Some people pay higher prices for tickets for trains because there demand is more inelastic.

4. Tax incidence. If demand is price inelastic, then a higher tax will lead to higher prices for consumers (e.g. tobacco tax). The tax incidence will mainly be borne by consumers. If demand is price elastic, firms will face a bigger burden, and consumers will have a lower tax burden.