Price Elasticity of Demand A basic introduction to the important concept of price elasticity of demand and its relevance both to businesses and consumers.

Applications of the idea of elasticity of demand The introduction of the congestion charge for motorists in London Consumer response to recent cuts in the prices of broadband access to the net How will demand for air travel respond if a new tax on aviation fuel is introduced?

Definition of Price Elasticity Price elasticity (Ped) measures responsiveness of demand to change in price of good itself Formula for calculating Ped is Ped = % change in Qdx / % change in Px When price falls we expect to see an expansion of demand When price rises we expect to see a contraction of demand Therefore an inverse relationship between price and demand (negative value for Ped) We ignore the sign but focus instead on the coefficient of elasticity

Values for price elasticity of demand If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is price inelastic If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to be unit elastic If Ped > 1, then demand responds more than proportionately to a change in price. Demand is said to be price elastic

Demand curves with different price elasticity Perfectly Elastic Demand Perfectly Inelastic Demand Demand Quantity Q1 Q2 Q3 P1 P2 P3

Inelastic and elastic demand curves Relatively Inelastic Demand Relatively Elastic Demand Price Price P2 P2 P1 P1 P3 P3 Demand Demand Q2 Q1 Q3 Q2 Q1 Q3

Elasticity of demand and total revenue Market A Market B Price Price Demand in segment B of the market is relatively inelastic. A higher unit price is charged and total revenue also increases Higher revenue from reducing the price from Pa to Pb (the gain in quantity sold more than offsets the lower price per unit) Pb Pa Pa Pb Demand Demand Qa Qb Quantity Qb Qa Quantity

Importance of price elasticity of demand for a business Firms can use price elasticity of demand (PED) estimates to predict: The effect of a change in price on quantity demanded The effect of a change in price on total revenue & expenditure The likely price volatility in a market following unexpected changes in supply – important for commodity producers The effect of a change in indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer Information on the price elasticity of demand can be utilized as part of a policy of price discrimination (or yield management). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel

Price Elasticity of Demand – A Relative Elastic Demand Price falls from £350 to £250 % change in price = 60% % change in demand = 100% Price elasticity = 1.67 i.e. demand is price elastic A B Demand

Price Elasticity of Demand – A Relatively Inelastic Demand B Price rises from £3.00 per packet to £6.00 following an series of increases in government taxes % change in price = 100% % change in demand = 20% Price elasticity = 0.2 i.e. demand is price inelastic Demand A

Price Elasticity of Demand along a Demand Curve Tutor2u Economics Revision Price Elasticity of Demand along a Demand Curve Elastic demand For a price fall Ped>1 Inelastic demand For a price fall Ped < 1 Demand (D) At mid-point of demand curve, price elasticity of demand = 1 Geoff Riley www.tutor2u.com

Price Elasticity of Demand along a Demand Curve Tutor2u Economics Revision Price Elasticity of Demand along a Demand Curve When price falls from £90 to £80 Total revenue increases Demand (D) At mid-point of demand curve, price elasticity of demand = 1 Geoff Riley www.tutor2u.com

Price Elasticity of Demand along a Demand Curve Tutor2u Economics Revision Price Elasticity of Demand along a Demand Curve When price falls from £30 to £20, total revenue decreases Demand (D) At mid-point of demand curve, price elasticity of demand = 1 Geoff Riley www.tutor2u.com

Demand Curves With Different Price Elasticity Relative Inelastic Demand

Demand Curves With Different Price Elasticity Relative Elastic Demand Relative Inelastic Demand

Extreme Values for Price Elasticity of Demand Tutor2u Economics Revision Extreme Values for Price Elasticity of Demand Perfectly Elastic Demand Perfectly inelastic demand – consumers totally insensitive to price changes Perfectly elastic demand – when each firm in the market produces perfect substitutes Geoff Riley www.tutor2u.com

Extreme Values for Price Elasticity of Demand Tutor2u Economics Revision Extreme Values for Price Elasticity of Demand Perfectly Inelastic Demand Perfectly inelastic demand – consumers totally insensitive to price changes Perfectly elastic demand – when each firm in the market produces perfect substitutes Geoff Riley www.tutor2u.com

Elasticity of Demand for a non-linear Demand Curve Tutor2u Economics Revision Elasticity of Demand for a non-linear Demand Curve Demand Perfectly inelastic demand – consumers totally insensitive to price changes Perfectly elastic demand – when each firm in the market produces perfect substitutes Geoff Riley www.tutor2u.com

Factors that Determine Ped Tutor2u Economics Revision Factors that Determine Ped (1) The number of close substitutes for a good / uniqueness of the product (2) The degree of necessity of consumption or whether the good is a luxury (3) The % of a consumer’s income allocated to spending on the good (4) The time period allowed following a price change (5) Whether the good is subject to habitual consumption – (6) The breadth of definition of a good or service. ( brand PED is often elastic, whereas the product’s PED may be inelastic) Key factor is the number of close substitutes in the market and the ease of switching Geoff Riley www.tutor2u.com

Elastic or Inelastic demand? Gateway cuts the price of their desktop PCs by 10% A fall in the price of Euro-star tickets An increase in the price of the Financial Times A taxi home from a night-club on a Friday night A rise in average car insurance premiums Motorway petrol prices rise by 5% after the budget Vodafone cuts their mobile phone charges The price of central heating oil rises by 20% due to a rise in world oil prices A local leisure club decreases monthly charges by 15% in a bid to increase the number of members

Case Study: Demand for Oil after Shocks

Time Frame and Elasticity: Oil Price Shocks Tutor2u Economics Revision Time Frame and Elasticity: Oil Price Shocks The longer the time frame => the more elastic is demand Two World oil price shocks of the 1970s Response to higher prices was modest in the immediate period As time passed, people found ways to consume less petroleum and other oil products Better mileage from their cars (switch to smaller vehicles) Higher spending on insulation in homes and factories Car pooling for commuters Car manufacturers invested enormous sums in more fuel efficient vehicles seeing a long term market opportunity Development of oil substitutes in the long run natural gas, solar heating, nuclear energy Higher prices made it more attractive to exploit higher cost reserves of oil – which increased supply and brought prices down again Long run demand will be more elastic than short run demand Geoff Riley www.tutor2u.com

Short Term Demand for Oil The demand for oil is inelastic in response to price changes in the short run This is mainly because it is an essential input into many production processes Price $ per barrel Oil Demand P3 P1 P2 D short-run Q3 Q1 Q2 Demand for Oil

Longer Term Demand for Oil – More Price Elastic Longer run demand is relatively more elastic if non-oil substitutes develop Price $ per barrel Oil Demand P3 P1 P2 D long-run D short-run Q3 Q1 Q2 Demand for Oil

Using Price Elasticity of Demand Tutor2u Economics Revision Using Price Elasticity of Demand How much tax revenue will higher “sin taxes” on cigarettes and alcohol provide? Why do airlines often give discounts for advance bookings? What happens to our demand for foreign holidays when the exchange rate appreciates? Why do hotels lower room-rates at weekends and why do car rental firms charge lower prices at weekend? Will a business always pass on higher costs to consumers (and this also applies to indirect taxes) ? Will the introduction of road tolls in London and other cities actually cut road congestion? Price elasticity of demand has many applications in the A Level syllabus Geoff Riley www.tutor2u.com