Download - Price elasticity demand
Price Elas+city of Demand
EdExcel Economics 1.2.3
What is Price Elas+city of Demand?
• Price elas4city of demand (PED) measures the responsiveness of demand a=er a change in the good’s own price
• The basic formula for calcula4ng the co-‐efficient of price elas+city of demand is: – Percentage change in quan+ty demanded divided by the percentage change in price
• All normal goods with downward sloping demand curves will have a nega4ve coefficient of price elas4city of demand
• Since changes in price and quan4ty usually move in opposite direc4ons, usually we do not bother to put in the minus sign
• We are more concerned with the co-‐efficient of elas+city
Elas4city is the responsiveness of X to a change in another variable
Price Elas+city of Demand in Ac+on
WH Smith have recently reduced the price of its Kobo Mini E-‐reader from £60 to £40. They predict that sales of the E-‐reader will increase from 15,000 units a month to 25,000 a month (na4onwide).
What is the price elas4city of demand for this price change for the Kobo Mini-‐reader? % change in price = -‐33% % change in demand = +66% Coefficient of PED = 2 I.e. demand is price elas4c
A business that makes suitcases aimed at holidaying tourists has increased its prices by 5%. As a consequence, they have seen a drop in sales between January and March by 15% (compared to the same 4me last year)
Calculate the price elas4city of demand and comment on the effect on total revenue % change in price = +5% % change in demand = -‐15% Coefficient of PED = 3 Total revenue will fall
Numerical Values for Coefficient of Price Elas+city
1. If Ped = 0 demand is perfectly inelas4c -‐ demand does not change when the price changes – the demand curve is ver4cal
2. If Ped is between 0 and 1 (% change in demand is smaller than the percentage change in price), then demand is inelas4c
3. If Ped = 1 (% change in demand is the same as the % change in price), then demand is unit elas4c. A 15% rise in price would lead to a 15% contrac4on in demand leaving total spending the same at each price level
4. If Ped > 1 then demand responds more than propor4onately to a change in price i.e. demand is elas4c. For example if a 10% increase in price leads to a 30% drop in demand. The price elas4city of demand for this price change is –3
Exam Hint: Be careful when discussing ‘food’ or ‘electrical goods’ – different classifica4ons within these groups will have different values of elas4city of demand and / or supply
What factors determine the PED of a product?
Number of close subs+tutes available for consumers • The more close subs4tutes there are, the more price elas4c the demand e.g. many brands of breakfast cereal
Price of the product in rela+on to total income • When the % of budget is high, demand is usually more price sensi4ve i.e. price elas4c
Cost of subs+tu+ng between different products • When subs4tu4on/switching costs are high, demand will tend to be price inelas4c
Brand loyalty and habitual consump+on • High levels of brand loyalty makes demand less price elas4c • Persuasive adver4sing can make demand price inelas4c
Degree of necessity / luxury • Standard assump4on is that necessi4es have a lower price elas4city of demand whereas luxuries are an op4onal spend
Inelas+c Demand (Ped < 1)
• Following a change in price, the total revenue earned by the producing firm will depend on the PED for its product.
• If the coefficient of PED is <1, a rise in market price (e.g. from P1 to P2) will lead to an increase in total revenue for the seller of the product.
If the co-‐efficient of price elas4city of demand <1, then demand is said to be price inelas+c i.e. unresponsive to a change in price
Price
Quan4ty
P1
P2
Q1 Q2
Demand
Increased revenue from selling at a higher price
Lost revenue from the
contrac4on in quan4ty sold
Example of Inelas+c Demand – Rare Earths
• China is the dominant supplier of rare earths – producing over 90% of world output
• The lack of close subs4tutes makes demand price inelas4c
• Low PED provides China with a source of monopoly power and creates condi4ons in which China can restrict exports of rare-‐earth metals causing price to rise and increase their total revenue
Rare-‐earth metals are an essen4al raw material in the manufacture of solar cells and bakeries and car catalysts
Projected global demand for products containing rare earths in
2014 (% change) Magnets 42
Batteries 13
Displays (containing phosphor) 10
Polish 10
FCC (molecule splitting) 9
Others 5
Extractive metallurgy 5
Car catalysts 4
Vitrious additives 3
Elas+c Demand (Ped > 1)
• If demand for a product is price elas4c, a supplier stands to gain extra revenue if they reduce their prices.
• The change in quan4ty demanded will be propor4onately higher than the reduc4on in price. This is shown in the diagram opposite.
If the co-‐efficient of price elas4city of demand >1, then demand is said to be price elas+c i.e. highly responsive to a change in price
Price
Qty
P2
P1
Q1 Q2
Demand
Increased revenue from selling more at a lower price
Lost revenue from selling at a lower price
Perfectly Inelas+c Demand (Ped = 0)
• A perfectly inelas4c demand curve is an extreme case.
• It implies that consumers are willing and able to pay any price for the product.
• If supply falls, equilibrium market price can rise without any contrac4on in quan4ty demanded.
If the co-‐efficient of price elas4city of demand = zero, demand is perfectly inelas+c i.e. demand does not vary with a change in price
Price
Qty
P2
P3
Demand
P1
Q1
S1
S2
S3
Perfectly Elas+c Demand (Ped = infinity)
• If demand is perfectly elas+c, a change in market supply (shown on the right as an outward shi= of supply) will not lead to any change in the equilibrium price.
• This demand curve applies to highly compe++ve markets where no supplier has any “pricing power”
If the co-‐efficient of PED = infinity, then demand is perfectly elas+c – there is one price at which consumers are prepared to pay
Price
Qty
P1 Demand
S1 S2
Q1 Q2
Unitary Elas+c Demand (Ped = 1)
• With a demand curve of unitary price elas+city, a change in price is met with a propor+onate change in demand
• This means that total spending by consumers on the product will remain the same at each price level
A demand curve with unitary price elas4city has a coefficient of PED equal to 1 (unity) throughout
Price
Qty
P1
Q1 Q2
P2
Demand
Co-‐Efficient of PED along a linear demand curve
• Price elas4city of demand along a straight line demand curve will vary
• At high prices, a reduc4on in price will have an elas4c price response – i.e. lower prices cause total revenue to rise
• Demand is price inelas4c towards the bokom of the demand curve – a fall in price causes total revenue to drop
For a straight-‐lined demand curve, the PED varies along the curve
Price
Qty
P1
D
Q1
P2
Q2
A fall in market price from P1 to P2 causes total spending to rise, therefore PED >1
P3
P4
Q3 Q4
A fall in price from P3 to P4 causes total spending to fall, therefore PED <1
Usefulness of Price Elas+city of Demand for Producers
Firms can use PED es4mates to predict: 1. The effect of a change in price on total revenue of sellers 2. The price vola+lity in a market following changes in supply –
this is important for commodity producers who suffer big price and revenue shi=s from one 4me period to another.
3. The effect of a change in an indirect tax on price and quan4ty demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
PED can be used by a business for price discrimina+on. • This is where a supplier decides to charge different prices for the
same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many airlines.
• Usually a business will charge a higher price to consumers whose demand is price inelas4c
• The taxi company Uber for example engages in surge pricing
Price Elas+city in Ac+on: Uber and Surge Pricing
Surge Pricing
Peak Demand
• Uber is a fast-‐growing taxi service app that now operates in more than 50 countries
• In May 2015, Uber was valued at about 41 billion U.S. dollars by venture-‐capital firms
• Uber engages in surge pricing – also known as dynamic pricing
• When market demand out-‐strips available supply e.g. at peak 4mes, then Uber raises the average fare on their app
• The aim is to encourage more drivers to take to the roads to expand supply
• The business is taking advantage of low price elas4city of demand at busy 4mes
• Some economists have cri4cised this policy especially during emergencies
Cri+cal Awareness: Limita+ons of Elas+ci+es
Problems with inaccurate or
incomplete data collec4on
Consumer price sensi4vity changes over
4me
Elas4city of demand varies by region / 4me
Not all businesses are profit maximisers
Elas4city will vary within product ranges e.g. economy and premium products
Rival producers will change their market
strategies from 4me to 4me
Price Elas+city of Demand
EdExcel Economics 1.2.3