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Lifetime Learning… Building Success… Towards Globalization

Economics -Chapter 3Elasticity

Lifetime Learning… Building Success… Towards Globalization

The Price Elasticity of Demand

• What is price elasticity of demand?

• The price elasticity of demand (PED) measures how much thequantity demanded of a good changes when its price changes.

• PED measures the responsiveness of the quantity demanded(QD) of a product to a change in its own price.

EIBFS/Economics

• Formula for calculating PED.

• PED = “percentage change in quantity demanded

percentage change in price.

• Can be rewritten as:Ed = ∆Q x P

∆P x Q

– Q: the original Quantity

– P: the original Price

– ∆Q: the change in quantity (New Quantity – Old Quantity)

– ∆P: the change in price( New Price – Old Price)

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Example

• Price increase from 10p to 20p

• Quantity demanded falls from10m to 8m per week.

• PED = Δq x pΔ p q

• q = 10 p = 10

• Δq = - 2 Δp = 10

Ed = -2 x 10 = - 0.2

• 10 10

• Ignore the negative sign.

• The absolute value is less than one; Inelastic demand

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Example

• Price increase from 30p to 40p

• Quantity demanded falls from6m to 4m per week.

• PED = Δq x pΔ p q

• q = 6 p = 30

• Δq = - 2 Δp = 10

Ed = -2 x 30 = 1

• 10 6

• The absolute value is one; Unity or unit elastic demand

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Example

• Price increase from 40p to 50p

• Quantity demanded falls from4m to 2m per week.

• PED = Δq x pΔ p q

• q = 4 p = 40

• Δq = - 2 Δp = 10

Ed = -2 x 40 = 2

• 10 4

• The absolute value is more than one;

• Elastic demand

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Measuring PED

• On a straight line demand curve the price elasticity of demandincreases as the price rises and the quantity demanded falls.

• Demand curve is more elastic as we move up the demandcurve from right to left.

• The reason for the negative sign is because of the negativeslope of the normal demand curve, therefore we ignore it.

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Types of Price Elasticity of Demand

Inelastic Demand

Elastic Demand

Unit Elastic Demand

Perfectly inelastic demand

Perfectly elastic demand

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Types of Price Elasticity of Demand

• Inelastic Demand: when the percentage change in quantitydemanded is less than the percentage change in its price.

• Elastic Demand: when the percentage change in quantitydemanded is greater than the percentage change in its price.

• Unit Elastic Demand: when the percentage change in quantitydemanded and percentage change price are equal.

• Perfectly inelastic demand: Whatever the % change in priceno change in quantity demanded.

• Perfectly elastic demand: An infinitely small % change in priceleads to infinitely large % change quantity demanded.

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• Inelastic Demand: % change in demand is less than one

• Elastic Demand: % change in demand is more than one

• Unit Elastic Demand: % change in demand is equal to one.

• Perfectly inelastic demand: Zero elastic, No change indemand due to change in price

• Perfectly elastic demand: infinity An small % change in priceleads to infinitely % change in demand.

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Varying Elasticity Curve __ Straight Line Demand Curve

•PED, usually varies along the length of demand curve on a straight line demand curve.

• Above the mid point the PED isgreater than 1; Elastic.

• Below the mid point PED isless than 1; Inelastic

• At the mid point PED is equalto 1; Unity

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Exceptions Constant Elasticity Curves

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Perfectly inelastic Perfectly elastic Unity elastic

•A Vertical Demand Curve has a constant elasticity of zero(Perfectly Inelastic)•A Horizontal Demand Curve has a constant elasticity of infinity ( PerfectlyElastic)•A Rectangular hyperbola Curve has a constant elasticity of one ( Unit elastic)

Varying Elasticity

Straight Line Demand Curve

• Above the mid point:

• PED; Greater than 1; Elastic

• Below the mid point:

• PED; Less than 1; Inelastic

• Mid point;• PED; Equal to 1; Unity

Constant Elasticity Demand Curves

• Vertical Demand Curve

– Perfectly Inelastic=0

• Horizontal Demand Curve

– Perfectly Elastic= infinity

• Rectangular hyperbola Curve

– Unit Elastic = 1

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Price elasticity of demand and Total Revenue

• Price elasticity of demand is important in relation toits effect on total revenue.

• Total revenue (TR) is total amount obtained from the sale ofa product.

Total Revenue = Price x Quantity sold

TR = P x q

where, P is price and q is quantity.

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Elasticity and Total Revenue

• Demand is Elastic→ PED >I

– Fall in price: Total revenue rises

– Rise in price: Total revenue falls

• Demand is Inelastic → PED < I

– Rise in price: Total revenue rises

– Fall in price: Total revenue falls

• Demand is Unit elastic → PED = I

– No change in Total Revenue

* (ignoring sign)

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Relationship between Price elasticity of demand and Total Revenue

Elasticity of Demand Price Total Revenue

Elastic >1 Fall

Rise

Rise

Fall

Unity PED=1 Fall

Rise

No change

No change

Inelastic <1 Fall

Rise

Fall

Rise

Factors Determining Price Elasticity of Demand

Two main important factors that determine the value ofPED are:

a) Availability of close substitutes: The closer the substitutefor a good, the more elastic the demand. ( the consumershall switch to closer substitute)

b) Time period. The longer the time available the more elasticthe demand as consumers take time to adjust theirpurchasing habits.

EIBFS/Economics