IGCSE Economics: Price Elasticity of Demand

IGCSE Economics: Price Elasticity of Demand Price Elasticity of Demand: ❖ Price elasticity of demand tells us how much quantity demanded will change when prices are changed. ❖ Official definition: In examining PED, we want to find out how much will demand fall or rise with a change of price for a certain good or service. ❖ Unofficial explanation: PED measures the responsiveness of quantity demanded to a given price change for a certain good or service. ❖ Since PED is always negative it is acceptable to state it as a positive figure. ❖ If the PED<1 then the demand is said to be price inelastic meaning that for any change in price there will only be a smaller change in quantity demanded. For instance, if the PED is ½ or 0.5 then for each 20% change in price there will only be a 10% change in quantity demanded. ➢ Demand is said to be price inelastic when the percentage change in quantity demanded is less than the percentage change in the price for a given good or service. ❖ If the PED>1 than the demand is said to be price elastic, meaning that if one was to have a change in price, there will be a larger change in quantity demanded. For instance, if the PED is 2 than for every 10% change in price there will be a 20% change in quantity demanded. ➢ Demand is said to be price elastic when the percentage change in price is less than the percentage change in quantity demanded for a given good or service. ❖ It is because some goods are price elastic (e.g. clothing) that you get big sales. With these goods the drop in revenue created by a fall in price is more than reimbursed by the rise in revenue caused by a rise in quantity demanded. ❖ Luxury goods usually have a demand curve with a shallow slope which tells us that demand is price elastic. ❖ Things like tap water and medicine are price inelastic because they are necessities necessary for the continuation of life. As such their price is closely regulated by the government to prevent any firms from abusing this fact and setting prices that are unreasonably high in order to achieve large profits. Special Cases: ❖ When PED = 0 then there will be no change in quantity demanded no matter the change in price. (Perfectly inelastic demand.) ❖ When PED = ∞ then there will be no quantity demanded at all for any price, i.e. quantity demanded = ∞. (Perfectly price elastic.) ➢ Infinite change in quantity demanded for any change in price. ❖ When the PED = 1 then any percentage change in quantity demanded will be equal to the percentage change in price when multiplied by -1. (Unitary elasticity.) What Influences PED: ❖ Availability of substitutes: ➢ i.e. Nike sports-ware has quite a few substitutes thus its demand is price elastic. ➢ The more substitutes a good or service has the more price elastic the demand for that good or service is. ❖ Habits and addiction: ➢ Things that are habitual to us or things that we are addicted too generally are price inelastic. ➢ For instance a smoker cannot just decide suddenly to stop smoking or to smoke less because the price of cigarettes has gone up. ❖ Advertising and brand loyalty: ➢ Brand loyalty is how much people prefer your brand over other brands. As such brands that are famous and have a high brand loyalty generally have a rather price inelastic demand. ➢ For instance a brand like Nike, being very famous, does not have to suffer much of a fall in quantity demanded for most price rises. Whereas less famous companies like Umbro, tend to have to suffer relatively larger drops in quantity demanded even if their price rise is the same as the price rise affected by Nike. ❖ Time period: ➢ As time passes, there will be more and more substitutes for your product or service. ➢ For instance, 30 years ago oil was the only fuel that could be used to fuel cars but now it is different, we have hybrid cars, electric cars and all sorts of other cars that do not need or need little fuel to function. Thus the demand of oil has become a little more price elastic during the past 30 years. ❖ Proportion of income spent on a given good or service: ➢ If the proportion of one’s income spent on a good is small than it is likely that that good has a demand which is price inelastic. ➢ For instance, newspapers which are very cheap are generally price inelastic. PED and Revenue: ❖ If demand is price elastic than a fall in price would bring a larger, relatively speaking, rise in quantity demanded; thus for these firms, a fall in price is not always a bad thing. ❖ If demand is price inelastic than a fall in price would bring a smaller, relatively speaking, rise in quantity demanded; thus, for these firms, a fall in price is necessarily a bad thing. ❖ If demand is price elastic, decreasing the price benefits the producer more: ➢ Fall in price causes a rise in total revenue. ➢ Rise in price causes a fall in total revenue. ❖ If demand is price inelastic, than increasing the price benefits the producer more: ➢ Rise in price causes a rise in total revenue. ➢ Fall in price causes a fall in total revenue. ❖ Remember that if revenue goes up price does not necessarily have to change. ❖ Proportion of income spent on a given good or service. PED and Tax Considerations: ❖ An increase in tax on a product causes the supply curve to shift to the left because tax is part of the factors of production. Thus an increase in tax also increase the price of the good or service being produced. ➢ Tax also reduces demand but I think this would depend on what type of tax one is talking about. ❖ For a government to collect a substantial tax revenue, taxes should be imposed on goods that have demands that are price inelastic because then an increase in price caused by tax, does not really cause much of a decrease in quantity demanded. ➢ Taxes are put on consumers (people buying products in a retail store) when the demand is inelastic compared to the supply. The tax is put on the producers when the supply is more inelastic.