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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 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 unit elastic • If Ped > 1, then demand responds more than proportionately to a change in price
Perfectly Elastic Demand Perfectly Inelastic Demand Demand Price Price P2 P1 P1 Demand P3 Q2 Q1 Q3 Q1 Quantity Quantity Demand curves with different price elasticity
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 Demand in segment B of the market is relatively inelastic. A higher unit price is charged and total revenue also increases Price 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 Quantity Qb Qa Qa Qb 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 Elastic demand For a price fall Ped>1 Inelastic demand For a price fall Ped < 1 Demand (D)
Price Elasticity of Demand along a Demand Curve When price falls from £90 to £80 Total revenue increases Demand (D)
Price Elasticity of Demand along a Demand Curve When price falls from £30 to £20, total revenue decreases Demand (D)
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 Perfectly Elastic Demand
Extreme Values for Price Elasticity of Demand Perfectly Inelastic Demand
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) Peak and Off Peak Demand • (7) The breadth of definition of a good or service
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 Second Global Oil Shock First OPEC oil shock Gulf War Strong Global Growth Asian Crisis Nominal Price Real Price OPEC collapse
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
Short Term Demand for Oil Oil Demand Price $ per barrel 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 P3 P1 P2 D short-run Q3 Q1 Q2 Demand for Oil
Longer Term Demand for Oil – More Price Elastic Oil Demand Price $ per barrel Longer run demand is relatively more elastic if non-oil substitutes develop P3 P1 P2 D long-run D short-run Q3 Q1 Q2 Demand for Oil
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? • Will the introduction of road tolls in London and other cities actually cut road congestion?