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Price Elasticity of Demand
Transcript of Price Elasticity of Demand
measure of the responsiveness quantity of a good demanded to changes in its price Price Elasticity Demand (PED) Determinants of PED Availability of substitutes
More substitutes available, the more elastic the demand
Many close substitutes for Product A, increase in price will cause consumers to switch products.
Lead to a relatively large drop in quantity demanded of Product A Broad or Narrow definition of a good/service
Broadly defined - Vegetables
Narrowly defined - Carrots
Broader definition the fewer substitutes it has, less elastic the demand.
Narrow definition the more substitutes it has, more elastic the demand. Necessity vs. Luxury
Necessity - less elastic
Luxury - more elastic
A 10% price change of a necessity will lead to less than a 10% drop in the Quantity Demanded Length of Time
Longer the time a consumer waits to make a purchasing decisions
10% change in price will lead to a greater than 10% change in Quantity Demanded
Heating oil -short term continue to buy -- long term consider alternatives Proportion of Income
The greater the proportion of income needed to buy a good, more elastic the demand.
Pen - small proportion - inelastic demand
Summer holiday - large proportion - elastic demand Addiction
Greater the degree of addiction to a substance the more inelastic the demand Definition & Formula for PED Since Price & Quantity Demanded are inversely related, the sign will always be negative
Take the absolute value Range of Values for PED Percentage change in Quantity Demanded
is smaller than
Percentage change in Price Demand is price inelastic
0 < PED < 1 A 10% change in price leads to less than 10% change in Quantity Demanded Percentage Change in Quantity Demanded
is larger than
Percentage Change in Price Demand is Price Elastic
PED > 1 A 10% increase in Price will lead to a greater than 10% decrease in Quantity Demanded Demand is Unit Elastic
PED = 1 Percentage Change in Quantity Demanded
is equal to
Percentage Change in Price A 5% increase in Price
will lead to
A 5% decrease in Quantity Demanded Demand is Perfectly Inelastic
PED = 0 There is no change in the Quantity Demanded no matter what happens to Price Change in Price leads to a infinitely large response in Quantity Demanded Demand is Perfectly Elastic
PED = Infinity Variable PED & Straight-line Demand Curve On a straight-line Demand Curve
Elastic Portion: high prices & low quantities
Inelastic Portion: low prices & high quantities
Unit Elastic: Mid-point The terms Elastic & Inelastic should not be used to refer to:
Entire demand curve - (except in the three special cases)
Refer to the specific portion of the demand curve that corresponds to a particular price or price range
DO NOT refer to goods as elastic or inelastic - ex. pencils are not inelastic! PED & Total Revenue
Total Revenue: amount of money received by a firm when they sell a good (TR = P x Q) Applications of PED Interested in knowing what will happen to the firm TR when the price of the good is changed. An increase in price will lead to a fall in TR Demand is Elastic - PED > 1 Consider this:
A 5% increase in price will lead to a greater than 5% decrease in Quantity Demanded A decrease in price will lead to a rise in TR Consider this:
A 5% decrease in price will lead to a greater than 5% increase in Quantity Demanded An increase in price leads to an increase in TR Demand is Inelastic - PED < 1 Consider this:
A 10% increase in price leads to leass than a 10% decrease in Quantity Demanded
TR will increase A decrease in Price leads to a decrease in TR Consider this:
A 10% decrease in Price will lead to less than a 10% decrease in Quantity Demanded
TR will decrease A change in price does not cause a change in TR Demand is Unit Elastic - PED = 1 Summary of Results:
Elastic PED - Price & TR change in opposite directions
Inelastic PED - Price & TR change in the same direction
Unit Elastic - As Price changes, TR will not change PED & the Firms Pricing Decision Increase TR a firm must:
Elastic Demand: Decrease its price
Inelastic Demand: Increase Price
Unit Elastic: Firm cannot increase TR with Price change PED & Excise Tax PED & Agricultural Products Food has a highly price inelastic demand.
Food is a necessity and does not have any close substitutes. As agricultural product prices fluctuate so does the farmers income.
Depends on revenues that they receive from selling their good. Poor crop results in a higher price & lower quantity of output.
Inelastic demand - % increase in Price is larger than the % decrease in Qd.
Total Revenue for the farmer increases Good growing season results in:
Lower price - higher output
% decrease in price is larger than the % increase in Qd.
Total Revenue falls.