Price elasticity of demand (PED)
Explain the concept of price elasticity of demand understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve
As already known, price and quantity demanded have a negative relationship. As price increases, demand decreased. PED enables us to know by how much there is a change in quantity to a given price change.
Price Elasticity of Demand - PED is calculated along a demand curve. If there is a bigger proportionate change in quantity demanded to the price, demand is referred to as Price Elastic. If there is a smaller proportionate change in quantity demanded to the price change, it is referred to as Price Inelastic.
Therefore, PED is the measure of the responsiveness of the demand in the market to a change in price.
The Equation for PED is :
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Remember, a PED value cannot be determined by the slope of curve, and the segments of the curve which PED is calculated for, is different to different segments of the same curve. This is because, each segment has different values, thus the percentage change is different to. Therefore, remember not to call a whole curve inelastic or elastic or whatever! IF you do, make sure you have based it on a specific segment!
There are a few things to be considered about the PED value.
Substitues: If a product has many, and close substitutes, the the PED would be of a very high value. For instance a good substitute of CocaCola is Pepsi/Big Cola, therefore they are good substitutes. Meanwhile, if you have CocaCola and Orange Juice, the PED won't be as high as they are not good substitutes. Also, the narrower the good is defined, the more the subtitles. E.g. The may not be many substitutes for 'cars' but there are many substitutes for Honda Civic's (e.g. Toyota Prius, Nissan Teana etc.)
Necessities vs Luxuries: As this is pretty obvious, I won't explain this in much detail. Necessities have a lower PED as a price change means the good still has to be bought. While luxuries have a high PED as the good can be compromised for. Theory of Needs vs Wants.
Length of time: This literally means what is says! The length of time taken to make a decision on a purchase of a good. The longer the time taken, the more the PED (more elastic) as consumer takes time to look at alternatives, practicalities and substitutes.
Proportion of income spent on a good: The higher the proportion of income the good's purchase takes up, PED is more elastic. For example, for a person with a $10000 salary, they would put thought into buying a refrigerator worth $8000, instead of a mobile phone costing $1000. Meanwhile, a person with a wage of $10 would spend more time on purchasing a meal worth $8 instead of a pen worth 50p. Therefore, the more the portion of the income, the more elastic the PED.
PED's can be compared between two curves if they have an intersection between each other.
You may calculate a PED using a graph, by just figuring out the values and reading it off substituting it into your equation above.
Explain the concept of price elasticity of demand understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve
As already known, price and quantity demanded have a negative relationship. As price increases, demand decreased. PED enables us to know by how much there is a change in quantity to a given price change.
Price Elasticity of Demand - PED is calculated along a demand curve. If there is a bigger proportionate change in quantity demanded to the price, demand is referred to as Price Elastic. If there is a smaller proportionate change in quantity demanded to the price change, it is referred to as Price Inelastic.
Therefore, PED is the measure of the responsiveness of the demand in the market to a change in price.
The Equation for PED is :
%CHANGE IN QUANTITY DEMANDED
%CHANGE IN PRICE
Considering that PED is always a negative value, because price and quantity demanded are inversely proportion, it is assumed that the value is negative, therefore the absolute value is taken instead (minus sign dropped)
Example of Working Out
If there is no differentiation between the initial and the final value of price and quantity, the average percentage is used instead.
e.g.
Change in Price
(P0+P1)/2
Different Values of PED
Graphs for each type of PED value:
Remember, a PED value cannot be determined by the slope of curve, and the segments of the curve which PED is calculated for, is different to different segments of the same curve. This is because, each segment has different values, thus the percentage change is different to. Therefore, remember not to call a whole curve inelastic or elastic or whatever! IF you do, make sure you have based it on a specific segment!
There are a few things to be considered about the PED value.
Substitues: If a product has many, and close substitutes, the the PED would be of a very high value. For instance a good substitute of CocaCola is Pepsi/Big Cola, therefore they are good substitutes. Meanwhile, if you have CocaCola and Orange Juice, the PED won't be as high as they are not good substitutes. Also, the narrower the good is defined, the more the subtitles. E.g. The may not be many substitutes for 'cars' but there are many substitutes for Honda Civic's (e.g. Toyota Prius, Nissan Teana etc.)
Necessities vs Luxuries: As this is pretty obvious, I won't explain this in much detail. Necessities have a lower PED as a price change means the good still has to be bought. While luxuries have a high PED as the good can be compromised for. Theory of Needs vs Wants.
Length of time: This literally means what is says! The length of time taken to make a decision on a purchase of a good. The longer the time taken, the more the PED (more elastic) as consumer takes time to look at alternatives, practicalities and substitutes.
Proportion of income spent on a good: The higher the proportion of income the good's purchase takes up, PED is more elastic. For example, for a person with a $10000 salary, they would put thought into buying a refrigerator worth $8000, instead of a mobile phone costing $1000. Meanwhile, a person with a wage of $10 would spend more time on purchasing a meal worth $8 instead of a pen worth 50p. Therefore, the more the portion of the income, the more elastic the PED.
PED's can be compared between two curves if they have an intersection between each other.
You may calculate a PED using a graph, by just figuring out the values and reading it off substituting it into your equation above.
Credit:http://economics.illinoisstate.edu/ntskaggs/images/graph.gif
As mentioned before, PED's are vital for market analysis for firms as it helps them make a choice and reason methods to increase their total revenue (TR)
- When demand is elastic, increase in prices cause a decrease in TR, while a decrease in price results in increase in TR
- When demand is inelastic, an increase in price results in an increase in TR, while a decrease in price results in a fall in TR
- If demand is unit elastic, a change in price doesn't change TR (TR is maximum when price is at a point where demand in unit elastic)
Also, you must explain why PED is low for commodities and high for manufactured, secondary goods. The simple reason is that primary commodities are necessities and don't have substitutes. While manufactured products usually have substitutes.
The consequences of a low PED for commodities means that as the demand is inelastic, a shift in the supply curve leads to highly fluctuated change, which is defined as volatile.
Possible fun theory: In this theory, it would actually be good for a farmer's crop to be bad as demand for agriculture goods is inelastic, and if there is decrease in supply, the prices increases, which increases the TR! However, the instability of crops is in fact a disadvantage to farmers.
PED's are vital for governments to know, as it enables them to know what goods they can place indirect taxes on. For instance, a good like cigarettes has a low PED as its an addiction for many, which they will give any price for. Therefore, a tax would not lead to a big different quantity of consumption, meaning that the government can earn loads of revenue, without risking jobs of people who are in the production of cigarettes. Also, the extra price would mean that some consumption is reduced, leading to better social welfare.
Cross-Price Elasticity of Demand (XED)
XED is a measure which indicates the responsiveness of demand of one good, to a change of a price of another group.
- Unlike PED, XED values have to have an either - or + sing to signs ify the value.
- Two substitutes will always have a positive value, and the more the elasticity of XED, the better they are substitutes of each other
- Two compliments goods have a negative XED value, the larger that absolute value of XED, the better the compliments they are
Situations where businesses would be wanting to know the XED
- Substitutes produced by single business: For e.g., in many occasions a business produces two products that are actually rivals, or in better terms, substitutes. For example, PepsiCo produces both, Pepsi and Mountain Dew. Therefore, if PepsiCo figures out the XED of its two products, it would be easier to make decisions, like setting a price. E.g. if XED is positive and low, it shows that both are substitutes, and a decrease in price of Pepsi will lead to a small decrease in the demand for Mountain Dew. While a large XED value means that a small drop in the price of Pepsi will lead to large decrease in the demand for MountainDew. Therefore, PepsiCo could have to find a good balance if it is to maximise its TR.
- Substitutes produced by rival business: If, for example, the XED between Macs and Samsung laptops was a big positive value, Apple would know that decreasing the price of Macs, would mean Samsung's sales will drastically drop, and eventually may get rid of a bit of competition
- Substitutes and mergers between firms: A merger is when two firms choose to join and make a single firm. Therefore, a firm merging with another firm would like if the value of XED is large and positive between them as it means that they would be able to eliminate completion by a substitute.
- Complementary Goods: Firms would occasionally like to know which other firms or goods their products are highly complementaries of. For instance, a hotel package firm and a flight booking firm would be big complements of each other (as one promotes the purchase of the other), therefore firms may collaborate to increase revenues.
Income Elasticity of Demand (YED)
The YED is a measure of the responsiveness of demand (causing a shift in D curve) to a change in income
YED is often used in the context of two types of goods
- Normal Goods: Normal goods are goods which have a positive value for YED. Meaning, that the demand is proportional to income. Most goods are normal goods. E.g. Demand for iPhone drops as income drops
- Inferior Goods: Inferior goods have a negative value for YED. Demand for such goods increases when there is a fall in income (inversely proportional). For example, the demand for public buses increases with a fall in people's income as people can't afford cars or other expensive transport systems.
It is also important to distinguish between necessity and luxury goods
- Necessity goods have a YED of less than one, (YED<1) and thus are called income inelastic demand. A percentage increase in income produces a smaller percentage in quantity demand.
- Luxury goods have a YED of more than one. (YED>1) and thus are called income elastic demand. A percentage increase in income produces a larger proportionate percentage increase in quantity demanded.
YED and markets
If a good or service has a big YED, the possibility of its expansion in the future is bigger. However, if there is a decrease in income, it would be one of the worst hit markets.
A product with a low YED would not have much expansion potential, but would be a far more stable one in case of fluctuations in the income.
YED and the Economy
An economy has 4 sectors, the primary, secondary, tertiary and quaternary (will ignore for now).
The Primary sector involves raw materials and agriculture produce etc. While the secondary sector is based on manufactured goods, and the tertiary focuses on services. With economic growth, the relative sizes of the sectors changes, which can be viewed through the YED measure.
For an agro economy, the YED for the primary goods are positive but generally with a YED of less than one (income inelastic demand). Therefore, if income rises there is a smaller proportionate change in the demand for primary goods. For instance, Thailand was previously known for its rubber production, however as the income of the local people has risen a lot , the focus has been on manufactured synthetic goods such as plastic. Therefore, now the thai economy has a large manufacturing sector.
Furthermore, the YED for manufactured food is above 1 but not much, therefore as income rises, a larger increase in the secondary sector, and with constant increase in income, the manufacturing sector starts to shrink, while the territory sectors with services (banking, healthcare, education etc.) increases.
Therefore, less developed countries have a large primary sector, more developed countries have a large secondary sector, and very developed countries have a large tertiary sector. And the same follows with the income.
The process of the sector shifts, suggests an increase in total output over time, and thus economic growth.
Note: This doesn't mean that the primary sector is shrinking or not growing. It means that the primary sector of an economy is growing, but slower than other sectors meaning that other sectors are now making a larger percentage of the total output.
Price Elasticity of Supply (PES)
The PES is the responsiveness of supply to a change in price. PES is calculated along a given supply curve.
- Supply is Price Inelastic (PES<1) when the value is less than one, meaning that there is a less proportionate change in supply to a price change. (HL: Note that for price inelastic supply graphs, the Q intercept is positive (intercepts at P=0) )
- Price Elastic supply is when value is more than one (PES>1) . Therefore, there is a larger proportionate change in supply to a change in price.
- Supply is unit elastic (PES=1) when the price change and quantity supplies are proportionate. (Any curve that passes through origin)
- Supply is perfectly inelastic when PES= 0. That means quantity supplied change doesn't change at all to any difference in price.
- Supply is perfectly inelastic (PES = infinite) when a small change in price leads to a massive change in quantity supplied.
Determinants of PES
- Time to produce : If a good is easy and quick to produce, it would be very likely that supply can easily change when theres a price change, in which case the supply would be elastic.
- Mobility of factors of production: The ease and speed with which firms can shift resources into the production of a good with a higher price, the higher the elasticity.
- Spare capacity of firms: In many cases, firms have a lot of spare resources and machinery that can easily be brought to use. In this case, the PES would be elastic.
- Ability to store stocks: If a firm can produce and stock its produce, and release whenever appropriate (to a specific price change) , the PES would be high. If the produce is too large or is not sortable (e.g. Agriculture produce that may get rotten), the PES won't be high
PES and types of produce
- Primary Commodities: Primary Commodities have a very low PES because firstly, they take much time to produce (e.g. takes a lot of time to grow wheat) . Secondly, agriculture goods, especially edible items, can often be stored for a long time, which also mens that supply can't be manipulated, thus PES is low as well. Another similar case can be the scarcity of resources. For instance, supply decreases if the oil wells in middle east dry up, in which case it would be hard to change the supply.
- Manufactured Commodities: Manufactured goods are generally more long lasting, and can be kept in stocks, therefore price can determine the quantity of supply when needed. Also, manufactured goods have very efficient machinery, thus supply can also be increased if needed.
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