Elastic Demand Inelastic Demand

Price elasticity of demand (PED)

Price elasticity of demand measures the responsiveness of demand after  a change in price

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

 Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of demand.

 

Values for price elasticity of demand

 

  1. If Ped = 0 demand is perfectly inelastic – demand does not change at all when the price changes – the demand curve will be vertical.
  2. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in price), then demand is inelastic.
  3. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level.
  4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand for this price change is –3

Factors affecting price elasticity of demand

  • The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch
  • The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract.
  • The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.
  • The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will have a more elastic demand
  • The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending.
  • Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).
  • Peak and off-peak demand – demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.
  • The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

Demand curves with different price elasticity of demand

PED

Elasticity of demand and total revenue for a producer / supplier

The relationship between elasticity of demand and a firm’s total revenue is an important one.

  • When demand is inelastic – a rise in price leads to a rise in total revenue –  a 20% rise in price might cause demand to contract by only 5% (Ped  = -0.25)
  • When demand is elastic  – a fall in price leads to a rise in total revenue – for example a 10% fall in price might cause demand to expand by only 25% (Ped  = +2.5)

Peak and Off-Peak Demand and Prices

Why are prices for package holidays more expensive during school holiday weeks? Why are rail fares more expensive at peak times? During peak demand periods, market demand is higher and also more price inelastic. This allows producers to sell their products for higher prices and make increased profits.

Price elasticity of demand

The table below gives an example of the relationships between prices; quantity demanded and total revenue. As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of $12 per unit when 520 units are sold giving total revenue of $6240.

Price

Quantity

Total Revenue

Marginal Revenue

$ per unit

Units

$s

$s

20

200

4000

18

280

5040

13

16

360

5760

9

14

440

6160

5

12

520

6240

1

10

600

6000

-3

8

680

5440

-7

6

760

4560

-11

 

Consider the elasticity of demand of a price change from $20 per unit to $18 per unit. The % change in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly elastic).

In this situation when demand is price elastic, a fall in price leads to higher total consumer spending / producer revenue

Consider a price change further down the estimated demand curve – from $10 per unit to $8 per unit. The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.

Change in the market

What happens to total revenue?

Ped is inelastic and a firm raises its price.

Total revenue increases

Ped is elastic and a firm lowers its price.

Total revenue increases

Ped is elastic and a firm raises price.

Total revenue decreases

Ped is -1.5 and the firm raises price by 4%

Total revenue decreases

Ped is -0.4 and the firm raises price by 30%

Total revenue increases

Ped is -0.2 and the firm lowers price by 20%

Total revenue decreases

Ped is -4.0 and the firm lowers price by 15%

Total revenue increases

Elasticity of demand and indirect taxation

Many products are subject to indirect taxes. Good examples include the duty on cigarettes (cigarette taxes in the Singapore are among the highest) alcohol and fuel. Here we consider the effects of indirect taxes on costs and the importance of elasticity of demand in determining the effects of a tax on price and quantity.

PED and tax

A tax increases the costs of a business causing an inward shift in supply. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier may be able to pass on some or all of this tax to the consumer by raising price. This is known as shifting the burden of the tax and this depends on the elasticity of demand and supply.

Consider the two charts above.

  • In the left hand diagram, the demand curve is drawn as price elastic. The producer must absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold). When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand.
  • In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the range of this demand curve) and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales. The price rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand from Q1 to Q2.

 

Example: Will price cuts work for Sony? Sony is cutting the price of its PlayStation 3 gaming console by nearly a fifth, hoping to jump-start sales of a five-year old device losing ground to Microsoft’s Xbox. The price tag on the 160 GB version has fallen to £200 in the UK and from €299 to €249 in Europe

News reports, Aug 2011.

The usefulness of price elasticity for producers

 

Firms can use PED estimates to predict:

  • The effect of a change in price on the total revenue & expenditure on a product.
  • The price volatility in a market following changes in supply – this is important for commodity producers who suffer big price and revenue shifts from one time period to another.
  • The effect of a change in an 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 PED can be used by a business as part of a policy of price discrimination. This is where a supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines.
  • Usually a business will charge a higher price to consumers whose demand for the product is price inelastic

Price elasticity of demand and changing market prices

The price elasticity of demand will influence the effects of shifts in supply on price and quantity in a market. This is illustrated in the next two diagrams.

PED

In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small change in the market price.

In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively small expansion in the equilibrium quantity.

Income elasticity of demand (YED)

 

Introduction

Income elasticity of demand measures the relationship between a change in quantity demanded for good X and a change in real income.  The formula for calculating income elasticity is:

% change in demand divided by the % change in income

Normal Goods

Normal goods have a positive income elasticity of demand so as consumers’ income rises more is demanded at each price i.e. there is an outward shift of the demand curve

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income.

Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25.

Inferior Goods

Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises. Typically inferior goods or services exist where superior goods are available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties.

The income elasticity of demand is usually strongly positive for

  • Fine wines and spirits, high quality chocolates and luxury holidays overseas.
  • Sports cars
  • Consumer durables – audio visual equipment, smart-phones
  • Sports and leisure facilities (including gym membership and exclusive sports clubs).

In contrast, income elasticity of demand is lower for

  • Staple food products such as bread, vegetables and frozen foods.
  • Mass transport (bus and rail).
  • Beer and takeaway pizza!
  • Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.

Product ranges and longer term trends

Income elasticity of demand will vary within a product range. For example the Yed for own-label foodsin supermarkets is less for the high-value “finest” food ranges.

There is a general downward trend in the income elasticity of demand for many basic products, particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and preferences. What might have been considered a luxury good several years ago might now be regarded as a necessity? How many of you regard a Sky sports subscription or an iPhone5, an iPad2 or a new Blackberry as a necessity?

Income elasticity of demand

The table below shows estimated price and income elasticity of demand for a selection of foods:

Product

Share of budget (% of household income)

Price elasticity of demand (Ped)

Income elasticity of demand (Yed)

All Foods

15.1

n/a

0.2

Fruit juices

0.19

-0.55

0.45

Tea

0.19

-0.37

-0.02

Instant coffee

0.17

-0.45

0.16

Source: DEFRA www.defra.gov.uk

The income elasticity of demand for most types of food is low – occasionally negative (e.g. for margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic.

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales.Luxury products with high income elasticity see greater sales volatility over the business cycle thannecessities where demand from consumers is less sensitive to changes in the cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services. Theincome elasticity of demand will also affect the pattern of demand over time.

  • For normal luxury goods – income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumer’s income spent on that product will go up.
  • For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall
  • For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.

Cross-price elasticity of demand (CED)

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of a related good Y.

We are looking here at the effect that changes in relative prices within a market have on the pattern of demand.

With cross elasticity we make a distinction between substitute and complementary products.

Cross price elasticity of demand – analysis diagrams

cross price elasticity of demand

Substitutes:

With substitute goods such as brands of cereal, an increase in the price of one good will lead to an increase in demand for the rival product. The cross price elasticity for two substitutes will be positive.

For example, the iPhone now provides genuine competition for the Blackberry in providing users with ‘push technology’ to send all emails through to a mobile device.

Another good example is the cross price elasticity of demand for music. Sales of digital music downloads have been soaring with the growth of broadband and falling prices for downloads. As a result, sales oftraditional music CDs are declining at a steep rate.

Complements:

Complements are in joint demand

The CPED for two complements is negative.

The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand.

When there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. An example might be games consoles and software games

Unrelated products

Unrelated products have a zero cross elasticity for example the effect of changes in taxi fares on the market demand for cheese!

Pricing for substitutes:

If a competitor cuts the price of a rival product, firms use estimates of CPED to predict the effect on demand and total revenue of their own product.

Pricing for complementary goods:

Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells for more than a pound. If firms have a reliable estimate for CPed they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn.

The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks and other refreshments can generate as much as 40 per cent of their annual turnover.

Brand and cross price elasticity

When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival products will decrease.

This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and achieve higher profits.

Price Elasticity of Supply (PES)

Introduction

Price elasticity of supply (Pes) measures the relationship between change in quantity supplied and a change in price.

  • If supply is elastic, producers can increase output without a rise in cost or a time delay
  • If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is:

Percentage change in quantity supplied divided by the percentage change in price

  • When Pes > 1, then supply is price elastic
  • When Pes < 1, then supply is price inelastic
  • When Pes = 0, supply is perfectly inelastic
  • When Pes = infinity, supply is perfectly elastic following a change in demand

What factors affect the elasticity of supply?

  • Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.
  • Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand – supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market.
  • The ease and cost of factor substitution: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. A good example might be a printing press which can switch easily between printing magazines and greetings cards.
  • Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place.

Price elasticity of supply

The non-linear supply curve

In the diagram below, the price elasticity of supply is high at low levels of demand (e.g. D1 and D2) but when demand is high, elasticity of supply is much lower (e.g. D4 and D5) – the main reason would be that at peak periods, suppliers reach capacity limits and find it hard to increase output in he short run.

Elasticity of demand and supply and price changes – a quick summary Elasticity determines how much a shift changes quantity versus price.

  • If D increases and S is perfectly inelastic, then price rises and quantity doesn’t change.
  • If S increases and D is perfectly inelastic, then price falls and quantity doesn’t change.
  • If D increases and S is perfectly elastic, then price stays the same and quantity rises.
  • If S increases and D is perfectly elastic, then price stays the same and quantity rises.