Price Elasticity of Demand(PED)

PED: The responsiveness of the quantity demanded of a good/service given a change in its
price, ceteris paribus.
Equation: % AQd / %AP

Sign: Always negative due to the law of demand; inverse relationship between quantity
demanded and price.
Magnitude:

• |PED| > 1: Price elastic - mor 。 then proportioncits change in quantity

demanded given a change in price.
• IPEDI < 1: Price inelastic - less than proportionate change in quantity demanded
given a change in price.
• IPEDI = oo： Perfectly price elastic - quantity demanded is infinitely sensitive
to price (Qd falls to 0 if price changes).
• |PED| =0: Perfectly price inelastic - no change in quantity demanded given a
change in price.

Price Elastic Demand IPEDI > 1

Price($)

Perfectly Price Inelastic Demand: IPEDI = 0 Perfectly Price Elastic Demand [PEDI = 8

Price($) Price(S)

Quantity Quantity
 Po
Pl
Varying PED Along a Demand Curve

The value of PED varies along a demand

Varvina PED Alona a Demand Curve
curve; a demand curve is neither strictly
Price($) —
elastic nor inelastic but has both elastic
and inelastic ranges. Therefore, it is
more accurate to describe a demand curve
as being relatively elastic/inelastic,
rather than just merely being
elastic/inelastic.

0 Qo Quantity

Factors Affecting the PED

• Number and closeness of substitutes: The greater/less the number of close

substitutes, the more elastic/inelastic the PED; consumers find it easier/more
difficult to switch to alternatives.
• Necessity vs luxury: Necessities have a more inelastic PED as consumers find it
more difficult to reduce consumption, while luxuries have a more elastic PED
as consumers find it easier to reduce consumption (note: luxury does not mean
the item is necessarily branded or high-end, merely that it is not a basic
necessity).
• Proportion of income spent on good: The greater/smaller the proportion of income
spent on the good, the more elastic/inelastic the PED; consumers are
significantly less able/still relatively able to afford the good when price
rises.
• Length of time: The greater/shorter the time period shown by the demand, the more
elastic/inelastic the PED as consumers find it easier/harder to switch when
prices rise as they have more/less time to seek alternatives and change their
habits.
Impact of Price Changes on Total Revenue
Price Elastic Demand IPEDI > 1

When PED is relatively inelostic, a rise in When PED is relatively elastic, a rise in
price leads to a rise in total revenue from price leads to a fall in total revenue from
Area（B+C）to Area（A +B）as quantity Area（B+C）to Area（A +B）as quantity
demanded falls less than proportionately demanded falls more than proportionately
relative to the increase in price. relative to the increase in price.

Conversely, a fall in price leads to a fall Conversely, a fall in price leads to a rise
in total revenue from Area（A+B）to in total revenue from Area（A+B）to
Area（B+C）as quantity demanded rises Jess Area（B+C）as quantity demanded rises more
than proportionately relative to the fall than proportionately relative to the fall
in price. in price.

PED and Firm Pricing Decisions

• Applying the knowledge of the impact on total revenues when price changes, this
suggests that firms should
o Increase price when demand is relatively price inelastic and quantity
demanded is in the price inelastic range.
o Decrease price when demand is relatively price elastic and quantity
demanded is in the price elastic range.

。
o Revenues are maximized at the point where I PED I = 0
• Revenues Profits; Profits = Revenues - Costs
Applications
Applications of
of PED
PED

PED in relation to Primary Commodities and Manufactured Products

PriEary Gommodities Manufactured Goods

Price⑶ / S, Price($) / Si

0 Q1 Q o Q 2 Quantity 0 Qt Qo 2 Quantity
Q

The PED of many primary commodities The PED of many manufactured goods (cars,
(crops, oil etc.) is inelastic as they smartphones etc.) is elastic as they have
lack close substitutes and are often many close substitutes and tend to be
necessities. luxuries (although some can be
necessities).
Moreover, primary commodities tend to face
great uncertainties in supply as supply is Manufactured goods are less susceptible to
often affected by factors such as weather the weather and natural disasters and so
and natural disasters. supply is often more stable.

Consequently, primary commodities Consequently, manufactured goods tend to

experience greater voletility in prices experience less volatility in prices.
and revenues for producers.

Counterintuitively, rising supply is bad

for primary producers while falling supply
is good, as revenues fall when supply
increases while revenues rise when supply
falls (for producers who have goods to
sell).
PED and Indirect Taxes
• Indirect taxes raise cost of production and leads to a fall in supply
• Tax revenues = Tax/Unit x Equilibrium Quantity.

The more inelastic the PED, the greater The more elastic the PED, the lesser the
the tax revenue earned by the government. tax revenue earned by the government

The more inelastic the PED, the smaller The more elastic the PED, the greater the
the fall in equilibrium quantity when fall in equilibrium quantity when prices
prices increase from the tax, thus the increase from the tax, thus the lesser the
greater the tax revenue. tax revenue.
Income Elasticity of Demand(YED)
YED: The responsiveness of the demand of a good/service given a change in income,
ceteris paribus.
Equation: % AQd / %AY
***Note: YED measures the extent that demand shifts when the income changes, but we cannot calculate the % change of demand (demand is
not a number), and thus we estimate the % change based on Qd.

Sign:

• Positive: Normal goods - a rise/fall in income leads to a rise/fall in demand

一
for the good.
• Negative: Inferior goods a rise/fall in income leads to a fall/rise
in demand for the good; inferior goods are goods that are bought when
consumers are unable to afford better and costlier options.
Magnitude:

• 0 < YED < 1: Necessities (a type of normal good); a change in income leads to
a less than proportionate change in demand.
• YED > 1: Luxuries (a type of normal good); a change in income leads to a more
than proportionate change in demand.

Impact of a rise in Incomes

Pri
ce (1
When there is a rise in incomes, demand
P
for normel goods will increese due to the

X
positive YED. The extent that demand rises
2

P
/X
i
will depend on the magnitude of the YED;
P
o : LuxuiyGoods X, luxury goods like cars will experience a
rior xDCare
greater rise in demand, while necessities

寸、
P
3

N, Dpasta
like pasta would experience a small rise
! \D0 in demand. Inferior goods such as canned
0 ° ° Qi 2 Quantity
3Q Q

food would experience a fall in demand

(The converse is also true when incomes
fall).
The Engel Curve
• Shows the relationship between the income and quantity demand of a product.
• Based on the formula, % AQd / %AY:
o YED > 1: When quantity demanded rises more than proportionately given a rise
in income
o 0< YED < 1: When quantity demanded rises less than proportoinately given a
rise in income
o YED = 0: When quantity demanded does not change with income o YED < 0: When
quantity demanded falls given a rise in income

Quantity
Applications of YED

YED ond Producers: The Rate of Expansion of Industries

• When incomes rise as economies expand over time, industries with YED > 1 (e.g.
cars, luxury bags) expands faster than industries with 0 < YED < 1 (e.g. food,
utilities) as demand for the former rises at a faster rate. Industries with YED
< 0 (e.g. canned food, 2nd hand clothing stores) will contract as they face
falling demand.
• Conversely, when incomes fall during a recession, markets for luxuries contract
the fastest, followed by necessities, while the markets for inferior goods will
expand.

YED ond the Economy

• Economies have three sectors: primary(0 < YED < 1), secondary(YED > 1) and
tertiary(YED > 1). As the economy expands and incomes rise, the relative
composition of the various sectors would change, with primary growing more
slowly than secondary and tertiary, and occupying a smaller and smaller
percentage of economic output over time.
• Developing countries thus have a greater proportion of primary and secondary
sectors as compared to developed countries, that have a greater proportion of
secondary and tertiary sectors.
• Primary sectors comprise agriculture and extraction-based industries (oil,
metals etc.); secondary sectors comprise manufactured goods (cars, smartphones
etc.) while tertiary sectors comprise services (legal services, financial
services etc.).
Price Elasticity of Supply(PES)
PES: The responsiveness of the quantity supplied of a good/service given a change in its
own price, ceteris paribus.
Equation: % AQs / %AP

Sign: Always positive due to the law of supply; direct relationship between price and
quantity supplied.
Magnitude:

• |PES| > 1: Price elastic 一 more than proportionate change in quantity

supplied given a change in price.
• |PES| < 1: Price inelastic - less than proportionate change in quantity supplied
given a change in price.
• |PES| = 0: Perfectly price elastic - quantity supplied is infinitely sensitive
to price (Qs falls to 0 if price changes).
• |PES| = oo： Perfectly price inelastic - no change in quantity supplied given a
change in price.

Price Elastic SUDDIV IPESI a 1 Price Inelastic SUDDIV IPESI v 1

Price($) Price($)

产
1
Po
SQ

P
i ------------------------------ …7

l'\
P

0 QQ QI Quantity 0 Qo Quantity
Factors Affecting PES

• Length of Time: The greater/shorter the time period shown by the supply, the
more/less elastic is the PES; the longer/shorter the time, the greater/lesser
the ability of firms to increase their production, particularly if the
production time is long.
• Mobility of Factors of Production: The greater/lesser the mobility of factors of
production, the more/less price elastic is the PES; more/less mobile factors of
production means that it is easier/harder to increase production when prices
rise as it is easier/harder to acquire the required resources.
• Spare Capacity of Firms: The greater/lesser the spare capacity of firms, the
more/less price elastic is the PES; more/less spare capacity means that it is
easier/harder to increase production when prices rise as the firm has the
more/less resources that are not currently being used.
• Ability to Store Stocks: The greater/lesser the ability to store stocks, the more/less
price elastic is the supply; more/less stocks means that it is easier/harder to
increase quantity supplied when prices rise.
Applications of PED
PES in Relation to Primary Commodities and Manufactured Goods
Primary Commodities Manufactured Goods

The PES of many primary commodities The PES of many manufactured goods (cars,
(crops, oil etc.) is inelastic due to long smartphones etc.) is elastic as they tend
production times and factor immobility to have shorter production times and
(e.g. lack of arable land). greater factor mobility.

Consequently, primary commodities Consequently, manufactured goods tend to

experience greater volatility in prices experience less volatility in prices when
and revenues for producers when demand demand changes.
changes.
Limitations in the use and application of elasticities
• Ceteris Paribus Assumption
o Changes to price and quantity as predicted by elasticities might not occur
if the ceteris paribus assumption fails to hold, where shifts in demand
and supply could also affect price and quantity. For example, falling
prices would not lead to rising revenues when PED > 1 if demand is also
falling at the same time.
• Time Log end Chcinging Elasticity Vcilues
o Historical data used to compute elasticity values may not account for
future changes in consumer/producer consumption and production patterns.
Thus, historical elasticity values for certain goods and services may not
be indicative future elasticity values. For example, a good with PED < 1
could become more and more elastic over time with the invention of
substitutes.
• Data Collection Limitations
o The failure to collect sufficient or accurate historical data to calculate
elasticity values limits the ability to use elasticities to predict
changes in price and output or revenues.
• Failure to Consider Costs when Increasing Revenues
o Increasing revenues based on the theory of elasticity does not account for
costs, and thus higher revenues might not result in higher profits.