3.

1 Price Elasticity of Demand

IB Economics

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 Price Elasticity of Demand
Success Criteria: I can…
1. Explain the concept of PED
2. Understand the formula for PED
3. State that PED is treated as +ve
4. Explain elastic, inelastic, unit, perfectly elastic,
perfectly inelastic by value & diagram
5. Explain the determinants of PED
6. Calculate the PED of a given example
7. Explain why PED varies along the slope
 Definition of Price Elasticity of
Demand
• Price elasticity (PED) measures responsiveness of demand for
good A to a change in the price of good A.
• The basic formula for calculating PED is:

Percentage change in quantity demanded

Percentage change in price
 Values for elasticity of demand
• If PED = 0 then demand is perfectly inelastic -
demand does not change when the price changes
• If PED is between 0 and 1 then demand is inelastic
• If PED = 1 then demand is said to unit elastic
• If PED > 1, then demand responds more than
proportionately to a change in price – i.e. demand is
elastic
• If PED = ∞, then demand is perfectly elastic
 Price Elasticity of Demand
• (i) When price falls we expect to see an expansion of
demand
• (ii) When price rises we expect to see a contraction
of demand
• Therefore an inverse relationship between price and
demand (always giving a negative value for PED)
• We ignore the sign but focus on the value
(coefficient) of elasticity for PED.
 An inelastic demand

Price Calculate the PED for a

£400 price increase

£200

350 400 Quantity Demanded

 An elastic demand curve

Price • Calculate the PED for a price increase

£150

£100

400 1200
How to calculate PED if you don’t
know the direction of the price change

Point PED is:

D Qx
average Qx
PED =
DPx
average Px
 Extreme Casesof Elasticity
P

• Perfectly Elastic
D

D Q
P
• Perfectly
Inelastic

Q
 Perfectly Elastic Demand
• When the elasticity is a very
large number (close to
infinity) demand is said to be
|e| =

8
perfectly elastic.
• A perfectly elastic demand
would show that at the 61
slightest increase in the
price, the quantity 60
demanded would drop to
zero.

0 Units 100 Units

Perfectly elastic demand curve
• What happens to QD as
price increases?
Price
• It disappears.
• What happens to QD as
price decreases?
• Demand will be infinite.
£200

400
 Perfectly Inelastic Demand
• When the elasticity is a very
small number (close to zero)
demand is said to be
perfectly inelastic. 120
• A perfectly inelastic demand
would show that even after a
large change in the price the
quantity demanded would |e| = 0
not change at all.
60

100 Units
Perfectly inelastic demand curve

Price • What happened to QD

£400 as price increases?
• Nothing!
£300
• Does this ever happen
£200 in the real world?
• Maybe if we calculated
PED for the Mona Lisa?

600 Quantity Demanded

 Unitary
Price
Here the % change in
PED = 1 price leads to the same
% change in quantity

Quantity
 Factors that Determine PED
(1) Number of close substitutes for a good and the
uniqueness of the product in the market
(2) Degree of necessity of consumption
(3) The % of a consumer’s income allocated to
consumers’ spending on the good
(4) The time period allowed following a price change
(5) Whether demand causes habitual consumption or
addiction
(6) The price level. Expensive or inexpensive.
 The number of Substitutes
Available.
The
The more
more
substitutes
substitutes exist
exist The
The more
more
for
for aa given
given good,
good, sensitive
sensitive (elastic)
(elastic)
the
the easier
easier itit demand
demand would
would
would
would be be for
for be
be to
to price
price
consumers
consumers to to changes
changes
switch.
switch.
 The Definition of the market.
• Broadly defined markets
have less elastic
demands as there are HDz
fewer substitutes. Ice Cream
B&J

Food
Soft drinks Biscuits
 The Definition of the Market.
Narrowly defined markets
have more elastic demands as
there are more substitutes.

Which is more
elastic?
Ben and Jerry’s
or all other
brands?
 Degree of Necessity

The more of a necessity a G or S is then

the more inelastic the demand will be.

Rice is a staple food in Asia and has an

inelastic demand.

On the other hand luxury items will have

a higher elasticity of deamnd
The % of a consumer’s income allocated to
consumers’ spending on the good

G and S that take up a high proportion

of a household's income will tend to
have a more elastic demand than
products where large price changes
makes little or no difference to
someone's ability to purchase the
product
 The amount of time to react
• The longer the time allowed, the easier it is for
consumers to find an alternative or modify
their behaviour.
• Goods have more elastic demands over longer
time horizons.
Example: Petrol.
 Time Frame and Price Elasticity: Oil Price
Shocks
• 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
 Short Term Demand for Oil

Price Oil Demand

The demand for oil $ per barrel

is inelastic in
response to price P3

changes in the
short run P1

This is mainly
P2
because it is an
essential input into
many production D short-run

processes
Q3 Q1 Q2

Demand for Oil

 Longer Term Demand for Oil – More Price
Elastic

Price Oil Demand

Longer run $ per barrel

demand is
relatively more P3

elastic if non-oil
substitutes develop P1

P2

D long-run

D short-run

Q3 Q1 Q2

Demand for Oil

Whether demand causes habitual consumption or
addiction

The elasticity will fall as the level of consumer

addiction increases
 The price level. Expensive or inexpensive.

low priced commodities are either necessities or

a small part of income is spent an them.
Therefore, their demand is inelastic.
Elasticity varies on the length of
the demand curve
Elasticity varies on the length of
the demand curve
At higher prices the %
Price Elastic change in P is small but the
% change in Qd is large. L/S

Unitary

Inelastic

At lower prices the % change

in P is large but the % change
in Qd is small. S/L D
Quantity
 Applications of PED
Success Criteria

• Examine the role of PED for firms in making decisions

regarding price changes and their effect on total
revenue.
• Explain why the PED for many primary commodities is
relatively low and the PED for manufactured products
is relatively high.
• Examine the significance of PED for government in
relation to indirect taxes.
An inelastic demand and revenue
Old revenue at £200 is
£80,000
Price
£400 New Total revenue at
£400 price
= price x quantity
= £140,000
£200
= total rev has increased
because PED is inelastic
and we put the price up.

350 400 Quantity Demanded

 An elastic demand curve and
revenue
Price • Total revenue when price = £200 = £240,000
• Total revenue when price = £400 =£160,000
• So raising price when demand is elastic will
decrease total revenue.
£400

£200

400 1200
 Elasticity of demand and total revenue –
for an increase in price

Market A Market B
Price
Price

Pb Pb
Pa Pa

Demand

Demand
Qb Qa Quantity Qb Qa Quantity

If we increase the price from Pa to Pb. The orange area shows the increase in
revenue from the increase in price. However the blue represents the loss in
revenue as the quantity demanded decreases. In which market did TR increase?
 What has happened to the firms revenue
in this example of a price cut?
Revenue lost = £1 x £100 = £100
Price (£)

Revenue gained = £9 x 25 = £225

10
9
Common
revenue £9 x
100 = £900 Demand

0 100 125 Quantity per period

Previous Revenue = £10 x 100 units = £1000

New Revenue = £9 x 125 units = £1125
What is our net gain in revenue? Is this elastic or inelastic?
Elasticity varies on the length of
the demand curve
At higher prices the %
Price Elastic change in P is small but the
% change in Qd is large. L/S

Unitary

Inelastic

At lower prices the % change

in P is large but the % change
in Qd is small. S/L D
Quantity
Relationship between PED and TR
P elastic
PED = 1

inelastic

Q
TR

Max TR

Q
 Price Unitary Price
Elasticity Elastic Inelastic
Demand Demand Demand
       
Price Total Total Total
Increase Revenue will Revenue will Revenue will
   FALL  stay SAME  RISE
     
       
Price Total Total Total
Decrease Revenue will Revenue will Revenue will
  RISE  stay SAME  FALL
     
 Importance of price elasticity of
demand for a business
• Firms can use PED estimates to predict:
1. The effect of a change in price on quantity
demanded
2. The effect of a change in price on total revenue
3. The likely price volatility in a market following
unexpected changes in supply
 Example of Volatility
mory chip prices surge in aftermath of Japan's 2011 qu

Prices of widely used

chips, including NAND
flash memory and
DRAM, have both risen
sharply since the
9.0-magnitude earthquake struck in Japan damaging
component and material suppliers vital to chip production.
The price of NAND flash memory, which has grown in
importance as the main data storage in iPads, iPhones and
other mobile devices, has increased by as much as 20%
since the earthquake.
 PED and Primary Commodities
• PED for primary commodities or raw or unprocessed
goods, which require minimum work to be made
available.
• The elasticity is usually low for primary commodities as
the determinants of elasticity tend towards inelastic.
• The goods tend to be inelastic because they are basic
necessities and they do not have many substitutes.
• So even if there is a change in the price of these goods,
the quantity demanded would not be impacted much
as people would continue to but the same quantity of
the product as it is a basic necessity.
 PED and Secondary Products
• The PED for manufactured products are usually high
because many of determinants deem these products
as elastic.
• Manufactured goods usually have many substitutes.
So people have a choice between the products. This
makes the manufactured goods elastic.
• Thus a change in the price of a manufactured good
will lead to a proportionately larger change in the
quantity demanded thus making the PED for
manufactured goods elastic.
 Primary v Manufactured

Price D primary S1
S2
Explain what
a happens when
P1
supply increases?
P2 You will need to add
P3 more labels to the
diagram.
Initial TR =
0P1aQ1 D manufactured

0 Q1 Q3 Q2 Quantity
 Importance of Elasticity for the
Government
Why does a government need to consider elasticity of product when
deciding whether or not to increase the tax on the product?
• If it an elastic product then if they increase the tax this will
increase the price of the product
• This means the quantity demanded will decrease more
significantly than the change in price (it is more responsive to
the price change)
• The production of the product may therefore decrease a lot
• Production workers are made unemployed
• Therefore governments are more likely to place taxes on
inelastic goods
• What about government revenue?
 Impact of a unit tax on
consumption and govt. revenue
a = old equilibrium
b = new equilibrium

Impact is reduced
Price S2
S1 consumption Q1-Q2

Unit Tax = bc
b
P2 Govt. revenue is
a P0P2 x Q2
P1
P0
c What happen to impact
and govt. revenue if
demand is inelastic?
D elastic

0 Q2 Q1 Quantity
Price Elasticity of Demand – Assessment 1

• You have 20 minutes to complete the

following question:

With the help of examples, explain the

determinants of price elasticity of demand (10)
Price Elasticity of Demand – Assessment 2
• You have 20 minutes to complete the
following question:

A businessperson wants to increase her

revenues. Using appropriate diagrams, explain
why knowledge of price elasticity of demand
would be useful (10)