Price Elasticity of DemandA basic introduction to the important concept of price elasticity of demand and its relevance both to businesses and consumers.

Applications of the idea of elasticity of demand

The introduction of the congestion charge for motorists in London

Consumer response to recent cuts in the prices of

broadband access to the net

How will demand for air travel respond if a new tax on aviation fuel is introduced?

Definition of Price Elasticity

• Price elasticity (Ped) measures responsiveness of demand to change in price of good itself

• Formula for calculating Ped is

– Ped = % change in Qdx / % change in Px

• When price falls we expect to see an expansion of demand

• When price rises we expect to see a contraction of demand

• Therefore an inverse relationship between price and demand (negative value for Ped)

• We ignore the sign but focus instead on the coefficient of elasticity

Values for price elasticity of demand

• If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes

• If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is price inelastic

• If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to be unit elastic

• If Ped > 1, then demand responds more than proportionately to a change in price. Demand is said to be price elastic

Demand curves with different price elasticity

Price Price

Perfectly Elastic Demand Perfectly Inelastic Demand

Demand

Demand

Quantity Quantity Q1Q2 Q3

P1 P1

P2

P3

Q1

Inelastic and elastic demand curves

Price

Demand

P1

P2

P3

Q1Q2 Q3

Price

Demand

P1P2

P3

Q1Q2 Q3

Relatively Inelastic Demand Relatively Elastic Demand

Elasticity of demand and total revenue

Market A Market B

QuantityQuantity

PricePrice

Pa

Pb

Demand

Demand

Higher revenue from reducing the price from Pa to Pb (the gain in quantity sold more than offsets the lower price per unit)

Demand in segment B of the market is relatively inelastic. A higher unit price is charged and total revenue also increases

QbQa Qb

Pb

Qa

Pa

Importance of price elasticity of demand for a business

• Firms can use price elasticity of demand (PED) estimates to predict:

– The effect of a change in price on quantity demanded

– The effect of a change in price on total revenue & expenditure

– The likely price volatility in a market following unexpected changes in supply – important for commodity producers

– The effect of a change in 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 price elasticity of demand can be utilized as part of a policy of price discrimination (or yield management). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel

Price Elasticity of Demand – A Relative Elastic Demand

THE DEMAND FOR PRINTERS

0

50

100

150

200

250

300

350

400

450

500

0 2 4 6 8 10 12 14

Quantity (000s)

Pri

ce P

er U

nit

(£)

Demand

A

B

Price falls from £350 to £250

% change in price = 60%

% change in demand = 100%

Price elasticity = 1.67

i.e. demand is price elastic

Price Elasticity of Demand – A Relatively Inelastic Demand

THE DEMAND FOR CIGARETTES

3

3.2

3.4

3.6

3.8

4

4.2

4.4

4.6

4.8

5

5.2

5.4

5.6

5.8

6

0 20 40 60 80 100 120 140

Quantity Demanded (Millions per month)

Pri

ce P

er U

nit

(£)

Demand

A

B

Price rises from £3.00 per packet to £6.00 following an series of increases in government taxes

% change in price = 100%

% change in demand = 20%

Price elasticity = 0.2

i.e. demand is price inelastic

Price Elasticity of Demand along a Demand Curve

0

10

20

30

40

50

60

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80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand (D)

Elastic demandFor a price fall

Ped>1

Inelastic demandFor a price fall

Ped < 1

Price Elasticity of Demand along a Demand Curve

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand (D)

When price falls from £90 to £80Total revenue increases

Price Elasticity of Demand along a Demand Curve

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand (D)

When price falls from £30 to £20, total revenue decreases

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand Curves With Different Price Elasticity

Relative Inelastic Demand

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand Curves With Different Price Elasticity

Relative Inelastic Demand

Relative Elastic Demand

Extreme Values for Price Elasticity of Demand

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Perfectly Elastic Demand

Extreme Values for Price Elasticity of Demand

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Perfectly Inelastic Demand

Elasticity of Demand for a non-linear Demand Curve

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Quantity (000 units per month)

Pric

e £

Demand

Factors that Determine Ped

• (1) The number of close substitutes for a good / uniqueness of the product

• (2) The degree of necessity of consumption or whether the good is a luxury

• (3) The % of a consumer’s income allocated to spending on the good

• (4) The time period allowed following a price change

• (5) Whether the good is subject to habitual consumption –

• (6) The breadth of definition of a good or service. ( brand PED is often elastic, whereas the product’s PED may be inelastic)

Elastic or Inelastic demand?

• Gateway cuts the price of their desktop PCs by 10%• A fall in the price of Euro-star tickets• An increase in the price of the Financial Times• A taxi home from a night-club on a Friday night• A rise in average car insurance premiums• Motorway petrol prices rise by 5% after the budget• Vodafone cuts their mobile phone charges• The price of central heating oil rises by 20% due to a rise in

world oil prices• A local leisure club decreases monthly charges by 15% in a

bid to increase the number of members

Case Study: Demand for Oil after Shocks

Time Frame and Elasticity: Oil Price Shocks

• The longer the time frame => the more elastic is demand

• 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

– Higher prices made it more attractive to exploit higher cost reserves of oil – which increased supply and brought prices down again

Short Term Demand for Oil

Demand for Oil

Price $ per barrel

Oil Demand

P1

P2

Q1 Q2

P3

Q3

The demand for oil is inelastic in response to price changes in the short run

This is mainly because it is an essential input into many production processes

D short-run

Longer Term Demand for Oil – More Price Elastic

Demand for Oil

Price $ per barrel

Oil Demand

P1

P2

Q1 Q2

P3

Q3

Longer run demand is relatively more elastic if non-oil substitutes develop

D short-run

D long-run

Using Price Elasticity of Demand

• How much tax revenue will higher “sin taxes” on cigarettes and alcohol provide?

• Why do airlines often give discounts for advance bookings?• What happens to our demand for foreign holidays when the

exchange rate appreciates?• Why do hotels lower room-rates at weekends and why do

car rental firms charge lower prices at weekend?• Will a business always pass on higher costs to consumers

(and this also applies to indirect taxes) ?• Will the introduction of road tolls in London and other cities

actually cut road congestion?