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Market Environment
Price Elasticity of Demand
Price Elasticity of Demand
 Elasticity is a general concept
¡ The responsiveness of one variable to a change in another
 Specifically Economists speak of
the price elasticity of demand (PeD)
¡ responsiveness of demand to a change in price
¡ It helps us understand how markets respond to changes in demand
or supply
÷for an individual firm in a competitive market
4
Price elasticity of demand
(or ‘responsiveness’ of demand to a fall or rise in price)
! Demand is E L ..A …S….T……I……C !!!!
! When we see the mass of consumers
! Either
! chase after the price reductions
! or flee from the price increases
! at various differing rates
! We are interested in how fast they move, maybe very slowly,
! maybe very fast, or something in between
5
A Perfectly Elastic Demand
curve would mean only ONE price in the market
achieved by intense competition.
Any breach of the ‘conditions of perfect competition’
which undermine these ‘perfectly flexible conditions’
i.e. (1) perfect information,
(2) complete mobility of all the factors of production in
and out of the market,
(3) with no costs of entry or exit,
Would mean that there would be variations in price
and the curve would no longer be horizontal.
Market demand curve for an individual firm
under perfect competition
O
P
Q
P
m D
Here, all of any specific good you
want to sell can be sold at ONE
price, and ONLY ONE.
WHY? Because these are the
conditions of ‘Perfect Competition’
(a very rare set of conditions, but a
useful didactic device)
The normally imperfect market conditions, uneven
up a firm, costly to close the business, etc, all making
changes less flexible,
mean that prices vary across the market.
We can rank these prices, and note that at the different
prices, there are different levels of demand.
On a chart, this will show fewer purchases of higher priced
goods, and that demand increases with the fall in prices,
so we get the First Law of Demand.
O O
D1
D2
100
6
100
6
10
90 50
7
Firm A Firm B
P P
Q Q
The demand for an individual firm’s product
will reflect many factors influencing the buyer, different for every
good (so the firm that produces it)
Price falls, but
consumers don’t
(an inelastic
response)
Price reduced and consumers
buy quite a lot more, a
relatively more elastic response
Quantity
Price
O Q3 Q2 Q1
P1
P2
P3
c
S2
S1
D
D’
a
b
The effect on
price of a shift in
supply depends
on the
responsiveness of
demand
(expressed in the
slope of the D
curve) to a
change in price.
Market supply and demand
10
The price elasticity of demand
…measures the sensitivity of the quantity
demanded of a good by consumers to a change in
its price (Alfred Marshall 1890)
It is defined as:
% change in quantity demanded
% change in price
Price Elasticity of Demand
 Measuring price elasticity of demand
%DQD /%DP
¡ We shall use percentage changes
¡ When we calculate, the sign will be negative if the D curve falls to the
right (is a negative slope): however we usually ignore the sign in the
result
÷elastic demand: e > 1
÷Inelastic demand: e < 1
÷unit elastic demand: e = 1
8
Demand
m
n
DQ = 10
DP = –2
Mid P
6 4 2
7

10
0 10 20 30 40 50
P (£)
Q (000s)
DQ DP
Ped = mid Q ÷ mid P
Mid Q
15
Measuring elasticity using the ‘arc’ or ‘mid-point method’
8
Demand
m
n
DQ = 10
DP = –2
Mid P
6 4 2
7

10
0 10 20 30 40 50
P (£)
Q (000s)
DQ
DP
Ped = mid Q ÷ mid P
10
-2
= 15 ÷
7
Mid Q
15
Measuring elasticity using the arc method
8
Demand
m
n
DQ = 10
DP = –2
Mid P
6 4 2
7

10
0 10 20 30 40 50
P (£)
Q (000s)
DQ
DP
Ped = mid Q ÷ mid P
10
-2
= 15 ÷
7
= 10/15 x -7/2
Mid Q
15
Measuring elasticity using the arc method
8
Demand
m
n
DQ = 10
DP = –2
Mid P
6 4 2
7

10
0 10 20 30 40 50
P (£)
Q (000s)
DQ
DP
Ped = mid Q ÷ mid P
10
-2
=
15 ÷
7
= 10/15 x -7/2
=
=
-70/30
-7/3 = -2.33
Mid Q
15
Measuring elasticity using the arc method
Q If the price of good X rises from £9 to £11 and as a result
quantity demanded falls from 100 units to 60 units, what is the
price elasticity of demand between these prices?
A. 2/–80 = –0.025 (wrong you calculated δp/midQ )
B. –80/2 = –40 (wrong you divided midpoint Q by δp)
C. 0.2/–0.5 = –0.4 (wrong you divided δp/δq !! (upside down!)
D. –0.5/0.2 = –2.5 (-40 units/mid point 80)/( +£2/mid point £10)
E. –1 (wrong, you simply gave up thinking at all!)
Price Elasticity of Demand
 The determinants of price elasticity of demand
 the number and closeness of substitute goods
÷closeness of one product to another (physical/practical similarity)
÷closeness of one brand to another (branding tries to differentiate more,
reducing substitution))
¡ the proportion of income spent on the good (think why this is!)
¡ Time (search efforts)
18
Only in September 2013 could the UK’s 46m bank
account holders with 80m. current accounts, switch
between 33 banks (7 day switching) after £750m
overhaul to interbank systems.
Still no account number portability however!!
Movement of accounts has previously been
cumbersome and the market far from competitively
‘perfect’.
¾ accounts are held by 4 banks! (Oligopoly)
the usual customer stays for 17 years.
New banks will probably be the winners, Metro,
Virgin, maybe First Direct.
Q The price elasticity of demand for holidays in
Greece is likely to be high because ?
A. people tend to book up a long time in advance.
B. there are plenty of different holidays abroad to choose from.
C. expenditure on holidays account for a relatively small part of
people’s total income.
D. holidays at home provide no real alternative.
E. people need a holiday if they are to cope with the year ahead –
The Importance of Price Elasticity of Demand to
Busines Decision Making
Price Elasticity of Demand & Business Decision Making
Now we know how to calculate the ‘price elasticity
of demand lets see how it
effects a firm’s sales revenue.
The sales revenue, is of course Price x Amount
sold.(TR = P x Q)
4 3 2 1 0
0 1 2 3 4 5
Consumers’ total
expenditure
=
firms’ total revenue
=
£2 x 3m = £6m
P(£)
Q (millions of units per period of time)
D
Total expenditure
Price Elasticity of Demand & Business Decision Making
¡Effects of a price change on sales revenue
÷Relatively elastic demand
¢TR changes in same direction as quantity e.g. TR goes up as
price falls and Q rises, because Q is rising relatively more
quickly than price is falling: that’s what >1 can be taken to
mean.
¢However the reverse is true as Q falls TR falls ( because P
rises)
P(£)
Q (millions of units per period of time)

a
4 D
20
5
10
b
Revenue falls
as price rises
Elastic demand between two points
Effects of a price change on sales revenue:
elastic demand –
TR changes in same direction as quantity
Price Elasticity of Demand & Business Decision Making
 Price elasticity of demand and a firm’s sales revenue (TR =
P x Q)
÷Relatively inelastic demand
¢TR changes in same direction as price
a
4
20
P(£)
Q (millions of units per period of time)

D
8
15
c
Revenue rises
as price rises
Inelastic demand between two points
TR changes in opposite
direction to quantity
27
But if we draw a straight
line, then any area PXQ
under the line, the Total
Revenue, rises then falls as
price falls. We can use this
geometrical fact to illustrate
the nature of elasticity.
a
d
e
A < E > D
D
D
P2
Q2
P1
Q1
P3
Q3
X1
X2
X3
Largest TR
28
Price elasticity for a straight line demand
curve
So the price elasticity varies along the length of a
straight-line demand curve.
D
Elastic Unit elasticity
Inelastic
Quantity
Price
D

29
Elasticity and price reductions
D
Elastic Unit elasticity
Inelastic
Quantity
Price

D
Quantity
Total
Revenue
(+)TR< (-)TR
(+)TR< (-)TR
For a price fall: demand
is elastic, if revenue from
new sales will exceed the
fall in revenue from
previous sales – total
revenue will rise;
demand is inelastic, if
revenue from new sales
will be less than the fall
in revenue from previous
sales – total revenue will
fall
Total
Revenue
Curve
Price
Quantity bought
Demand (Average
Revenue) or Price
Curve
Marginal
Revenue
Curve

Price Elasticity of Demand & Business Decision Making
¡ special cases
÷totally inelastic demand: PeD = 0
÷Totally elastic demand PED = ∞
÷Unit elastic demand PED = 1
P2
P
O Q1 Q
P1
D
b a
Give an example
of this sort of
Totally inelastic demand (PeD = 0)
Q2
P
O Q1 Q
P1 D
a b
D
Think of an example of the sort of good
where the buyer won’t find (much)
difference in price anywhere
Infinitely elastic demand (Pe= ¥)
P
O 40 Q
20
D
a
b
D
100
8
Revenue stays the
same as
price changes
Unit elastic demand (Pe= –1)
Q If demand drops to zero at the slightest
increase in price, demand is:
A. unitary elastic.
B. relatively inelastic.
C. perfectly (infinitely) elastic.
D. perfectly inelastic.
E. relatively elastic.
36
Summary: Elasticity and revenue
When price is changed, the impact on a firm’s total revenue
(TR) will depend upon the price elasticity of demand.
For a price
increase
decrease
Demand is
elastic
TR
decreases
TR
increases
Demand is
unit elastic
TR does not
change
TR does not
change
Demand is
inelastic
TR
increases
TR
decreases
For a price
Q If a rise in the price of good X results in the amount of
money spent on good Y remaining the same, then:
A. X and Y are perfect substitutes.
B. X and Y are perfect complements.
C. the cross-price elasticity of demand for Y with respect to X is
infinite.
D. the cross-price elasticity of demand for Y with respect to X is 1.
E. the cross-price elasticity of demand for Y with respect to X is 0.
‘Demand’ and Three standards of living
1) like 19th Century Ireland, where poor people
primarily ate potato’s with pork pickings/gravy.
If potato prices rose, they gave up the pork
‘scratchings’ to buy more potato’s – abandoning
bacon!
So Potato’s were called called a ‘Giffin’ good.
(P up Q up !) which contradicts the ‘First law of
demand’
A ‘Giffen’ good, named after a gentleman who
supposedly observed that as basic staples (potatoes)
rose in PRICE, MORE was consumed – i.e. ‘perverse’
consumer demand pattern.
Explanation: as prices of basics rose, the poor
actually stopped spending on other items in order to
keep up the consumption of basics, but in the process
spent MORE on the basic/staple as prices rose.
40
Normal and inferior goods
(expressed on an Engel curve)
! A NORMAL GOOD has a positive income
elasticity of demand
! an increase in income leads to an increase in the
quantity demanded
” e.g. holidays
! An INFERIOR GOOD has a negative income
elasticity of demand
! an increase in income leads to a fall in quantity
demanded (‘better’ tastes can be afforded)
” e.g. margarine
! A LUXURY GOOD has an income elasticity of
demand greater than 1(at higher levels of income)
” e.g. wine
41
Income and the demand curve ( usual
price/ quantity relation)
For an increase in income:
Quantity
Price
D0
Pric
D1
D0
D1
NORMAL GOOD INFERIOR GOOD
Quantity
Demand curve
moves to the right
Demand curve
moves to the left
Three standards of living today
1)like 19th Century Ireland, where poor people
primarily ate potato’s with pork pickings/gravy.
If potato prices rose, they gave up the pork
‘scratchings’ to buy more potato’s -abandoning
bacon! Potato’s called a ‘Giffin’ good.
in this third category reduces price elasticity of
demand.
2) the lower middle class which can afford meat, cutting
back when it is expensive. This generates high ( >1) price
elasticity of demand for grain as feed stock (a factor price),
because of the 2:1 to 8:1 ratio range between meat and
grain i.e. for 1 kg of meat given up, 2 to 8 kg of grain is no
longer fed to animals.
Hence, in the early stages of wheat shortage when people are
used to some meat, but are price sensitive about it, they eat
less, and much less grain is bought at the ruling price, so the
‘price elasticity of demand’ for wheat rises sharply.
3) The rich eat meat and are price insensitive about it. An
increase in the number of people in this third category
reduces price elasticity of demand.
Other Elasticities
Income elasticity of demand
%DQD/%DY (how much more will you buy of a good when your
income rises, prices now remaining the same)
¡ measurement
¡ determinants
÷degree of ‘necessity’ of the good
÷rate at which wants are met (you could afford food, but now buy more wine)
÷level of income of consumers
÷importance of perceptions of the product (promote luxuries as ‘normal’)
45
The income elasticity of demand
The income elasticity of demand measures
the sensitivity of quantity demanded to a
change in income:
% change in quantity demanded of a good
% change in consumer income
The income elasticity may be positive or
negative.
46
Engel Curves
Y
Q
Normal
Inferior
Luxury good
Other Elasticities
 Cross-price elasticity of demand
%DQDa/%DPb The consumption of A changes with price B
¡ measurement
¡ determinants
÷closeness of complements or substitutes
÷time period (lags.. Petrol bought for years after car purchased)
÷effects of changes in competitors’ pricing strategy
÷strategies to make a product less cross-price elastic (less dependent on others)
48
The cross price elasticity of demand
The cross price elasticity of demand for good i
with respect to the price of good j is :
% change in quantity demanded of good i
% change in the price of good j
This may be positive or negative
The cross price elasticity tends to be positive
if two goods are substitutes: e.g. tea and coffee
The cross price elasticity tends to be negative
if two goods are complements e.g. tea and milk.
Price Elasticity of Supply
 Measuring price elasticity of supply: %DQS/%DP
¡ elastic and inelastic supply
 Determinants of price elasticity of supply
¡ amount that costs rise as output increases
¡ time period
÷immediate
÷short run
÷long run
P1
S2
P
O Q2 Q
P0
Q0 Q1
S1
Supply curves with different price elasticity of supply
Q In which one of the following cases is good X likely to
have a more price-elastic supply than good Y?
A. It is more costly to shift from producing X to another product than
from Y to another product.
B. The supply of Y is considered over a longer period of time than X.
C. X is a minor by-product of Y.
D. Consumers find it easier to find alternatives to Y than to X.
E. The cost of producing extra units increases more rapidly in the
case of Y than in the case of X.
52
Elasticity is higher in the long run
• In the short run, consumers may not be able
expenditure.
• If price changes persist, consumers are
• Demand thus tends to be
• more elastic in the long run
• but relatively inelastic in the short run.
D1
D2
P1
Q1
P
O Q
a
Supply in different time periods
D1
D2
Si
b a
P1
P2
Q1
P
O Q
Supply in different time periods
D1
D2
Si
SS
b a
c
P1
P3
P2
Q1 Q3
P
O Q
Supply in different time periods
D1
D2
Si
SS
SL
b a
c
d
P1
P3
P2
Q1 Q3
P
O Q
P4
Q4
Supply in different time periods
The Working of
Competitive Markets
Government economists have to worry about
Elasticity and the Incidence of Tax
Elasticity and the Incidence of Tax
Effects on supply curve
S + specific tax
S
amount of
specific tax
e.g. per capita
tourist tax at
any hotel
P
O Q
Effect of a tax on the supply curve
A tax shifts the
supply curve
upwards by the
amount of the tax
per unit.
S
P
O Q
Effect of a tax on the supply curve
e.g. 10% of a
rising price
Q VAT is an example of ?
A. a specific tax.
B. an excise duty.
C. a direct tax.
E. a tax on the final value of a product.
Indirect Taxes
 The impact and incidence of taxation
¡ the producers’ share
¡ the consumers’ share
S
O
S + tax
P1
P2
Q2 Q1
D
P1 + tax
P
Q
Govt imposes
tax on a good,
BUT some
consumers stop
impact is
blunted.
New
equilibrium
price (after tax)
is P2
Effect of a tax on price and quantity
Tax
collected
Tax
imposed
Indirect Taxes
Elasticity and the impact and incidence of
taxation
S + tax
S
O
P1
Q1
D
P
Q
Incidence of tax: inelastic demand
S + tax
S
O
P1
P2
Q2 Q1
D
P
Q
Incidence of tax: inelastic demand
P2
– t
P1
P2
P
S + tax
S
D
PRODUCERS’ SHARE
O
Q2 Q1
CONSUMERS’
SHARE
Q
Incidence of tax on producer: inelastic demand
S + tax
S
P1 O
Q1
D
P
Q
Incidence of tax: elastic demand
CONSUMERS’
SHARE
P2 – t
PRODUCERS’
SHARE
O
P2
Q2
P
Q
S + tax
S
P1
Q1
D
Incidence of tax: elastic demand
S + tax
S
P1 O
Q1
D
P
Q
Incidence of tax: inelastic supply
S + tax
S
P2 P1 O
Q1
D
Q2
P
Q
Incidence of tax: inelastic supply
S + tax
S
P2 P1 O
Q2 Q1
D
P
Q
CONSUMERS’ SHARE
Incidence of tax: inelastic supply
S + tax
S
O
P2 – t
P1
P2
Q2 Q1
D
P
Q
CONSUMERS’ SHARE
PRODUCERS’ SHARE
Incidence of tax: inelastic supply
P S + tax
O Q
P1
Q1
D
S
Incidence of tax: elastic supply
P S + tax
O Q
P1
P2
Q1
D
Q2
S
Incidence of tax: elastic supply
P S + tax
O Q
P1
P2
Q2 Q1
D
S
CONSUMERS’
SHARE
Incidence of tax: elastic supply
P S + tax
O Q
P2 – t
P1
P2
Q2 Q1
D
S
CONSUMERS’
SHARE
PRODUCERS’
SHARE
Incidence of tax: elastic supply
Q The producer’s share of a tax
will be larger when …?
A. the greater the elasticity of both demand and supply.
B. the less the elasticity of both demand and supply.
C. the less the elasticity of demand and the greater the elasticity
of supply.
D. the greater the elasticity of demand and the less the elasticity
of supply.
E. the closer the elasticity of demand is to –1 and the closer the
elasticity of supply to 1.
The Working of
Competitive Markets
The Time Dimension of
The Time Dimension of Market Adjustment
 Short-run and long-run price adjustment
¡ short- and long-run demand curves
S1
P1
Q1
P
O Q
a
S2
Response of demand to an increase in supply
S1
S2
D short-run
P1
P2
Q1 Q2
P
O Q
a
b
Response of demand to an increase in supply
S1
S2
D short-run
D
long-run
P1
P3
P2
Q1 Q2 Q3
P
O Q
a
c
b
Demand is
more elastic in
the long run.
Response of demand to an increase in supply
The Time Dimension of Market Adjustment
 Short-run and long-run price adjustment
¡ short- and long-run demand curves
¡ short- and long-run supply curves
D1
P1
Q1
P
O Q
a
Response of supply to an increase in demand
D1
D2
P1
Q1
P
O Q
a
Response of supply to an increase in demand
D1
D2
S short-run
P1
P2
Q1 Q2
P
O Q
a
b
Response of supply to an increase in demand
D1
D2
S
long-run
P1
P3
P2
Q1 Q2 Q3
P
O Q
a
b
c
S short-run
Supply is more
elastic in the
long run.
Response of supply to an increase in demand
89
Elasticity is higher in the long run
• In the short run, consumers may not be able (or ready) to
• If price changes persist, consumers are more likely to
• Demand thus tends to be
• more elastic in the long run
• but relatively inelastic in the short run.
Q The short-run (retail) supply of freshly cut flowers is
much less price elastic than that of pot plants because:
A. households generally keep pot plants much longer before
throwing them away (and often never throw them away).
B. fresh flowers are more likely to be purchased for special
occasions.
C. the price of freshly cut flowers fluctuates much more than that
of pot plants.
D. supplies of fresh flowers fluctuate much more with the weather
and the season.
E. florists cannot keep freshly cut flowers as long as pot plants.

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