Quick Quiz 27th Sept 2011

1. Define demand (1 mark)2. Illustrate the impact on demand

when there is a rise in price (4 marks)

3. Explain 2 factors that will increase demand (4 marks)

Elasticity of Demand

Objectives

• To understand and be able to calculate price, income and cross elasticity of demand

• Be able to evaluate the business relevance of these elasticity estimates

Price Elasticity of Demand (PED)

• Measures the responsiveness of demand for a product to a change in its price

• When demand is very responsive to changes in price it is said to be ‘price elastic’

• When demand is not very responsive to changes in price it is said to be ‘price inelastic’

Calculating PED

% ∆ QD% ∆ P

PED =

Remember

• The %Δ QD is found by dividing the change in QD by the original QD

Δ QD X 100 Original QD

And Δ P is found by dividing the change in P by the original P

= %Δ QD

Example

• The price of a product rises from £20 to £24 and demand falls from 400 to 300

• The PED will be -25%/20% = -1.25

• Note PED is generally negative so for ease of comparing elasticities, economists tend to ignore the minus sign when interpreting figure

Value Description of Response

Perfectly Inelastic

PED= 0 A change in price will have no effect on QD

Inelastic 0<PED<1

The %Δ in QD is less than the %Δ in P (i.e. demand is not very responsive to changes in P)

Unitary PED=1 The %Δ in QD equals the %Δ in price

Elastic PED>1 The %Δ in QD is more than the %Δ in P (i.e. demand is very responsive to changes in P)

Perfectly Elastic

PED= ∞ A change in price will cause an infinite change in the QD

Diagrams• Perfectly Inelastic Demand- ‘for a given change in

price there will be no change in quantity demanded’

• Perfectly Elastic Demand- ‘for a given change in price there will be an infinite change in quantity demanded’

•  Inelastic Demand- ‘for a given change in price there will be a proportionately smaller change in quantity demanded’

• Elastic Demand- ‘for a given change in price there will be a proportionately greater change in quantity demanded’

Perfectly Inelastic Perfectly Elastic

P

Q Q

PD

D

Different products are likely to have different elasticities of demand. The elasticity will depend on a number of factors (to follow)

Price

Quantity

QuantityInelastic

demandElastic demand

DD

Unit PED

• If price is raised by a certain percentage then the quantity demanded will fall by the same percentage

• Eg. A 10% increase in price will lead to a 10% fall in demand

• Revenue does not change as the price changes

PD

Q

A curve with unitary elasticity is a rectangular hyperbola with the formula PQ=k (k is a constant value)

The 10% Rule• Always use the 10% rule when

explaining elasticities• Eg. What does a PED of -1.9 indicate?• Demand is elastic. A change in the

price will lead to a proportionately larger change in quantity demanded. I.e. for a 10% rise in price, there will be a 19% fall in quantity demanded.

• Calculation: QD/10%= -1.9• So 10%x -1.9= QD= -19%

• What about these ones?• PED= -0.7• PED= -1.3• PED=-2• PED=-1

Short Activity on PED

PED and Revenue

Total Revenue

• TR= Price x no. of units sold

• Complete the next activity- PED and Revenue

Activity• A firm producing decorative candles lowers

the price of one of its scented candles from £4 to £3.60 and finds that the weekly quantity demanded increases from 600 per week to 630

1. Calculate the PED for the scented candles, showing your working

2. Calculate the change in total revenue3. Illustrate the demand curve, showing the

change in revenue4. Should the firm have lowered the price of

their candles?

Activity• A pizzeria lowers the price of its most

popular takeaway pizza, the Margherita, from £5 to £4.50 and finds that the weekly quantity demanded increases from 60 to 72

1.Calculate the PED, showing your workings2.Calculate the change in total revenue3.Illustrate the demand curve, showing the

change in total revenue4.Should the firm have lowered its price?

Conclusions• If a firm has a product which is price

inelastic and it lowers it’s price it will receive a fall in total revenue, if it increases its price it will receive an increase in total revenue

• If a firm has a product which is price elastic and it lowers it’s price it will receive an increase in total revenue, if it increases it’s price it will receive a fall in total revenue.

Elasticity along a straight line

• Elasticity is not a measure of the slope of the demand curve

• For a straight line downward sloping demand curve, the value of PED falls as price falls

• Pencil, ruler and graph paper.....

Illustrate a demand curve using the following points

• Point A £20 Qty 60• Point B £18 Qty 80• Point C £10 Qty 160• Point D £8 Qty 180• Calculate the elasticity as we move from

point A to point B• Calculate the elasticity as we move from

point C to point D• What can we conclude from this?

Price Elasticity along a straight line demand curveP

D1

A

C

B

Q

Price Elasticity along a straight line demand curveP

D1

A

C

B

Q

At point A PED is ∞ (Q=0)

At point C PED is 0 (P=0)

At point B (exactly half way along the line) PED is 1

Factors Affecting PED

• In pairs• Think of a product which is likely to

have price inelastic demand• Why does is have price inelastic

demand?

Factors Affecting PED

• Availability of substitutes, less substitutes = more inelastic

• Time period- longer= more price elastic, habit, lack of info, durable goods purchased, l/t can change

• Necessities have a lower PED than luxuries- increase in P unlikely to reduce D

• Goods which form a relatively low proportion of total expenditure have lower elasticities than those which form a more significant proportion

Questions

• Answer questions on sheet• PED WORKSHEET