CIMA BA1 Syllabus B. Microeconomic And Organisational Context Of Business - Elasticity of Demand - Notes 2 / 3
Price Elasticity of Demand
If Pizza Express raises its prices by 10% percent, what will happen to its revenues?
The answer depends on how consumers will respond. Will they spend more or less in Pizza Express or will they go somewhere else?
The most common elasticity measurement is price elasticity of demand.
It measures how much consumers respond in their buying decisions to a change in price.
The coefficient of PED is measured as:
Since demand usually increases when the price falls, and decreases when the price rises, elasticity has a negative value.
However it is usual to ignore the minus sign and just describe the absolute value of the coefficient.
Interpreting price elasticity of demand
Value greater than 1: Elastic demand
Demand is said to be price elastic = responsive to price changes.
When demand is elastic, companies will experience:
A rise in revenue if prices are cut, and
A fall in revenue if prices are increased.
Value less than 1: Inelastic demand
Demand is said to be price inelastic = unresponsive to price changes.
When demand is price inelastic, companies will experience:
A fall in revenue if prices are cut, and
A rise in revenue if prices are increased.
Goods whose income elasticity of demand is positive are said to be NORMAL GOODS, meaning that demand for them will rise when household income rises.
If income elasticity is negative, the commodity is called an INFERIOR GOOD since demand for it falls as income rises.
Methods - Price elasticity of demand
Simple method (also known as the non-average arc method).
Average (midpoint) method
1) Simple Method
This measures the responsiveness of demand compared to the starting or initial demand and price.
Example 1 - Simple method
Initial demand at €1.10 per unit is 700,000 units.
New demand at €1.20 per unit is 650,000 units.
% change in demand:
(650,000 - 700,000) / 700,000 x 100% = - 7.1%
% change in price:
1.20 - 1.10 / 1.10 x 100% = 9.09%
Price elasticity of demand = -7.1 / 9.09 = -0.78
Demand is INELASTIC over the demand range considered, because the price elasticity of demand (ignoring the minus sign) is less than 1.
2) Average (midpoint) method
- measures the responsiveness of demand compared to the average demand and price.
Example -Average (midpoint) method
Initial demand at €1.10 per unit is 700,000 units.
New demand at €1.20 per unit is 650,000 units.
Average demand = (650,000 + 700,000) / 2 = 675,000
% change in demand:
(650,000 - 700,000) / 675,000 x 100% =7.4%
Average price = (1.20 + 1.10) / 2 = 1.15
% change in price:
1.20 - 1.10 / 1.15 x 100% = 8.7%
Price elasticity of demand = -7.4 / 8.7 = -0.85
In the Exam
Use the midpoint (average arc) method ONLY if asked in an exam question
but if no method is stated use the Simple method
Factors that determine the value of price elasticity of demand
Number of close substitutes within the market
The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price.
In this case, the substitution effect will be quite strong
Luxuries and necessities
Necessities tend to have a more inelastic demand, whereas luxury goods and services tend to be more elastic.
Percentage of income spent on a good
It may be the case that the smaller the proportion of income spent, taken up with purchasing the good or service, the more inelastic demand will be.
Habit forming goods
Goods such as cigarettes and drugs tend to be inelastic in demand.
Preferences are such that habitual consumers of certain products become desensitized to price changes.
Time period under consideration
Demand tends to be more elastic in the long run rather than in the short run.