Elasticity of Demand

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ELASTICITY OF DEMAND AND THE IMPACT OF SUBSTITUTE AND COMPLEMENTARY GOODS

Price Elasticity of Demand

If Pizza Hut raises its prices by ten percent, what will happen to its revenues?

The answer depends on how consumers will respond. Will they cut back purchases a little or a lot? 

This question of how responsive consumers are to price changes involves the economic concept of elasticity.

  • 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.

  • Price elasticity of demand (PED) is a measure of the extent of change in the market demand for a good in response to a change in its price.

The coefficient of PED is measured as:

Percentage change in quantity demanded / Percentage change in price

  • 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.

  • If we are measuring the responsiveness of demand to a large change in price, we can measure elasticity between two points on the demand curve, and the resulting measure is called the arc elasticity of demand.

Example

Annual demand at €1.10 per unit is 700,000 units. 
Annual demand at €1.20 per unit is 650,000 units.
Average quantity over the range is 675,000 units.
Average price is €1.15.

  • % change in demand =  50,000 / 675,000 x 100% = 7.4%
                          
    % change in price =  10c / 115c x 100% = 8.7%
                    
    Price elasticity of demand = -7.4 / 8.7 = -0.85

Demand is INELASTIC over the demand range considered, because the price elasticity of demand (ignoring the minus sign) is less than 1.

Price elasticity of demand is considered to be elastic.

When the answer is greater than 1 (ignore the minus sign).

Factors that determine the value of price elasticity of demand

  1. 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

  2. Luxuries and necessities

    Necessities tend to have a more inelastic demand, whereas luxury goods and services tend to be more elastic. 

    For example, the demand for cinema tickets is more elastic than the demand for bus travel. 

    The demand for vacation air travel is more elastic than the demand for business air travel.

  3. 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.

  4. 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.

  5. Time period under consideration

    Demand tends to be more elastic in the long run rather than in the short run.

Income elasticity of demand

  • Income elasticity of demand = % change in quantity demanded /  % change in income

Demand for a good is income elastic if income elasticity is greater than 1 and it is inelastic between 0 and 1.

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.

Cross elasticity of demand

Cross elasticity involves a comparison between two products. 

The concept is a useful one in the context of considering substitutes and complementary products.

  • Cross elasticity of demand = % change in quantity demanded of good A / % change in the price of good B

cross elasticity value
perfect complements -1
complements -ve
unrelated products 0
substitutes +ve
perfect substitutes +1
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