Price Elasticity of Demand
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Price Elasticity of Demand
So far we have simply looked at the formula and how to make various calculations. Most importantly, though, you need to be able to interpret these numbers and explain what they mean.
In the example with the CrispyChoc, the value of the elasticity was -2.5. Using easier figures than the ones in the question, this means that for a 10% increase in the price of CrispyChocs, the quantity demanded will fall by 25%. The proportionate change in demand is larger than the proportionate change in price. In other words, the demand for CrispyChocs is very responsive to a given change in price. Goods and services like this that have an elasticity of demand greater than one, are said to have elastic demand. I remember this by thinking of an elastic band. If an elastic band is very elastic, then it will be very responsive to a good tug.
If you managed the question about unleaded petrol, you will have found that it had an elasticity of -0.6. Using easier figures than the ones in the question, this means that for a 10% increase in the price of unleaded petrol, the quantity demanded will fall by 6%. The proportionate change in demand is smaller than the proportionate change in price. In other words, the demand for unleaded petrol is not very responsive to a given change in price. Goods and services like this that have an elasticity of demand less than one, are said to have inelastic demand. In this case, the very stiff, or inelastic, band would not be very responsive to a good tug.
Some goods have an elasticity of one. A 10% rise in their price results in a 10% fall in their demand. The proportions are the same. Demand is neither elastic nor inelastic. These goods are said to have unitary demand.
Although unlikely in the real world, economists like to look at the extremes as they form useful benchmarks. At one end, the elasticity of demand can be said to equal infinity. This is known as perfectly elastic demand. At the other end, the elasticity of demand can equal zero. This is known as perfectly inelastic demand. This one is a little more realistic. Looking at petrol, for instance, it is possible that, following a 5% increase in its price, the demand for the product remains unchanged because the good is such a necessity.
The number line below summarises the above:
You may be thinking, "what types of goods have elastic demand and what types of goods have inelastic demand". Good question. See the section on 'the determinants of the value of the price elasticity of demand' for the answers.
Now you need to know how to draw demand curves that represent these various elasticities:
Notice that I've left the minus signs out. In the first diagram, any change in price (e.g. P1 to P2) causes the quantity demanded to remain unchanged (stays at Q1).
The second diagram is harder to explain. If you can imagine that an infinitesimally small drop in price (so small that you can't see it on the diagram) has caused an infinite rise in demand (the horizontal demand curve goes on forever). Then you can just about see that the horizontal demand curve represents infinite (or perfect) elasticity. This horizontal demand curve is associated with firms in perfectly competitive markets (see the topic 'Market structure' for much more detail).
The third diagram represents unitary elasticity. The parabola shape means that, wherever you are on the curve, a given percentage change in the price of the good will result in an identical percentage change in the quantity demanded.
Most of the time the elasticity is somewhere between these extremes. The two diagrams below try to illustrate this:
The first diagram shows a flattish demand curve, although it is not horizontal. Notice that for a relatively small increase in price (from P2 to P3) the quantity demanded has fallen by a relatively large amount (from Q2 to Q3). %Qd > %P, and so demand is elastic.
The second diagram shows a very steep curve, although it is not vertical. Notice that the increase in price is huge (from P4 to P5), but the fall in the quantity demanded is relatively small (from Q4 to Q5). %Qd < %P, and so demand is inelastic.
There is a catch, though. The value for the elasticity of demand changes as you move up or down the curve. Obviously this is not true for horizontal, vertical or parabola demand curves, but it is for the majority of curves, which fall into the relatively elastic or relatively inelastic camps. The diagram below explains this.
To make the maths easy, I've drawn a curve that is 45 degrees to the horizontal. Where the demand curve hits the y-axis, the price is 20, and where the demand curve hits the x-axis, the quantity demanded is 20.
Now look at the change going on at point A. The price fell from 19 to 18 (a 5% fall, approximately) causing the demand to rise from 1 to 2 (a 100% increase). This gives an elasticity of (-)20 which is very elastic.
At point B, the price fall from 10 to 9 represents a 10% fall, and the resulting rise in the quantity demanded from 10 to 11 represents a 10% rise. The elasticity, therefore, is unitary.
At point C, the price fell from 2 to 1 (a 50% fall) causing a rise in demand from 18 to 19 (a 6% rise, approximately). This gives an elasticity of (-)0.12, which is very inelastic.
So, every part of the demand curve above (or to the left) of point B will be elastic, and every point below (or to the right) of point B will be inelastic. Straight-line downward sloping demand curves are most elastic at the top. The elasticity then continually falls as one moves down the curve, reaching unitary elasticity somewhere in the middle. Past this point, the curve becomes inelastic, reaching a value of zero when the curve hits the x-axis.
Earlier in this Learn It, we asked the question: "what type of goods have elastic demand, and what type of goods have inelastic demand?" Well, this depends on a number of factors which are explained below:
Does the good in question have close substitutes? This is probably the most important determinant. We were discussing petrol earlier. As a car driver, I think it's safe to say that there is nothing else that I could put into my car that would make it go! There are no substitutes. So, when the price of petrol rises, I am likely to buy more or less the same amount of petrol, unless I make a concerted effort to use public transport (unlikely, especially if one lived in the countryside) or give up the car (even more unlikely!). Some consumers will make an effort to cut down on petrol, but taking the country as a whole, the fall in the demand for petrol following a given price rise will be relatively very small. Petrol has very inelastic demand.
You can probably think of lots of examples of markets where there are many firms all competing with each other selling similar products. Just think how many substitutes there are for CrispyChocs when choosing a chocolate bar in a newsagent. This means that the demand for CrispyChocs is very elastic; for a given rise in the price of a CrispyChoc the fall in demand will be proportionately larger. The width of definition of a product will also affect the elasticity. CrispyChocs may well have elastic demand, but the elasticity of 'food' in general will be very inelastic.
What is the time period in question? Demand for any good tends to be more inelastic in the short run and more elastic in the longer run. Looking back at the example of petrol, when oil prices rose sharply in the mid-70s, the immediate affect on demand was small. People still needed petrol for their cars; those who used oil dependent heating couldn't use another fuel. As time went by, though, people could look into buying more fuel-efficient cars, or heating systems that used a different fuel (like gas central heating, for example). As time goes by, consumers are more likely to be able to react to changes in the price of various goods by changing habitual spending patterns.
How much of one's income is spent on the good in question? Consumers will be more sensitive to price changes of goods that will cost them a lot of money. One of the biggest purchases a consumer is likely to make is a new car. This represents a large proportion of one's income. The consumer will be more sensitive to price changes for 'big ticket' items; demand for these goods will be relatively elastic. On the other hand, if a good represents a very small proportion of one's income, its demand will be relatively inelastic. A box of matches tends to cost around 10p. If the price rose to 15p, which is a huge 50% rise, the product is still so cheap that most people will buy them anyway.
Is the good in question a necessity or a luxury? It can be argued that necessities have relatively inelastic demand, whereas more luxurious goods are more elastic in nature. I should think most peoples' demand for basic foodstuffs remains fairly constant regardless of changes in their prices. On the other hand, people will be more price sensitive if a good is not essential. If the price for smoked salmon rose, there would probably be a proportionately larger fall in demand. Smoked salmon is seen as a treat to most people, a luxury rather than a necessity.