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Elasticity of Demand
Price Elasticity of DemandPrice Elasticity of Demand
• Defining price elasticity of demand (PeD)
– measures the strength of response of consumer demand to a change in price.
– Measures our reaction to a change in price
• Defining price elasticity of demand (PeD)
– measures the strength of response of consumer demand to a change in price.
– Measures our reaction to a change in price
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Defining Total consumer Expenditure
TE = P × Q
• Illustrating TE graphically
• Defining Total consumer Expenditure
TE = P × Q
• Illustrating TE graphically
0
1
2
3
4
0 1 2 3 4 5
Consumers’ total expenditure =
firms’ total revenue=
£2 x 3m = £6m
Consumers’ total expenditure =
firms’ total revenue=
£2 x 3m = £6m
P(£)
Q (millions of units per period of time)
D
Total expenditureTotal expenditure
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Effects of a price change: elastic demand– Price rises Total Expenditure falls
• Effects of a price change: elastic demand– Price rises Total Expenditure falls
4
20
P(£)
Q (millions of units per period of time)
0
aD
Elastic demand between two pointsElastic demand between two points
Expenditure fallsas price rises
5
10
b
P(£)
Q (millions of units per period of time)
0
aD
Elastic demand between two pointsElastic demand between two points
4
20
5
10
b
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Effects of a price change: inelastic demand– Price rises: Total Expenditure rises
• Effects of a price change: inelastic demand– Price rises: Total Expenditure rises
Expenditure risesas price rises
a4
20
P(£)
Q (millions of units per period of time)
0
D
Inelastic demandInelastic demand
8
15
c
Price Elasticity of DemandPrice Elasticity of Demand
• Applications to pricing decisions
• Applications to tax decisions
Income Elasticity (at end)• Revenue predictions
• Government revenue changes from taxes on products
• Applications to pricing decisions
• Applications to tax decisions
Income Elasticity (at end)• Revenue predictions
• Government revenue changes from taxes on products
Price Elasticity of DemandPrice Elasticity of Demand
• Measuring price elasticity of demand
– use of percentage changes
– the sign: positive or negative?
– the value: greater or less than 1?
• Measuring price elasticity of demand
– use of percentage changes
– the sign: positive or negative?
– the value: greater or less than 1?
% change in QD
% change in P
Price Elasticity of DemandPrice Elasticity of Demand
• Measuring price elasticity of demand
– greater than -1 then price elastic
– less than -1 then price inelastic
• Measuring price elasticity of demand
– greater than -1 then price elastic
– less than -1 then price inelastic
% change in QD
% change in P
Price Elasticity of DemandPrice Elasticity of Demand
• Determinants of price elasticity of demand
– availability of substitute goods
– proportion of income spent on the good
– habit
– fashion
– frequency of purchase
• Determinants of price elasticity of demand
– availability of substitute goods
– proportion of income spent on the good
– habit
– fashion
– frequency of purchase
Elastic or Inelastic?Elastic or Inelastic?
Elastic or InelasticElastic or Inelastic
Elastic or InelasticElastic or Inelastic
Elastic or Inelastic?Elastic or Inelastic?
Elastic or InelasticElastic or Inelastic
Elastic or Inelastic?Elastic or Inelastic?
Measuring Elasticity
% change in QD
% change in P
÷Change in QD
Original QD
Change in P
Original P
0
2
4
6
8
10
0 10 20 30 40 50
P (£)
Q (000s)
Demand
m
n
Measuring ElasticityMeasuring Elasticity
Price elasticity of demand
% change in QD
% change in P
÷10
10
2
8
= 4
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Special cases– PeD = 0
• Special cases– PeD = 0
P2
P
QO Q1
P1
D
b
a
Totally inelastic demand (PD = 0)Totally inelastic demand (PD = 0)
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Special cases– PeD = 0
– PeD =
• Special cases– PeD = 0
– PeD =
Q2
P
QO Q1
P1 Da b
Infinitely elastic demand (PD = )Infinitely elastic demand (PD = )
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Special cases– PeD = 0
– PeD = – PeD = –1
• Special cases– PeD = 0
– PeD = – PeD = –1
P
QO 40
20
D
100
8
a
Unit elastic demand (PD = –1)Unit elastic demand (PD = –1)
b
Price Elasticity of Demand and Consumer Expenditure
Price Elasticity of Demand and Consumer Expenditure
• Special cases– PeD = 0 – perfectly inelastic
– PeD = - perfectly elastic
– PeD = –1 – unitary elasticity
• Special cases– PeD = 0 – perfectly inelastic
– PeD = - perfectly elastic
– PeD = –1 – unitary elasticity
Demand Changes with IncomeDemand Changes with Income
• Consumers increase the demand for most good when income rises – NORMAL GOODS
• Demand for a good may fall when income rises and vice versa – INFERIOR GOODS
• Consumers increase the demand for most good when income rises – NORMAL GOODS
• Demand for a good may fall when income rises and vice versa – INFERIOR GOODS
The London Restaurant marketThe London Restaurant market
• Watch the video clips and comment on the types of goods and their elasticities:– Restaurant Food
– Prepacked sandwiches
– Sandwich boxes
• Watch the video clips and comment on the types of goods and their elasticities:– Restaurant Food
– Prepacked sandwiches
– Sandwich boxes
Goods can be both!Goods can be both!
• Bread
• NORMAL if you are on a low income
• INFERIOR for higher income earners
• Bread
• NORMAL if you are on a low income
• INFERIOR for higher income earners
Other ElasticitiesOther Elasticities
• Income elasticity of demand– measurement– determinants
• degree of necessity• rate at which people are satisfied• level of income
– Applications – we can work out the effect of a price change/tax change
• Income elasticity of demand– measurement– determinants
• degree of necessity• rate at which people are satisfied• level of income
– Applications – we can work out the effect of a price change/tax change
Income ElasticityIncome Elasticity
• If sellers know the income elasticity of their product they can predict what will happen to their revenue when incomes change
• The Government would also be able to predict changes in revenue from taxes on products
% Change in demand
% Change in Income
• If sellers know the income elasticity of their product they can predict what will happen to their revenue when incomes change
• The Government would also be able to predict changes in revenue from taxes on products
% Change in demand
% Change in Income
If income rises?If income rises?
• Some products are still out of our reach. How much is an Aston Martin? £183,000
• Some products we will buy no more of. Eg a newspaper
• Some we will buy a little more of eg food. (Food is income inelastic in a high-income economy such as ours).
• Some we will buy more of eg entertainment, meals out. Income elasticity tends to be greater than 1
• Some we will buy less of eg no more Tesco Value for me or white bread!
• Some products are still out of our reach. How much is an Aston Martin? £183,000
• Some products we will buy no more of. Eg a newspaper
• Some we will buy a little more of eg food. (Food is income inelastic in a high-income economy such as ours).
• Some we will buy more of eg entertainment, meals out. Income elasticity tends to be greater than 1
• Some we will buy less of eg no more Tesco Value for me or white bread!
Income ElasticityIncome Elasticity
• A normal good will always have a positive income elasticity because quantity demanded and income either both increase (+/+) or both decrease (-/-)
• An inferior good will always have a negative elasticity - opposite signs each way
• A normal good will always have a positive income elasticity because quantity demanded and income either both increase (+/+) or both decrease (-/-)
• An inferior good will always have a negative elasticity - opposite signs each way
Giffen GoodsGiffen Goods
• Theory by Sir Robert Giffen!
• A giffen good is a special sort of inferior good
• Giffen observed that the consumption of bread increased as the price rose
• Bread was the staple food of those on low incomes – bread would ‘fill’ empty stomachs! And as its price had risen they could afford less luxuries like meat and so bought more bread
• Theory by Sir Robert Giffen!
• A giffen good is a special sort of inferior good
• Giffen observed that the consumption of bread increased as the price rose
• Bread was the staple food of those on low incomes – bread would ‘fill’ empty stomachs! And as its price had risen they could afford less luxuries like meat and so bought more bread
Income EffectIncome Effect
• If the price of a good rises, the real income of a consumer falls
• Cannot buy the same basket of goods and services as before.
• If the price of a good rises, the real income of a consumer falls
• Cannot buy the same basket of goods and services as before.
SubstitutionSubstitution
• If the price of a good rises, consumers will buy less of that good and more of others because it is relatively more expensive.
• If the price of a good rises, consumers will buy less of that good and more of others because it is relatively more expensive.
Cross ElasticityCross Elasticity
• The quantity demanded of a good varies according to the price of other goods
• Eg a rise in the price of beef would increase demand for pork (substitute)
• A rise in the price of cheese would lead to a fall in demand for macaroni (complement)
• The quantity demanded of a good varies according to the price of other goods
• Eg a rise in the price of beef would increase demand for pork (substitute)
• A rise in the price of cheese would lead to a fall in demand for macaroni (complement)
Cross ElasticityCross Elasticity
% ∆ Q demanded good X
% ∆ Price of another good Y
• Two goods which are substitutes will have a positive cross elasticity
• Two goods which are complements will have a negative cross elasticity
• The cross elasticity of goods which have little relationship to each other would be zero (independents)
% ∆ Q demanded good X
% ∆ Price of another good Y
• Two goods which are substitutes will have a positive cross elasticity
• Two goods which are complements will have a negative cross elasticity
• The cross elasticity of goods which have little relationship to each other would be zero (independents)
Example – positive cross elasticityExample – positive cross elasticity
• A rise in the price of fish may cause demand for chicken to increase (substitutes)
• A rise in the price of fish may cause demand for chicken to increase (substitutes)
Pri
ce o
f F
ish
Quantity of Chicken Demanded
What will have happened to the demand curve for chicken?
Example – negative cross elasticityExample – negative cross elasticity
• A rise in the price of air travel causes a fall in the demand for foreign holidays (complementary goods)
• A rise in the price of air travel causes a fall in the demand for foreign holidays (complementary goods)
Quantity of foreign holidays demanded
Pri
ce o
f ai
r tr
avel
What will have happened to the demand curve for foreign holidays?
Example – zero cross elasticityExample – zero cross elasticity
• A rise in the price of apples leaves the demand for gloves unaffected!
• However we must remember that a change in the price of a product affects our purchasing power and may affect the demand for an unrelated product.
• A rise in the price of apples leaves the demand for gloves unaffected!
• However we must remember that a change in the price of a product affects our purchasing power and may affect the demand for an unrelated product.
Quantity of gloves demanded
Pri
ce o
f ap
ple
s
The significance of cross elasticityThe significance of cross elasticity
• Firms may realise that if a product has a high positive cross-elasticity, then a decrease in price will attract more customers.
• A low positive cross –elasticity gives a firm more power to raise the price.
• A high negative cross elasticity means lowering the price of the cheaper complement can increase sales of the other product.
• Firms may realise that if a product has a high positive cross-elasticity, then a decrease in price will attract more customers.
• A low positive cross –elasticity gives a firm more power to raise the price.
• A high negative cross elasticity means lowering the price of the cheaper complement can increase sales of the other product.