Elasticity of DemandElasticity of Demand

IB Business and ManagementIB Business and Management

What is Elasticity?What is Elasticity?

Elasticity measures how responsive demand Elasticity measures how responsive demand is to a change in a particular variableis to a change in a particular variable

The IB syllabus includes:The IB syllabus includes:

Price Elasticity of DemandPrice Elasticity of Demand

Income Elasticity of DemandIncome Elasticity of Demand

Cross-price Elasticity of DemandCross-price Elasticity of Demand

Advertising Elasticity of DemandAdvertising Elasticity of Demand

PRICE ELASTICITY OF PRICE ELASTICITY OF DEMANDDEMAND

ElasticityElasticity

The relationship between The relationship between price and demandprice and demand

Elastic Demand?Elastic Demand?

Price Elasticity of DemandPrice Elasticity of Demand

Price Elasticity of demand is Price Elasticity of demand is concerned with how responsive the concerned with how responsive the demand for a product is to a change demand for a product is to a change in pricein price

How much How much will the demand change will the demand change as a result of a change in the price?as a result of a change in the price?

Price Inelastic GoodsPrice Inelastic Goods

Goods where demand is relatively Goods where demand is relatively unresponsive to a change in priceunresponsive to a change in price

Demand will reduce but by a relatively Demand will reduce but by a relatively small amount small amount

Firms would like their products to be Firms would like their products to be price inelastic.... Why?price inelastic.... Why?

Can you think of any examples?Can you think of any examples?

Price Elastic GoodsPrice Elastic Goods

Demand for the product is relatively Demand for the product is relatively responsive to a change in priceresponsive to a change in price

Firms will have very little freedom to Firms will have very little freedom to increase prices as this will result in a increase prices as this will result in a large decrease in demandlarge decrease in demand

Can you think of any examples? Can you think of any examples?

Calculating Price ElasticityCalculating Price Elasticity

PED = PED = % Change in quantity demanded % Change in quantity demanded % change in price% change in price

Example: Example: The price for a wardrobe is reduced The price for a wardrobe is reduced from £50 to £47 and as a result sales rise from £50 to £47 and as a result sales rise from 2,000 to 2,240 units.from 2,000 to 2,240 units.

% change in demand = 240/2000 X 100 = 12%% change in demand = 240/2000 X 100 = 12%% change in price = -£3/£50 X 100 = -6%% change in price = -£3/£50 X 100 = -6%PED = +12%/-6% = -2PED = +12%/-6% = -2

Classifying Price ElasticityClassifying Price Elasticity

PED Value (ignoring PED Value (ignoring minus sign)minus sign)

Negative value less Negative value less than 1than 1 Price InelasticPrice Inelastic

Exactly -1Exactly -1 Unit ElasticityUnit Elasticity

Negative Value more Negative Value more than 1than 1 Price ElasticPrice Elastic

Price Elasticity will always have a negative value – Why?

PED and Revenue for Price PED and Revenue for Price Elastic ProductsElastic Products

Revenue = Selling Price x Quantity DemandedRevenue = Selling Price x Quantity Demanded

Therefore firms who assess their products to be Price Elastic should consider carefully before increasing prices and can be in a difficult position if their costs increase

PED and Revenue for Price PED and Revenue for Price Inelastic ProductsInelastic Products

Revenue = Selling Price x Quantity DemandedRevenue = Selling Price x Quantity Demanded

Therefore firms who assess their products to be Price Inelastic have great freedom with their selling price.

Using PED to calculate Using PED to calculate changes in revenueschanges in revenues

PED = PED = % Change in quantity demanded % Change in quantity demanded % change in price% change in price

How could we rearrange this formula to How could we rearrange this formula to make % change in quantity demanded make % change in quantity demanded the subject?the subject?

% change in quantity demanded = PED X % change in price% change in quantity demanded = PED X % change in price

E.g. A product costs £100. At this level demand for the E.g. A product costs £100. At this level demand for the product is 60 unitsproduct is 60 units

What would revenue be at this price level?What would revenue be at this price level?

Total Revenue = £100 X 60 = £6,000Total Revenue = £100 X 60 = £6,000

The company are considering increasing the price to £110The company are considering increasing the price to £110

% change in quantity demanded = PED X % change in price% change in quantity demanded = PED X % change in price

The product is Price Inelastic – PED -0.5The product is Price Inelastic – PED -0.5What will the % change in demand be?What will the % change in demand be?If PED is -0.5 a 10% increase in price will result only in a 5% If PED is -0.5 a 10% increase in price will result only in a 5%

decrease in demanddecrease in demandSo the new level of demand will be?So the new level of demand will be?

60 ÷ 100 x 95 = 5760 ÷ 100 x 95 = 57

So what will the new revenue be?So what will the new revenue be?

New Total Revenue = £110 X 57 = £6,270New Total Revenue = £110 X 57 = £6,270

Answer:Answer: The product is Price Elastic – PED -2The product is Price Elastic – PED -2

What will the % change in demand be?What will the % change in demand be?If PED is -2 a 10% increase in price will result in a 20% If PED is -2 a 10% increase in price will result in a 20%

decrease in demanddecrease in demandSo the new level of demand will be?So the new level of demand will be?

60 ÷ 100 x 80 = 4860 ÷ 100 x 80 = 48

So what will the new revenue be?So what will the new revenue be?

New Total Revenue = £110 X 48 = £5,280New Total Revenue = £110 X 48 = £5,280

Exam Question (b) (i)Exam Question (b) (i)

Exam Question (b) (ii)Exam Question (b) (ii)

Factors influencing Price Factors influencing Price Elasticity Elasticity

Necessity or luxuryNecessity or luxury Availability of substitutesAvailability of substitutes Income of customersIncome of customers Brand LoyaltyBrand Loyalty

QuestionsQuestions

1.1. Why do firms prefer to sell products Why do firms prefer to sell products that are price inelastic?that are price inelastic?

2.2. How can firms reduce the price How can firms reduce the price elasticity of their products?elasticity of their products?

Implications of Price Implications of Price Elasticity of DemandElasticity of Demand

Helps firms decide on their pricing Helps firms decide on their pricing policypolicy

Helps predict the effect of exchange Helps predict the effect of exchange rate fluctuations on exported goodsrate fluctuations on exported goods

Helps governments to work out Helps governments to work out optimum levels of taxation on goods optimum levels of taxation on goods to maximise tax revenuesto maximise tax revenues

What do the following What do the following graphs show?graphs show?

Exam Question (b) (i)Exam Question (b) (i)

Exam Question (b) (ii)Exam Question (b) (ii)

INCOME ELASTICITY OF INCOME ELASTICITY OF DEMANDDEMAND

Income Elasticity of DemandIncome Elasticity of Demand

Income elasticity of demand is Income elasticity of demand is concerned with how responsive the concerned with how responsive the demand for a product is to a change demand for a product is to a change in incomein income

How much How much does the demand for a does the demand for a product increase or decrease with a product increase or decrease with a change in consumer’s incomes?change in consumer’s incomes?

Calculating Income Calculating Income ElasticityElasticity

IED = IED = % change in demand % change in demand % change in income% change in income Whereas an increase in price will always Whereas an increase in price will always

lead to a fall in demand (negative lead to a fall in demand (negative correlation) an increase in demand can lead correlation) an increase in demand can lead to either a fall or a rise in demand to either a fall or a rise in demand depending on the type of product. depending on the type of product.

Therefore IED can be negative or positiveTherefore IED can be negative or positive

Interpreting Income Interpreting Income Elasticity of DemandElasticity of Demand

An IED with a value < 1 is income An IED with a value < 1 is income inelastic and a value of > 1 are inelastic and a value of > 1 are income elastic (regardless of whether income elastic (regardless of whether they are negative or positive)they are negative or positive)

Products can be split into one of Products can be split into one of three categories: Normal Goods, three categories: Normal Goods, Luxury goods or Inferior goodsLuxury goods or Inferior goods

Inferior ProductsInferior Products Inferior products are those where an increase in Inferior products are those where an increase in

income leads to a decrease in demandincome leads to a decrease in demand Inferior products have a negative IEDInferior products have a negative IED Inferior products can be income elastic or Inferior products can be income elastic or

inelasticinelastic Demand falls as incomes rise and people tend to Demand falls as incomes rise and people tend to

buy more luxury productsbuy more luxury products E.g. A 10% increase in income leads to a 5% E.g. A 10% increase in income leads to a 5%

decrease in demand for Tesco Value white bread. decrease in demand for Tesco Value white bread. IED = -5%/10% = -0.5IED = -5%/10% = -0.5

Luxury GoodsLuxury Goods

Luxury goods are products where an Luxury goods are products where an increase in income will lead to a large increase in income will lead to a large increase in demand and vice versa.increase in demand and vice versa.

Luxury goods are therefor income elasticLuxury goods are therefor income elastic Luxury goods have a positive IED >1Luxury goods have a positive IED >1 E.g. An increase in income of 10% leads to E.g. An increase in income of 10% leads to

a 20% increase in demand for cruise a 20% increase in demand for cruise holidays. IED = 20%/10% = +2 holidays. IED = 20%/10% = +2

Normal goodsNormal goods Normal goods are products where an increase in Normal goods are products where an increase in

income leads to a small increase in demand and income leads to a small increase in demand and vice versavice versa

These products have a positive income elasticity These products have a positive income elasticity < 1< 1

Normal goods are therefore income inelasticNormal goods are therefore income inelastic These products are normally ‘everyday’ itemsThese products are normally ‘everyday’ items E.g. A 10% increase in income leads to a 6% E.g. A 10% increase in income leads to a 6%

increase in the demand for jammy dodgers. IED = increase in the demand for jammy dodgers. IED = 6%/10% = +0.6 6%/10% = +0.6

Normal, Inferior or LuxuryNormal, Inferior or Luxury

Issues with income elasticityIssues with income elasticity

Can help a firm to predict sales if Can help a firm to predict sales if they know the economic forecastthey know the economic forecast

Goods can fall into different Goods can fall into different categories to different groups of categories to different groups of people. What is considered a people. What is considered a necessity is subjectivenecessity is subjective

Goods can move between categories Goods can move between categories over timeover time

QuestionQuestion

Product AProduct A Product BProduct B

Price ElasticityPrice Elasticity -3.5-3.5 -0.5-0.5

Income ElasticityIncome Elasticity +0.4+0.4 +2.5+2.5

What products can be drawn about the nature of the two products A and B?

CROSS-PRICE ELASTICITY CROSS-PRICE ELASTICITY OF DEMANDOF DEMAND

Cross-price elasticityCross-price elasticity

Measures how responsive the Measures how responsive the demand for a product is to a change demand for a product is to a change of price of of price of anotheranother product product

These other products can be:These other products can be: SubstitutesSubstitutes ComplementsComplements Not-relatedNot-related

Calculating Cross-price Calculating Cross-price elasticityelasticity

CED = CED = % change in demand for Good % change in demand for Good A A % change price of Good B% change price of Good B

SubstitutesSubstitutes

Substitute products compete for Substitute products compete for demand as they can be used in place demand as they can be used in place of each otherof each other

These products can be competitor These products can be competitor products or other products that fulfill products or other products that fulfill the same needsthe same needs

Suggest some substitutes Suggest some substitutes for these products…..for these products…..

Train travel

Elasticity of demand and Elasticity of demand and substitute productssubstitute products

What is likely to happen to the demand for a What is likely to happen to the demand for a product if the price of it’s substitute increases?product if the price of it’s substitute increases?

There is a positive relationship between the There is a positive relationship between the demand for a product and the price of it’s demand for a product and the price of it’s substitutessubstitutes

The cross-price elasticity will be a positive The cross-price elasticity will be a positive numbernumber

The higher the value the greater the elasticityThe higher the value the greater the elasticity

ComplementsComplements

Complements are products that are Complements are products that are joint in demand as they are related joint in demand as they are related productsproducts

Suggest some complements Suggest some complements for these products…..for these products…..

Elasticity of demand and Elasticity of demand and complement productscomplement products

What is likely to happen to the demand for a What is likely to happen to the demand for a product if the price of it’s complement product if the price of it’s complement increases?increases?

There is an inverse relationship between the There is an inverse relationship between the demand for a product and the price of it’s demand for a product and the price of it’s complementscomplements

The cross-price elasticity will be a negative The cross-price elasticity will be a negative numbernumber

The more negative the value the greater the The more negative the value the greater the elasticityelasticity

Other considerations with Other considerations with cross-price elasticitycross-price elasticity

What would it mean if the calculation What would it mean if the calculation returned a result of zero?returned a result of zero?

Knowledge of cross-price elasticity Knowledge of cross-price elasticity can help businesses forecast the can help businesses forecast the impact on revenues if competitors impact on revenues if competitors implement a price changeimplement a price change

ADVERTISING ELASTICITY ADVERTISING ELASTICITY OF DEMANDOF DEMAND

Advertising elasticity of Advertising elasticity of demanddemand

Advertising elasticity of demand Advertising elasticity of demand (AED) measures the degree of (AED) measures the degree of responsiveness of demand for a responsiveness of demand for a product following a change in the product following a change in the advertising expenditure for the advertising expenditure for the productproduct

Calculating Advertising Calculating Advertising Elasticity of demandElasticity of demand

AED = AED = % change in demand % change in demand

% change in advertising expenditure% change in advertising expenditure

Can the results be positive or negative?Can the results be positive or negative?

What would a large figure suggest?What would a large figure suggest?

How might a firm use this information How might a firm use this information in planning it’s marketing strategy?in planning it’s marketing strategy?

Considerations with AEDConsiderations with AED

Is very difficult to determine in reality Is very difficult to determine in reality as it is difficult to determine whether as it is difficult to determine whether advertising expenditure or another advertising expenditure or another factor lead to a change in demand factor lead to a change in demand

Also, AED is dependent on the Also, AED is dependent on the effectiveness of the advertising effectiveness of the advertising rather than just the amount of rather than just the amount of expenditureexpenditure