Sunday, 3 April 2011

Price Elasticity of Demand (Microeconomics)

Price elasticity of demand can be a difficult to concept to get to grips with, so i'll attempt to keep this simple and easy to understand.

Firstly, what do we mean by elasticity? Well, the elasticity is the extent to which demand responds to a change in market conditions... in this case the market conditions are price. So, price elasticity of demand measures the responsiveness of demand to a change in price.

There is a special formula for calculating the price elasticity of demand (PED) of a good...

PED = % Change in demand ÷ % Change in price.

The result of this formula will always be a negative value. Now, this figure will tell us how elastic the good is.

  • When PED = -1 .... Demand has unitary elasticity. Meaning that a rise in price will cause a fall in demand of equal amount. And vice versa if price falls.
  • When PED = 0 .... Demand is perfectly inelastic. Meaning that any change in price will have no effect on demand what-so-ever.
  • When PED is between -1 and -Infinity .... Demand is elastic. Meaning a change in price will have a more than proportionate effect on demand.
  • When PED is between -1 and 0 .... Demand in inelastic. Meaning a change in price will have a less than proportionate effect on demand.

The price elasticity of demand of a good dictates how steep the demand curve will be on a supply and demand diagram for that particular good. If a good is perfectly inelastic the demand curve will be vertical, because demand is the same at any given price. If a good is very elastic then the demand curve will be virtually horizontal because a small change in price will have a large effect on the demand for the good. 

Generally, if a good is considered a necessity... such as petrol, cigarettes or insulin then its PED will always be very inelastic because people need these items, no matter the price they have to buy them. On the flip side, if a good is considered a luxury good... such as holidays abroad, new cars and CDs then its PED will be very elastic because they aren't needed and people can stop buying them even if the price rises a little.

There are three main determinants of price elasticity of demand:

  1. Availability of substitute goods. If there are plenty of substitute goods available then it is highly likely that the PED of this product will be elastic because there are plenty of alternatives for consumers if prices rose. Also if there are no substitute goods, then the chances are the product will be inelastic.
  2. The price of the product compared to peoples income. If the good takes up a very small amount of peoples income then price is likely to be inelastic as people don't worry about price rises as they will only be tiny. However, if the good is a large percentage of peoples income then price is likely to be elastic because a price rise will have a large effect and stop people purchasing.
  3. Time. If people find it difficult to change spending habits on goods then those goods will be inelastic as people cannot change what they buy quickly, even if prices rise. However, if people can change there spending habits for goods quickly then those goods will be elastic.

Lets do a little example of working out the price elasticity of demand. Remember these figures are made up! Say the cost of a book rises from £10 to £12, causing a fall in demand from 5000 to 4500.

The % change in demand would be -10% (-500÷5000 x 100)
The % change in price would be 20% (2÷10 x 100) 

So, we have -10% ÷ 20% = -0.5. This result tells us that this books price elasticity of demand is inelastic, a 20% rise in price only caused a 10% fall in demand. Must be one good book!

Thanks for reading!

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