What is ped
Measure of the sensitivity of quantity demanded to a change in price of a good or service
How do you calculate ped
% change in quantity demanded / % change in price
Interpret all ped values
Ped = 0 - perfectly inelastic - demand does not change in response to a change in price
0<Ped<1 - inelastic - demand isn’t responsive to price - % change in demand is smaller than the change in price
Ped=1 - unitary - % change of both demand and price are equal
1<PED<infinity - elastic - demand is responsive to price - % change in demand is larger than the change in price
Ped = infinity - consumers demand an unlimited quantity of the good at that price - if price were to rise demand would fall to 0
Factors that influence ped
Availability of close substitutes- consumers can easily switch when price rises if there’s a lot of substitutes - elastic
Proportion of income spent on the goods- goods taking a larger share of income - elastic demand as price changes have a significant impact on budget
Necessity vs luxury - necessities have inelastic demand as consumers can not easily reduce consumption , luxuries are elastic as they r more discretionary
Time period - in the short run demand tends to be inelastic as consumers need time to adjust behaviour or find alternatives - long run - demand more elastic as consumers can change habits or technology
Brand loyalty - strong brand loyalty makes demand more inelastic
Habitual consumption - demand more inelastic as it’s a habit
Importance of ped
Firms use ped to set prices that maximise total revenue - if demand is inelastic rise in price means more revenue
Government use ped to to predict the effect of indirect taxes - if demand is inelastic consumers bear most of the tax burden - smaller fall in quantity - high and stable tax revenue
Firms use to assess market power and competitive threats - firms with inelastic demand can increase price without large demand loss - pricing power and brand strength
Firms in markets with elastic demand face strong competition so must focus on differentiation or cost efficiency
What is yed
Income elasticity of demand - a measure of sensitivity of quantity demanded to a change in consumer incomes
Interpret YED
If yed is below -1 - elastic inferior good
If yed is between -1 and 0 - inelastic inferior good
If yed = 0 , no relationship between income and quantity demanded
If yed is between 0 and 1 - inelastic normal goods ( necessities )
If yed is above 1 - elastic normal good (superior good )
Factors that influence YED
Nature of the good - necessities have low positive YED since consumers buy roughly the same amount regardless of income
Luxuries - high YED - as demand rises more than proportionally with income
Level of consumer income - in early stages of income growth demand shifts rapidly towards good with high yed so these sectors expand but as income saturates growth slows . If income gains are concentrated among the wealthy , luxury sectors grow disproportionately while mass market demand remains weak so aggregate yed can mislead policy . Engel curve - shows how marginal spending patterns change with income
Importance of YED
Predicting the impact of economic growth or recession - during economic growth demand for luxury goods rises sharply benefiting firms in those sectors - firms can forecast sales and governments can predict structural changes in the economy and can predict how tax revenues will change as income rises
Problems with all elasticity calculations
Measurement problems - data lag , aggregation bias - when data are group together this hides or distorts the true relationship between variables that exist at individual or sub group level
Cross elasticity of demand
Measures responsiveness of demand for L e good to a change in price of another
Equation for xed
%change in quantity demanded of good A / % change in price of good B
Interpretation of xed
Strong complement - xed below -1
Weak complement - xed between -1 and 0
Xed=0- unrelated
Weak substitute - xed between 0 and 1
Strong substitute - xed above 1
Factors that influence xed
Degree of closeness of the relationship between the goods - close substitutes - if price of B increases consumers switch to A and a larger percentage rise in quantity demanded of A
Consumer switch cost - low information or high search cost for a substitute lead to dampened substitution as consumers don’t know alternatives until information spread
Brand loyalty - if price B rises and that product has higher brand loyalty many consumers stay despite higher price
Time dimension - short run - habit / contract - low xed
Long run - consumers find alternatives or technology changes - xed increases
Importance of xed
Helps firms understand market competition - if two goods have a high positive xed they are close substitutes - firms can use this to identity competitive threats and adjust pricing , branding or quality to maintain market share
Determines impact of indirect taxes - if two goods are complements a tax on one reduces demand for both - prevents unintended market distortions
Can guide mergers - if two goods are strong substitutes merging could reduce competition and help them raise prices increasing both their market shares and profit
What is pes
Price elasticity of supply - measure or sensitivity of quantity supplied of a good or service to a change in the price of that good or service
Equation for pes
% change in quantity supplied / % change in price
Interpretation of pes
Pes - between 0 and 1 - supply is not responsive to price - inelastic - slow or limited response
Pes - between 1 and infinity - supply is responsive to price - elastic - producers respond quickly
Pes -1 - unitary supply - change in price and supply are the same
Pes- infinity- firms are prepared to supply any amount at that price
Pes-0- firms will supply a fixed quantity whatever the price
Determinants of pes
Time period - short run - pes is typically price inelastic because firms can not rapidly alter capital or labour input - so price rise causes only a small increase in quantity supplied and large price volatility (degree of variation in price over time) - eval - short run in elasticity varies by industry
Long run - more elastic supply - over time firms invest , build capacity , new firms enter , factors are reallocated - long run supply smooths price volatility as firms plan capital expenditure and capacity expansion in anticipation of demand - however requires time , finance and low barriers to entry so increase in pes may be ,omitted where investment is costly or regulation is strict
Spare production capacity and ease of factor mobility - firms with inventories can release stock immediately onto market when price increases - causes a large percentage increase in quantity supplied in response to price - price is more elastic
If capital and labour are easily reallocated supply can expand faster - higher pes - eval supply side policy labour market flexibility trade unions
Importance of pes
Helps firms predict revenue and profit changes - when demand rises and pushed prices up firms with elastic supply can expand output increasing total revenue - guides business investment and capacity planning if low pes invest in extra capacity or inventories
Informs government policy - if supply is inelastic - tax mainly raises prices rather than cutting output - consumers bear the burden
If supply is elastic - producers can adjust output more easily softening price impacts
