PRICE ELASTICITY OF DEMAND

• When the price of a good rises, the demand will typically fall; in reverse manner when the price falls the demand will rise. However the extent to which demand changes can vary considerably

• When demand is very responsive to price changes it is defined as elastic; when demand is unresponsive it is known as inelastic

So for example if the price of DVD players falls by 10% and demand rises by 30% (i.e. is very responsive to the price change) this constitutes elastic demand

If however the price of petrol rises by 10% and demand falls by 5% (is not very responsive to the price change) then demand is inelastic

• More precisely price elasticity of demand is measured

% change in Qd of a good

% change in its price

PRICE ELASTICITY OF DEMAND (con)

• Thus in the first example it is measured as - 30%  = -3                                                                                10%

• The measurement is negative because price and demand move in opposite directions

• In the second case elasticity is measured as - 5% = -.5                                                                                10%

• Thus when numerically the measurement is > 1 (in absolute terms) demand is elastic; when the measurement is < 1, then demand is inelastic.

P(£)

Q (millions of units per period of time)

0

aD

Elastic demand between two pointsElastic demand between two points

Expenditure fallsas price rises

4

20

5

10

b

a4

20

P(£)

Q (millions of units per period of time)

0

D

Expenditure risesas price rises

Inelastic demand between two pointsInelastic demand between two points

8

15

c

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Elasticity is determined by a number of factors:

• When goods are close substitutes for each other demand tends to be very elastic (>1). By contrast demand is inelastic (< 1) for necessities

• Elasticity also depends on the amount of income spent

on a good. When a small amount of overall income is spent demand tends to be inelastic

• Elasticity also depends on the time period involved. In the short term (e.g. immediately after an alcohol price increase in a budget) demand tends to be very elastic, though much more inelastic in the long run). In other cases demand is more inelastic (e.g. for meat products) in the short than in the long run

• Elasticity also depends on whether goods are durable or non-durable

MEASUREMENT OF ELASTICITY• There are two types of measurement of elasticity i.e. arc and point

• Though point measurements are more accurate they relate to (theoretical) infinitesmally small changes in price and quantity

Arc measurements are used in practice though there is a degree of arbitrariness due to two equally valid ways of calculation (which give opposite answers)

So the most correct answer is based on an average of the two other answers

Example: If milk is €1with 100,000 bottles sold and then when the price

goes up to €1.10, 95,000 bottles are sold.

Using old price (P1) and old quantity (Q1) as base,

PED = - 5,000/100,000 divided by 10/100 = -.5

However using new price (P2 ) and new quantity (Q2) as base

PED = - 5,000/95,000 divided by 10/110 = -.58

Best measurement = ∆Q/ (Q1+ Q2) divided by ∆P/(P1+ P2)

= -5,000/195,000 divided by 10/210 = .54

0

2

4

6

8

10

0 10 20 30 40 50

P (£)

Q (000s)

Q P

mid Q mid PPd =

10 2 15 7

=

= 10/15 x 7/2

= 70/30

= 7/3 = 2.33

Demand

m

n

Q = 10

P = –2

Mid P

7

Mid Q15

Measuring elasticity using the arc methodMeasuring elasticity using the arc method

P

Q

50

30

0 40 100

D

r

Pd = (1 / slope) x P/Q

= 100/50 x 30/40

= 60/40

= 1.5

Measuring elasticity at a pointMeasuring elasticity at a point

fig

0

2

4

6

8

10

0 10 20 30 40 50

P

Q

Demand

n

m

l

k

Pd = (1 / slope) x P/Q

(1 / slope) is constant

= 50/10 = 5But P/Q varies:

at n, P/Q = 8/10at m, P/Q = 6/20at l, P/Q = 4/30

l

Different elasticities along a straight-line demand curveDifferent elasticities along a straight-line demand curve

PRICE ELASTICITY AND CONSUMER EXPENDITURE

• The basic rule is as follows  

If demand is elastic when P increases TR will fall If demand is inelastic when P rises, TR will increase

If demand is elastic when P falls, TR will increase

If demand is inelastic, when P falls, TR will decrease  

• In terms of the demand curve elastic demand leads to a more horizontal (flat) shape

Inelastic demand leads to a more vertical (steep) curve

• If the demand curve is totally horizontal, this represents totally elastic demand (i.e. infinite). If the demand curve is totally vertical, this represents totally inelastic demand (i.e. 0)

IMPORTANT APPLICATIONS OF ELASTICITY

• Tax increases with respect to excise duties and VAT by a Government

in the budget; for tax revenue to increase demand must be inelastic

• Proposed price increases (or decreases) by a company; in the case of monopolies like ESB (where demand for electricity is inelastic) price increases are likely to increase total revenue; in other cases where there are close substitutes such as budget airlines demand is very price elastic so that reductions in fares is more likely to increase revenue

• Price elasticity of demand is also very important in both export and import markets

For example assuming that export markets such as the UK and US are price competitive (with close substitutes) a rise in the Euro against sterling and the dollar would (other things being equal) lead to a drop in export revenues for Irish firms.

INCOME ELASTICITY OF DEMAND

• Income elasticity of demand is also important. It measures the responsiveness of demand to a change in income

% change in Qd of a good % change in income

• Generally income elasticity is positive. For example an increase in income will lead to increased demand for a product. However for inferior goods demand actually falls as income rises so that income elasticity is negative.

• The definition of a normal good is one with a positive income elasticity of

demand

• Demand is very income elastic for luxuries (e.g. foreign holidays) and income inelastic for necessities (e.g. food).

• For a wide range of goods and services income would be the most important determinant of demand; this helps to explain why a recession is so damaging for business

CROSS ELASTICITY OF DEMAND

• Cross elasticity of demand measures the responsiveness in demand of one good to a change in price of the other.

% change in Qd of good X % change in P of good Y

• Cross elasticity is especially important for substitutes and complements.

For substitutes (i.e. goods that can be used in place of each other) cross elasticity is measured as positiveIn other words if the price of Coca Cola was to rise, then the demand for a close substitute (Pepsi Cola) will also rise

For complements (i.e. goods that are used jointly) cross elasticity is negative. Thus if the price of petrol was to rise, then the demand for cars will fall (other things remaining equal).

PRICE ELASTICITY OF SUPPLY

• This measures the responsiveness of supply to a change in demand

% change in Qs of a good % change in its price  

• If supply changes by more than price (as a %) then supply is elastic. If it changes by less then it is inelastic  

• Supply differs from demand in that it takes a longer time typically for supply to react to price. These time periods are divided into 4 periods as follows Immediate market period, short run, long run, very long run

• Thus with respect to oil in the immediate market period supply is totally fixed. Therefore any increase in demand will lead to an increase in price. In the short run existing oil wells could be more intensively worked leading to some increase in supply. In the long run new oil wells could be opened up leading to a greater increase in supply. In the very long run the technology of oil production could change leading to further possible increases.

D1

D2

S long-run

P1

P3

P2

Q1 Q2 Q3

P

Q O

b

c

S short-run

a

Response of supply to an increase in demand

Response of supply to an increase in demand

S1

S2

D short-run

D long-run

P1

P3

P2

Q1 Q2 Q3

P

Q O

a

b

c

Response of demand to an increase in supply

Response of demand to an increase in supply

SPECULATION

• Speculation will tend to have a stabilising effect on price fluctuations when suppliers or demanders believe that a change in price is only temporary

• Speculation will have a destabilising effect on price fluctuations when suppliers and/or buyers believe that a change in price heralds similar

changes to come in the future

• Gambling can be of two kinds

- when the odds are known (where it is referred to as risk)

- when the odds are not known (where it is referred to as uncertainty)

The buying of appropriate information can reduce uncertainty

Stockholding can also reduce uncertainty

MAXIMUM AND MINIMUM PRICES • Government usually set minimum prices above free market prices (setting

a price floor below which prices are not allowed to fall)

• Maximum prices are then set below free market prices (setting a price ceiling above which prices are not allowed to rise)

• The Common Agricultural Policy is a good example of a minimum price approach

• Rent controls provide an interesting example of the alternative maximum price approach

S + tax

S

O

P1

P2

Q2 Q1

D

CONSUMERS’SHARE

CONSUMERS’SHARE

P2 - t P2 - t PRODUCERS’ SHAREPRODUCERS’ SHARE

P

Q

Incidence of tax: inelastic demandIncidence of tax: inelastic demand

S + tax

S

O

P2 - t

P1

P2

Q2 Q1

D

CONSUMERS’SHARE

CONSUMERS’SHARE

PRODUCERS’ SHARE

PRODUCERS’ SHARE

P

Q

Incidence of tax: elastic demandIncidence of tax: elastic demand

S + tax

S

O

P2 - t

P1

P2

Q2 Q1

D

P

Q

CONSUMERS’ SHARECONSUMERS’ SHARE

PRODUCERS’ SHAREPRODUCERS’ SHARE

Incidence of tax: inelastic supplyIncidence of tax: inelastic supply

S + taxP

Q O

P2 - t

P1

P2

Q2 Q1

D

SCONSUMERS’

SHARECONSUMERS’

SHARE

PRODUCERS’ SHARE

PRODUCERS’ SHARE

Incidence of tax: elastic supplyIncidence of tax: elastic supply

Source: National Food Survey 2000 (National Statistics, 2001), extracted from Tables 6.1, 6.3, 6.4 and 6.5

Elasticities of demand for various foodstuffs (UK)

Elasticities of demand for various foodstuffs (UK)

P

Q O

P1

S2

D2

P2

Q1 Q2

D1

S1

Decline in food prices over timeDecline in food prices over time

Long-term increases in supply likely to be

greater than long-term increases in demand.

P

Q O

D

Sa3

Q3 Q1

Sa1

Q3

Y

aP1

P3

P3

de

Released from buffer stock

Buffer stocks to stabilise incomesBuffer stocks to stabilise incomes

COSTCOSTREVENUE FROMREVENUE FROM

SALE OF SURPLUSSALE OF SURPLUSON WORLD MARKETON WORLD MARKET

P

Q O Qs2

Pw

Pi

SEU

Qd2

DEU

a bf c

Surplus

NET COSTNET COST

Intervention pricede

Minimum prices for a product where the EU is self-sufficientMinimum prices for a product where the EU is self-sufficient

Qs1Qd1

fig

P

Q O

D

Q1Qe

Pe

Pg

Pm

S + subsidy

S

Sub

sidy

Total paid in subsidy

Effect of subsidies on foodstuffsin which the country is self-sufficient

Effect of subsidies on foodstuffsin which the country is self-sufficient

MARKET ADJUSTMENT OVER TIME

• Full adjustment of price demand and supply to a situation of disequilibrium

will not be instantaneous

• As price elasticities of demand vary with the time period under

consideration, the short-term price change can differ from the long-term

• If prices are likely to change in the future this will affect the behaviour of

buyers and sellers now

- a belief that prices will go up (e.g. houses) will cause consumers to buy

now; a belief that prices will come down will cause them to postpone

present expenditure

- a belief that prices will go up will cause producers to postpone selling now;

a belief that prices will go down will cause producers to sell now

S2

D3

Stabilising speculation: initial price fall

P1

P2

P

Q O

P3

D2

a

b

c

S1

D1

Speculators believe that the

fall in price to P2 is only temporary.

Stabilising speculation: initial price rise

P1

P2

P

Q O

P3

S1

S2

D1

D2

a

b

D3

c

Speculators believe that the

rise in price to P2 is only temporary.

Destabilising speculation: initial price fall

P1

P2

P

Q O

P3

S1

S2

D1

D2

a

b

D3

c

Speculators believe that the fall in price to P2 signifies a trend.

Destabilising speculation: initial price rise

P1

P2

P

Q O

P3

S1

S2

D1

D2

a

b

D3

c Speculators believe that the

rise in price to P2 signifies a trend.

MARGINAL UTILITY THEORY

• Total and marginal utility

• meaning of total utility

– marginal utility: TU/Q

• diminishing marginal utility: as the consumption of a product increases (assuming

no significant time delay as between units) the extra utility or satisfaction

experienced on each additional unit consumed tends to diminish and in extremes

become negative

- marginal utility: TU/Q

for example if one consumes four cups of coffee in one session, the utility

of the marginal unit (i.e. each additional cup of coffee) will diminish

- total and marginal utility curves

fig

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

MU

Ollie's utility from consuming crisps (daily)Ollie's utility from consuming crisps (daily)

• The optimum level of consumption: the one-commodity version

– consumer surplus is the notion that a consumer can gain a surplus of utility. For example using a previous example if one is willing to pay €2 for the each of the four cups of coffee consumed then this implies that the utility from the last cup justifies the price paid. Therefore as the marginal utility is higher on the 1st, 2nd and 3rd units, then one thereby obtains surplus utility on the earlier units consumed

• marginal consumer surplus: MU – P

• total consumer surplus: TU – TE

• maximising consumer surplus: P = MU

• Marginal utility and the demand curve

MARGINAL UTILITY THEORY

fig

Totalconsumer

expenditure

Totalconsumer

expenditure

Total consumer surplus

Total consumer surplus

MU

MU, P

QO

P1

Q1

Consumer surplusConsumer surplus