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The price elasticity of demand
…measures the sensitivity of the quantity demanded of a good to a change
in its price
It is defined as:
% change in quantity
demanded
% change in price
Elastic demand
- when the price elasticity is more negative than -1
- i.e. when the % change in quantity demanded exceeds the change in
price
- e.g. if quantity demanded falls by 7% in response to a 5% increase
in price
- elasticity is -7 ¸ 5 = -1.4
Inelastic demand
- when the price elasticity lies between -1 and 0
- i.e. when the % change in quantity demanded is smaller than the change
in price
- e.g. if quantity demanded falls by 3.5% in response to a 5% increase
in price
- elasticity is - 3.5 ¸ 5 = - 0.7
Unit elastic demand
- UNIT ELASTIC demand
- when the price elasticity is exactly -1
- i.e. when the % change in quantity demanded is equal to the change
in price
- e.g. if quantity demanded falls by 5% in response to a 5%
increase in price
- elasticity is - 5 ¸ 5 = -
1
What determines the price elasticity?
- The ease with which consumers can substitute another good.
- EXAMPLE:
- consumers can readily substitute one brand of detergent for another
if the price rises
- so we expect demand to be elastic
- but if all detergent prices rise, the consumer cannot switch
- so we expect demand to be inelastic
Elasticity is higher in the long run
- In the short run, consumers may not be able (or ready) to adjust their
pattern of expenditure.
- If price changes persist, consumers are more likely to adjust.
- Demand thus tends to be
- more elastic in the long run
- but relatively inelastic in the short run.
Elasticity and revenue
When price is changed, the impact on a firm’s total revenue (TR) will
depend upon the price elasticity of demand.
|
For
a price increase |
For
a price decrease |
| Demand
is elastic |
TR
decreases |
TR
increases |
| Demand
is unit elastic |
TR
does not change |
TR
does not change |
| Demand
is inelastic |
TR
increases |
TR
decreases |
Elasticity and tube fares
- Passengers can use buses, taxis, cars etc
- so demand may be elastic (e.g. - 1.4)
- and an increase in fares will reduce the number of journeys demanded
and total spending
- If passengers do not have travel options
- demand may be inelastic (e.g. - 0.7)
- so raising fares will have less effect on journeys demanded
- and revenue will improve
The cross price elasticity of demand
- The cross price elasticity of demand for good iwith respect to the
price of good j is :
% change in quantity demanded
of good i
% change in the price
of good j
- This may be positive or negative
- The cross price elasticity tends to be negative if two goods are substitutes:
e.g. tea and coffee
- The cross price elasticity tends to be positive if two goods are complements
e.g. tea and milk.
The income elasticity of demand
- The income elasticity may be positive or negative.
Normal and inferior goods
- A NORMAL GOOD has a positive income elasticity of demand
- an increase in income leads to an increase in the quantity demanded
- e.g. dairy produce
- An INFERIOR GOOD has a negative income elasticity of demand
- an increase in income leads to a fall in quantity demanded
- e.g. coal
- A LUXURY GOOD has an income elasticity of demand greater than 1
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