PRICE ELASTICITY OF DEMAND (PED)
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PRICE ELASTICITY OF DEMAND (PED): Measures the responsiveness of the quantity demanded
of a good to a change in price
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Inelastic Demand ( 0 < | PED | < 1) : Quantity demanded is relatively unresponsive to price
Elastic Demand ( 1 < | PED | < ∞) : Quantity demanded is relatively responsive to price
As there is a Negative Causal Relationship between the price of a good and quantity demanded, the price elasticity of demand (PED) will always take a negative value:
For any percentage increase in price (a positive denominator), there follows a percentage decrease in quantity demanded (a negative numerator), thus resulting in a negative PED
Similarly, for any percentage decrease in price (a negative denominator), there follows a percentage increase in quantity demanded (a positive numerator), thus also resulting in a negative PED
However, to avoid confusion when making comparisons between different values of PED, the PED is treated as a positive value; hence, the absolute value of PED is obtained and evaluated
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Example: DVD Players
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Suppose that in a department store, consumers buy 6000 DVD players at the original price of $255
per unit. However, when the price is increased to $300 per unit, consumers buy 5000 DVD players.
Calculate the PED for DVD players in this department store.
As the absolute value of PED is 0 < 0.94 < 1, the PED for DVD players is Elastic
TYPES OF PRICE ELASTICITY OF DEMAND (PED)
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As the price elasticity of demand (PED) compares the percentage change in quantity demanded of a good to the percentage change in price, the PED can take a range of values with varying significance:
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SPECIAL CASES:
PRICE ELASTICITY OF DEMAND (PED) ALONG DEMAND CURVE
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The price elasticity of demand (PED) varies along any downward-sloping, straight-line demand curve:
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Demand is price elastic at high prices and low quantities
Demand is unitary price elastic at the midpoint of demand curve
Demand is price inelastic at low prices and high quantities
Elastic Demand
At high prices and low quantities, the percentage change in quantity demanded is relatively large (as the denominator of 𝚫Qd / Q is small), while the percentage change in price is relatively small (as the denominator of 𝚫P / P is large)
Hence, the PED, given by a large percentage change in quantity demanded over a small percentage change in price, is greater than one (1 < PED < ∞), implying elastic demand
Unitary Elastic Demand
At the midpoint of the demand curve, the percentage change in quantity demanded is equal to the percentage change in price
Hence, the PED, given by an equal percentage change in quantity demanded and price, is one, implying unitary elastic demand
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Inelastic Demand
At low prices and high quantities, the percentage change in quantity demanded is relatively small (as the denominator of 𝚫Qd / Q is large), while the percentage change in price is relatively large (as the denominator of 𝚫P / P is small)
Hence, the PED, given by a small percentage change in quantity demanded over a large percentage change in price, is less than one (0 < PED < 1), implying inelastic demand
NOTE: The terms ‘elastic’ and ‘inelastic’ should not be used to refer to an entire demand curve due to varying elasticity along the curve (with the exception of the three special cases where PED is constant: perfectly inelastic demand, unitary elastic demand, and perfectly elastic demand)
DETERMINANTS OF PRICE ELASTICITY OF DEMAND (PED)
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DETERMINANTS OF PRICE ELASTICITY OF DEMAND: Factors that affect the elasticity of a good or service
1) NUMBER AND CLOSENESS OF SUBSTITUTES
If a good has many close substitutes, consumers can easily switch to an alternative substitute if there is a change in price; hence, the demand for good will be price elastic
If a good has no close substitutes, consumers cannot switch to an alternative substitute if there is a change in price; hence, the demand for good will be price inelastic
2) DEGREE OF NECESSITY
If a good is essential, it is categorized as necessities; hence, the demand for the good will be price inelastic as it needs to be consumed
If a good is non-essential, it is categorized as luxuries; hence, the demand for the good will be price elastic as it does not need to be consumed
3) TIME PERIOD
In a short time period, consumers have no time to consider the necessity of the good and find alternative substitutes; hence, the demand for the good will be price inelastic
In a long time period, consumers have more time to consider the necessity of the good and find alternative substitutes; hence, the demand for the good will be price elastic
4) PROPORTION OF INCOME
If the price of a good represents a small proportion of income, a change in price will have a smaller impact on the absolute amount of income spent; hence, the demand for the good will be price inelastic
If the price of a good represents a large proportion of income, a change in price will have a larger impact on the absolute amount of income spent; hence, the demand for the good will be price elastic
PRICE ELASTICITY OF DEMAND (PED) AND EFFECTS OF PRICE CHANGES ON TOTAL REVENUE
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TOTAL REVENUE (TR): Amount of money received by firms when they sell a good or service:
Total Revenue = Price x Quantity
The effect of a change in price on total revenue will depend on the price elasticity of demand (PED) of a good:
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Inelastic Demand ( 0 < PED < 1 ): Price and total revenue changes in the same direction
Unitary Elastic Demand ( PED = 1 ): Total revenue remains unchanged as price changes
Elastic Demand ( 1 < PED < ∞): Price and total revenue changes in opposite directions
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Hence, as the price elasticity of demand (PED) falls along a downward-sloping, straight line demand curve, total revenue is maximized when demand is unitary elastic:
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On the upper portion of the demand curve, where price is high and quantity demanded is low, demand is elastic; firms can therefore increase total revenue by lowering price
In this way, total revenue will increase as price falls, moving the firm along the demand curve until the midpoint where PED is unitary elastic
If prices fall below this midpoint, the total revenue will decrease as price is now in the inelastic portion of the demand curve
For this reason, firms maximize their total revenue at the midpoint of the demand curve where demand is unitary elastic - as total revenue remains unchanged as price changes
Inelastic Demand
When demand is inelastic, a decrease in price leads to a smaller percentage increase in quantity demanded; hence, the loss from the fall in price is larger than the gain from the quantity increase, resulting in an overall decrease in total revenue
When demand is inelastic, an increase in price leads to a larger percentage decrease in quantity demanded; hence, the gain from the rise in price is larger than the loss from the quantity decrease, resulting in an overall increase in total revenue
In other words, when demand is inelastic, price and total revenue changes in the same direction
Unitary Elastic Demand
When demand is unitary elastic, a decrease in price leads to the same percentage increase in quantity demanded; hence, the loss from the fall in price is equal to the gain from the quantity increase, resulting in total revenue to remain unchanged
When demand is unitary elastic, an increase in price leads to the same percentage decrease in quantity demanded; hence, the gain from the rise in price is equal to the loss from the quantity decrease, resulting in total revenue to remain unchanged
In other words, when demand is unitary elastic, Total revenue remains unchanged as price changes
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Elastic Demand
When demand is elastic, a decrease in price leads to a larger percentage increase in quantity demanded; hence, the loss from the fall in price is smaller than the gain from the quantity increase, resulting in an overall increase in total revenue
When demand is elastic, an increase in price leads to a larger percentage decrease in quantity demanded; hence, the gain from the rise in price is smaller than the loss from the quantity decrease, resulting in an overall decrease in total revenue
In other words, when demand is elastic, price and total revenue changes in opposite directions
PRICE ELASTICITY OF DEMAND (PED) OF PRIMARY COMMODITIES
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PRIMARY COMMODITIES: Goods arising directly from the use of natural resources or the factor of production ‘land’: this includes agricultural (food and non-edible products such as cotton), fishing, and forestry products, as well as products of extractive industries (oil, coal, and minerals)
The price elasticity of demand (PED) of primary commodities is relatively low:
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As primary commodities are necessities with no close substitutes, consumers cannot refuse to consume the good and cannot switch to an alternative substitute
For this reason, the demand for primary commodities is relatively unresponsive to price, with a change in price leading to a smaller percentage change in quantity demanded
Hence, the demand for primary commodities is price inelastic
PRICE ELASTICITY OF DEMAND (PED) OF MANUFACTURED PRODUCTS
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MANUFACTURED PRODUCTS: Processed goods arising from factors of production ‘capital’ and ‘labour’ using raw materials and intermediate inputs
The price elasticity of demand (PED) of manufactured products is relatively high:
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As manufactured products are often luxuries with many close substitutes, consumers can refuse to consume the good and can switch to an alternative substitute
For this reason, the demand for manufactured products is relatively responsive to price, with a change in price leading to a larger percentage change in quantity demanded
Hence, the demand for manufactured products is price elastic
PRICE ELASTICITY OF DEMAND (PED) AND INDIRECT TAXES
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INDIRECT TAX: Tax levied on the consumption of goods and services paid for by consumers
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The more inelastic the demand for the taxed good, the larger the tax revenue for the government
In Figure (a) - showing a market with inelastic demand - and Figure (b) - showing a market with elastic demand - the initial market equilibrium is at Point A, determined by the intersection of the demand curve, D1, and supply curve, S1; hence, the equilibrium price and quantity is Pe and Qe respectively
Suppose the government introduces an indirect tax on every unit produced
As the cost per unit will increase by the tax per unit levied, production becomes less profitable; thus, firms will decrease supply, resulting in a leftward shift of the supply curve from S1 to S2 (vertical distance between S1 and S2 is equal to the per unit tax)
This change in supply forms a new after-tax market equilibrium at Point B, determined by the intersection of the demand curve, D1, and the new supply curve, S2; hence, the new equilibrium price increases to Pt, while equilibrium quantity decreases to Qt
As a tax revenue arises from an indirect tax, the shaded area represents the tax revenue collected and gained by the government ( Tax Revenue = Tax Per Unit x Quantity )
While tax revenue is generated by goods with both inelastic and elastic demand, the size of tax revenue varies between the two markets
In the case of inelastic demand, quantity demanded is relatively unresponsive to price: an increase in price (due to an indirect tax) leads to a smaller percentage decrease in quantity demanded, resulting in a large tax revenue
In the case of elastic demand, quantity demanded is relatively responsive to price: an increase in price (due to an indirect tax) leads to a larger percentage decrease in quantity demanded, resulting in a small tax revenue
For this reason, the overall tax revenue is larger when demand is inelastic; indirect taxes are therefore imposed on goods such as cigarettes and petrol which have low PED
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