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Understanding Price Elasticity in Economics

Learn about price elasticity of demand and its impact on goods with real-world examples and formula explanation. Understand how changes in price, income, and other goods affect demand sensitivity.

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Understanding Price Elasticity in Economics

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  1. Elasticity Powerpoint produced by Rachel Farrell (PDST) & AoifeHealion (SHS, Tullamore)

  2. Elasticity of demand Shows how sensitive demand is to: 1. A change in the price of the good itself Price Elasticity of Demand (PED) 2. A change in consumers’ income Income Elasticiy of Demand (YED) 3. A change in the price of another good Cross Elasticity of Demand (CED)

  3. Price Elasticiy of Demand • Is the percentage/proportionate change in the demand (quantity) for a good caused by the percentage/proportionate change in the price of that good.

  4. Q P P1 + P2 Q1 + Q2  PED is measured by using the following formula: Where: • P1 = the original price of the good • P2 = the new price of the good • Q1 = the original quantity demanded • Q2 = the new quantity demanded • Delta Q = the change in quantity demanded • Delta P = the change in price

  5. – Q + P + Q – P Note 1 A negative (–) number means that the good: • Obeys the law of demand (eg a normal good) • When P QD or when P QD Applying this to the formula Each gives a negative number or

  6. + Q + P – Q – P Note 2 A positive (+) number means that the good • Does not obey the law of demand (eg. a giffen good) • When P QD or when P QD Applying this to the formula Each gives a positive number or

  7. Note 3 If the numerical value (ignoring the sign) is >1 then the PED is elastic. This means that the percentage change in demand is greater than the percentage change in price. If the ans is >–1 then it is a LuxuryGood (holiday) ie: even if the price changes slightly there will be a large reduction in demand.

  8. The Price Elasticity of Demand for this product is elastic. The change in price causes a more than proportionate change in demand. Degree of slope > 45º. Price D P2 D Q2 Quantity Elastic Demand Curve (flatter) Luxury goods, e.g. foreign holidays. P1 Q1

  9. Note 4 If the result is < +1 or < –1 then the PED is inelastic. This means that the percentage change in demand is less than the percentage change in price. If the ans is < –1 then it is a Necessity ie. even if the price change is large the demand will not change much as people cannot do without it.

  10. The price elasticity of demand for this product is inelastic. The change in price has caused a less than proportionate change in quantity demanded. Degree of slope < 45º. Price D P2 D Q2 Quantity Inelastic Demand Curve (steeper) Necessities, e.g. Domesticuse of electricity. P1 Q1

  11. Note 5 If the result is = +1 or = –1 then the PED is equal to unity or unit elasticity. This means that the percentage change in demand is equal to the percentage change in price. If the ans is = –1 then it is a “Luxury-necessity” Eg. needs that are really wants, dvd player, I-pod…

  12. The price elasticity of demand for this product is equal to unity. The price change has caused demand to change in direct proportion to the change in price. Degree of slope = 45º. Price D P1 D Q1 Quantity Equal to Unity Curve “Luxury/necessities”, e.g. a freezer. P2 Q2

  13. Q P P1 + P2 Q1 + Q2  Example 1 2008 Q 1. (b) (iii) P1= €40 P2 = €50 Q1=60 units Q2=40 units 40 + 50 X –20 = -1.8 60 + 40 10 Therefore PED is elastic, obeys the law of demand, eg. luxury good……

  14. Q P P1 + P2 Q1 + Q2  Example 22007 SQ 3. P 1 = €1.50 P 2 = €1.00 Q 1 = 50 units Q 2 = 90 units 1.50 + 1.00 X 40 = - 1.43 50 + 90 - 0.50 Therefore PED is elastic, obeys the law of demand, eg. luxury good……

  15. Price P D Quantity Exceptional PED (perfect comp) In this case any change in price will cause D to fall to zero. Thus PED is perfectly elastic (or equal to infinity).

  16. D Price P1 D Quantity Q1 Exceptional PED (vital med) P2 In this case any change in price between P1 and P2 will have no effect on the amount demanded. Thus the PED is perfectly inelastic (or = zero).

  17. Factors affecting elasticity • Necessity = inelastic v luxury = elastic • Substitute available = elastic v no substitute available = inelastic • Alternative uses = elastic • Durable = elastic v non durable = inelastic

  18. Complementary good • Eg. • Set of golf clubs = dearer = elastic • Golf balls = cheaper = inelastic • The demand for golf balls will be influenced more by the price of clubs rather than the balls themselves.

  19. An increase in the price of balls is unlikely to have much effect on the demand for balls or clubs. • However an increase in the price of clubs will affect both the demand for clubs and balls.

  20. PED of normal goods and Total Revenue When PED > 1 You need to decrease price to increase total revenue (same direction) When PED < 1 You need to decrease increase price to increase total revenue (opp dir) When PED = 1 There is no effect on TR when P changes

  21. Giffen goods and change in TR For Giffen goods Price and total revenue always change in the same direction regardless of the degree of PED. The demand for Giffen goods goes up when their price is increased. As price increases more goods are sold at a higher price therefore TR must also increase. The same logic applies to a decrease in price.

  22. Income Elasticity of Demand (YED) Measures the relationship between a change in income and the resulting change in demand. It can be: Positive(+) = Normal Good, as Y rises D rises Negative (-) = Inferior Good & Giffen Good, as Y rises D falls

  23. YED can be Elastic (> I1I): the change in income causes a more than proportionate change in demand. (Luxury Good) Inelastic (< I1I): the change in income causes a less than proportionate change in demand. (Food) Equal to unity ( = I1I): the change in income causes a proportionate change in demand.

  24. Q Y Y1 + Y2 Q1 + Q2  Measurement of YED YED is measured by using the following formula: Where: • Y1 = the original income • Y2 = the new income • Q1 = the original quantity demanded • Q2 = the new quantity demanded • Delta Q = the change in quantity demanded (sign nb) • Delta Y = the change in income (sig nb)

  25. Example • Income went from €200 to €250 • Demand went from 5 units to 8 units • 200+250 x +3 • 5 + 8 +50 • +2.07 • Normal, Luxury Good

  26. 2002 Q 3 (a) • Normal Good Y inc, QD inc (+) Eg. holiday • Inferior Good Y inc, QD dec (-) • Eg. potatoes

  27. (b) Let Y = €100 Consumer spends (40 % of €100) €40 on the good Y doubles to €200 Consumer spends (30 % of €200) €60 on the good Y Inc and QD Inc Normal Good

  28. (c) • YED potatoes -0.1 • YED designer clothes +2.5

  29. (d) YED = +1.8 Y D • Y expected to rise by 5% • Demand (Sales) will rise by 1.8 times 5% • 5% X 1.8 = 9% • 20,000 x 9 = 1,800 100 20,000 + 1,800 = 21,800 units

  30. YED = -0.5 Y D • Y expected to rise by 2% • Demand (Sales) will decrease by 2 times 0.5 % • 0.5 % X 2 = 1% • 10,0000 x 1 = 100 100 10,000 - 100 = 9,900 units

  31. 2009 Q 1. (b) (ii) • YED low price meat • -0.1 • YED for iphones • +4.6

  32. 2009 Q 1 (c) YED = +2.5 Y D • Y decreases by 8% • Sales decrease by 2.5 times 8% • 8%X2.5=20% • Sales falls by 20% • 100,000X20 = 20,000 units 100 • 100,000-20,000 = 80,000 units

  33. Uses of YED

  34. Cross Elasticity of Demand (CED) Cross elasticity of demand measures the relationship between the change in price of one good (A) and the resulting change in demand for another good (B). +ive = substitute, an inc P A = an inc D B -ive = complementary, an in P A = dec in D B > 1 elastic, < 1 inelastic, = 1 unitary

  35. Q(B) P(A) P(A)1 + P(A)2 Q(B)1 + Q(B)2  Measurement of CED CED is measured by using the following formula: The demand for product B reacts to a change in the price of product A. Where: • P(A)1 = the original price of A • P(A)2 = the new price of A • Q(B)1 = the original quantity of B • Q(B)2 = the new quantity of B • Delta Q(B) = the change in quantity of B (sign nb) • Delta P(A) = the change in price of A (sign nb)

  36. 2006 Q 1 (c) 5 + 6 X + 4 10 + 14 + 1 + 1.83 Substitute, elastic

  37. 2003 Q 2 (b) 27 + 23 X -400 1,200 + 800 -4 + 2.5 Substitute, elastic

  38. 1999 Q 4 (b) B = +2.5 Substitute, elastic C = -0.6 Complementary, inelastic D = + 0.3 Substitute, inelastic E = -1.4 Complementary, elastic

  39. Closest substitute • +0.3

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