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Ismail Hassan
Price Elasticity of Demand

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You will remember that changes in prices of a good or service can cause changes in quantity demanded of that same good.  If the price of pencils drops, the quantity demanded will increase (Law of Demand).  We also saw how prices of a good or service can affect the demand of other related goods.  For instance, a drop in price of fountain pens can increase the demand of ink.
 
In the previous lessons we have already seen how supply and demand can be combined to produce market equilibrium.  The theory of supply and demand can be used to answer a wide range of important and interesting questions.  For instance, we can foresee what will happen to price of burgers if Manchester United and Real Madrid were to play a match on campus!  We also know what will happen to the equilibrium price of rubber if the price of palm oil increases.
 
So far we only know that changes in price do have an effect on quantity demanded or demand, but to make this knowledge really useful, we need to know how much demand responds to changes in price.  For instance, if 100 units of pencils are demanded when priced at RM1.00 per unit, how many more units will be demanded if price is reduced to 90 sen?  What's the percentage change to quantity demanded of pencils if we reduced the price of pencils by 10%?  If we raise the price of burgers sold on campus by 20%, we certainly know that less quantities will be bought, but the question is how much less quantities will be demanded?  Will a 20% price increase results in a 20% reduction in quantity demanded?  Or will the quantity demanded be reduced by more than 20%? Or by less than 20%?
 
Some goods or services are very sensitive to price.  A slight change in price will have quite a large change in quantities demanded.  While some are not too sensitive.  Even a large change in price doesn't affect quantities demanded by much.  For some goods, there are not sensitive to price changes at all.  Small or large changes in price does not change the quantity demanded at all!  Yet, there are goods or services that are very sensitive to price changes.  A slight change in price, may result in no quantity demanded at all.
 
Quantifying how responsive demand (and supply -- we'll study this more later) is to changes in prices is the concept of elasticity.  The price elasticity of demand (usually simply called "price elasticity") measures how much the quantity demanded of a good changes when its price changes.  The precise definition of the price elasticity is the percentage change in quantity demanded divided by the percentage change in price.
 
As mentioned above, goods vary in their price elasticy, or sensitivity to price changes.  Some goods cause huge changes in quantity demanded even with a slight change in price, while other change very little even with a significant change in price.  When the price elasticity of a good is high, we say that the good has "elastic" demand, which means that its quantity demanded responds greatly to price changes.   When the price elasticity of a good is low, it is "inelastic" and its quantity demanded responds little to price changes.
 
To calculate Price Elasticity of Demand (ED), use the following formula:
 
Change in Quantity     divide by    Change in Price
      (Q1+Q2)/2                               (P1+P2)/2
 
This formula works too.
 
Change in Quantity     x            Price     
       Quantity                   Change in Price

 

CHANGE IN PRICE AND CHANGE IN QUANTITY:  According to the law of demand, a change in price will have an effect on the quantity demanded. As price of a good or service increases, the quantity demanded decreases and vice-versa. What is change in price? A change in price occurs when the price of a good or service increases or decreases. For instance, if the price of pencils increases from RM1.00 per unit to RM1.20 per unit, then there is a change in price. The change in price is 20 sen per unit. If the price of pencils decreases from RM1.00 per unit to 80 sen per unit, again there is a change in price of 20 sen. It doesnt really matter if price increases or decreases. What is important is to know the difference between the old and the new price. The difference is the change in price.

A change in price will result in a change in quantity demanded. A change in quantity demanded occurs when the quantity demanded increases or decreases. For instance, if the quantity demanded of pencils increases from 20 units to 30 units, then there is a change in quantity demanded. The change in quantity demanded is 10 units. If quantity demanded decreases from 20 units to 10 units, then there is also a change in quantity demanded of 10 units. It doesnt matter if quantity demanded increases or decreases. What is important is know the amount of change. It is useful to remember that the change in quantity demanded of a particular good or service is the result of the change in price of that particular good or service.

The understanding of the concept of change in price and change in quantity demanded is important when studying elasticity of demand. Although the quantity of goods or services demanded depends very much of its price, the way price affects the quantity demanded of the various types of goods is different. For some goods, the quantity demanded is very sensitive to price changes. A slight change in price will result in a large change in the quantity demanded. While for some goods, the quantity demanded is not very sensitive to price changes. Even a large change in price doesnt affect the quantity demanded by much. This is the concept of price elasticity of demand. Price elasticity of demand studies how the quantity demanded of goods and services is affected by price changes.

HOW TO MEASURE PRICE ELASTICITY OF DEMAND(note: Price Elasticity of Demand measures the sensitivity of quantity demanded because of changes in price)  To measure price elasticity of demand (that is, to look at the changes of quantity demanded of a particular good because of a change in its price), you need to first calculate the change in price, and then determine the change in quantity demanded as a result of that change in price. Lets look at the following example.

Price (RM)

Quantity Demanded (unit)

150

100

100

120

The quantity demanded of shoes is 100 units at RM150 per unit. The quantity demanded increases to 120 units when price is reduced to RM100 per unit. In this example the change in price is RM50 (RM150 RM100 = RM50) and the change in quantity demanded is 20 units (120 units 100 units = 20 units).

The formula to calculate Price Elasticity of Demand is as follows:

Change in Quantity     x            Price     
       Quantity                   Change in Price
 
= 20/100 x 150/50
= 0.2 x 3
= 0.6
 
Based on the calculation, a 1% increase in price of shoes will result in a 0.6% change in quantity demanded.  Therefore it can be concluded that this good has a price inelastic demand (or alternatively, you may say the price elasticity of demand is inelastic). See table below for summary table on elasticities.
 
or you may use this formula (which is more accurate)
 
Change in Quantity     divide by    Change in Price
      (Q1+Q2)/2                               (P1+P2)/2

 

  • When a 1% change in price calls forth more than a 1% change in quantity demanded, this is price-elastic demand.
  • When a 1% change in price evokes less than a 1% change in quantity demanded, this is price-inelastic demand.
  • One important special case is unit-elastic demand, which occurs when the percentage change in quantity is exactly the same size as the percentage change in price. In this case a 1% change in price results in a 1% decrease in demand.

Example

Consider the situation where price is raised from RM90.00 to RM110.00. Quantity demanded falls from 240 to 160. Price elasticity is the ratio of percentage change in quantity divided by percentage change in price. We drop the minus sign from the numbers so that all elasticities are positive.Price = RM90.00 and Quantity Demanded = 240 units

Price = RM110.00 and Quantity Demanded = 160 units

Percentage price change = Change in P/P = 20/90 = 22%

Percentage quantity change = Change in Q/Q = -80/240 = -33%

The price increase is 22% with the resulting quantity decrease being 33%. The price elasticity of demand is 33/ = 1.5. The price elasticity is greater than 1, and this good therefore displays price-elastic demand.

 

When calculating elasticities, there are three key steps where you have to be especially careful.

  • First note that we drop the minus signs from the numbers by treating all percentage changes as positive. That means all elasticities are positive, even though prices and quantities demanded move in opposite directions because of the law of downward-sloping demand.
  • Second, note that the definition of elasticity uses percentage change in price and demand rather than actual changes. That means that a change in the units of measurement does not affect the elasticity. So whether we measure price in sen or ringgits, the price elasticity stays the same.
  • A third point concerns the exact procedure for calculating percentage change in price and quantity. It is not immediately clear what value we should use for P in the denominator. Is it the original value, or the final value, or something in between? For very small percentage changes, it doesnt matter much. But for larger changes, the difference is significant. To avoid ambiguity, we always take the average price to the base price for calculating price changes.

Taking this third point into consideration, we come up with the following formula.

Change in Quantity     divide by    Change in Price
      (Q1+Q2)/2                               (P1+P2)/2 

ELASTICITY AND REVENUE  The notion of price elasticity is useful for analyzing supply and demand. One important application of elasticity is to help clarify whether a price increase will raise or lower revenues. This is key question for many businesses, ranging from airlines to restaurants to magazines, which must decide whether it is worthwhile to raise prices, and whether the higher prices make up for lower demand. Lets look at the relationship between price elasticity and total revenue.

Total revenue is by definition equal to price times quantity (or P x Q). If consumers buy 5 units at RM3.00 each, total revenue is RM15.00. If you know the price elasticity of demand, then you know what will happen to total revenue when price changes.

  1. When demand is price-inelastic, a price decrease reduces revenue.
  2. When demand is price-elastic, a price decrease increases total revenue.
  3. In the borderline case of unit-elastic demand, a price decrease leads to no change in total revenue.

For example, business travelers have an inelastic demand for air travel, so an increase in business fares tends to raise revenue. By contrast, leisure travelers have much more elastic demand for air travel, because they have much more choice about where and when they are traveling. As a result, raising leisure fares tends to decrease revenues.

Summary table on elasticities

Value of demand Elasticity

Description

Definition

Impact on Revenues

Greater than one

(ED >1)

Elastic Demand

Percentage change in quantity demanded greater than percentage change in price

Revenues increase when price decreases.

Equal to one

(ED = 1)

Unit-elastic demand

Percentage change in quantity demanded equal to percentage change in price.

Revenues unchanged when price decreases.

Less than one

(ED<1)

Inelastic demand

Percentage change in quantity demanded less than percentage change in price.

Revenues decrease when price decreases.

 

DETERMINANTS OF PRICE ELASTICITY OF DEMAND What are the factors that affect the sensitivity of quantity demanded of a good or service when there is a change in price?

  1. The availability of close substitutes. Goods or services with close substitutes tend to have elastic demand than goods or services without close substitutes. For example, chickens and beef are close substitutes. If the price of chickens rises, people will switch to beef. So the quantity demanded of chickens is very sensitive to price. A slight increase in price of chickens will result in a big drop in its quantity demanded. With a close substitute, a 1% increase in the price of chickens per kilogram will certainly results in a more than 1% reduction in the quantity demanded. For goods or services without a close substitute, they have rather inelastic demand. They are not too sensitive to price changes where a 1% change in price will result in a less than 1% change in quantity demanded. The train up Penang Hill is an example. If the ticket price is raised by 1%, the quantity demanded will be reduced by less than 1%.
  2. Proportion of total income spent on a particular good or service. How much do you spend on sweets and candies? Probably not very much. If you earn RM2000.00 monthly, spending RM2.00 a week on sweets and candies will not cause even a small dent on your total income. So, if the price of sweets is raised from say, 50 sen a dozen to RM1.00 a dozen, youd probably continue to buy about the same amount each week. For goods that you only spend a very small fraction of your income on, will a rather inelastic demand. A 1% rise on price will cause a less than 1% change in quantity demanded. But what about goods or services that you spend quite a substantial amount of your income on? For goods or services that we spend quite a large amount of our income on will have an elastic demand. A price increase will cause a larger cut on our income so we may not be willing to spend much more than we already had. For instance, if a person spends close to 40% of his salary on petrol already, an increase in price of petrol will result in him buying much less.
  3. Types of goods necessities versus luxuries. The staple food of Malaysians is rice. If the price of rice increases, the quantity demanded by consumers will drop only very slightly. And if the price decreases, the quantity demanded will rise just slightly. Rice is an example of a necessity. Necessities are goods or services that we cannot have without. Usually, necessities are goods and services needed to fulfill our psysiological and safety needs. Some other examples of necessities are water, electricity, gas, houses, and cooking oil.
  4. Adjustments to a price change over time.  Given enough time, consumers are able to adjust to price changes accordingly and goods with elastic demand may turn inelastic.  Take cars for instance.  People are rather sensitive to price of cars where a 1% increase in the price of cars will result in a more than 1% reduction in the quantity demanded.  However, this situation will only be true perhaps for just a few months after the price increase.  Later, the effect of time makes consumers "accept" the new price and the increase in price will not have much effect on the change in the quantity demanded.