CIE IGCSE Economics 0455 Section 2 - Units 8 and 9

2.3 - Price Elasticity What is Elasticity? Why do we need Elasticity?

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. It allows us to analyze supply and demand with greater precision.

When price of a product increase the quantity demanded will contract for most goods and services, but firms will like to know by how much consumer demand will contract or expand as prices change. Similarly, a government will like to know how much tax revenue can be generated from imposing a tax on a particular goods and services.

The following two diagrams will give insight how the same percentage increase in price can impact quantity demanded differently due to the nature of elasticity of demand.

The demand curve is quite steep. When price rises by 33.33% demand contracts by just 11.11%, a fall from 90 to 80 units per period.

The demand curve is quite flat. When price rises by 33.33% demand contracts by 58.33%, a fall from 120 to 50 units per period.

In this case demand is said to be price inelastic as the percentage change in price is much larger than the percentage change in quantity demanded.

In this case demand is said to be price elastic as the percentage change in price is less than the percentage change in quantity demanded.

Price Elasticity of Demand Price elasticity of demand (PED) is the percentage in quantity demanded given a percentage change in the price. It is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Price elasticity of demand for a good is calculated as follows: PED =

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%

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%

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Percentage changes are worked out as follows:

x

% change in quantity demanded =

x

% change in price =

Inelastic Demand  If a small change in price of a good causes only a slight change in quantity demanded then the demand for that product is called price inelastic, i.e., quantity demanded stretches very little when price changes (Figure 1).  Percentage change in price is greater than percentage change in quantity demand.  Price elasticity of demand is less than 1.

Elastic Demand

 If a small change in price of a good causes a big change in quantity demanded then the demand

for that product is called price elastic, i.e., quantity demanded stretches significantly when price changes (Figure 2).

 Percentage change in price is less than percentage change in quantity demand.

 Price elasticity of demand is greater than 1.

PED and firms’ total revenue are closely linked. If demand is price inelastic (PED = 0.5), when the price is lowered, there is only a very small extension in demand and so total revenue falls. Therefore, an increase in price will raise total revenue if demand is price inelastic.

On the other hand, if demand is price elastic (PED = 5), when the price is lowered, sales increase proportionately more than the change in price resulting in total revenue to rise.

Therefore, an increase in price will reduce total revenue if demand is price elastic.

Perfectly Elastic Demand PED = ∞

Perfectly Inelastic Demand PED = 0

An increase in price has no effect on the quantity demanded. Whatever may be the price same quantity is demanded.

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A slight increase in price drops quantity demanded to zero. While, at a price below P, quantity demanded is infinite.

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Unitary Elastic Demand PED = 1

A percentage change in the price of a product will cause an equal percentage change in the quantity demanded, meaning that the total amount spent on that product by consumers will remain the same whatever its price.

Demand curves showing different PED

1. The number of substitutes - When consumers can choose among a large number of substitutes for a particular good, demand for any of them is likely to be price elastic.

Demand will be price inelastic will there are fewer substitutes.

2. The nature of the good - Necessity goods have often inelastic demand while, luxury goods have elastic demand. Note that, habit forming goods are inelastic to a certain degree.

3. The period of time - The longer consumers have to find cheaper substitute for a good, the more likely they will find one. Hence, demand will be more price elastic in the long run.

4. The proportion of income spent on a commodity - If the proportion of income used to pay for a product is more, then the demand for that product will be elastic and vice versa.

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