Unit 1 Micro: Price Elasticity of Demand

Revision note on price elasticity of demand

Price elasticity of demand (Ped) measures the responsiveness of demand following a change in its own price. The formula for calculating the co-efficient of elasticity of demand is: Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of demand.

Values for price elasticity of demand

1. If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the demand curve will be drawn as vertical.

2. If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic.

3. If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.

4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 10% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is –3

Factors affecting price elasticity of demand

1. The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch.

2. The cost of switching between products – there may be significant costs involved in switching. In this case, demand tends to be relatively inelastic. For example, mobile phone service providers may insist on a12 month contract.

3. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.

4. The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will tend to have a more elastic demand

5. The time period allowed following a price change – demand tends to be more price elastic, the longer that consumers have to respond to a price change. They may search for cheaper substitutes and switch their spending.

6. Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).

7. Peak and off-peak demand - demand tends to be price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.

8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.