Monday, September 22, 2014

Elasticity 1 - PED, Price Elasticity of Demand

Elasticity 1

Ok,, elasticities,, What's the purpose of elasticity?

It's (as a business owner) nice to know that raising the price of your product won't/ or will destroy your income and thus your business. (How much will your revenue change with a price change).

4 sections under this topic:
  • PED or price elasticity of demand 
  • XED or cross price elasticity of demand
  • YED or income elasticity of demand
  • PES or Price Elasticity of Supply

PED - Price Elasticity of Demand

Good Video to watch to get introduced to the concept of PED.
PED - measures the responsiveness of quantity demanded to a change in price along a given demand            curve. 

Formula - 

Yes, this above is the formula but almost never are we given the % change in Qd or Price.

Usually we are given a table of old and new prices and quantities and asked to derive the % change in Qd and price.   

more useful formula - 
This is known as the midpoint formula.

Example 1:

Example 2:
2008 AP Microeconomics Exam
Answer (B) elastic - use the formula above. Do the math.

PED varies along a demand Curve.

On a linear negatively sloped demand curve price elasticity varies continuously as one travels up or down the curve. 

This makes total sense, responsiveness t a price change (PED) will be higher, the higher the initial price of the good, the more expensive it is.

  • PED > 1, demand is price elastic =  % change in Qd is larger than the change in price.

Notice in the graph above, a 25% reduction in price leads to a much larger % change in Qd.
Also notice the demand curve is almost horizontal.

  • 0 < PED < 1, demand is price inelastic = % change in Qd is smaller  than the change in price.

Notice the demand curve is almost vertical.
  • PED = 1 or Unit Elasticity, % change in Qd is equal to the % change in price.

  • PED – ∞, Demand is infinitely or perfectly elastic, a small change in price leads to an infinite change in Qd.
Usually, perfectly elastic demand describes a perfectly competitive firm,,, It can sell any amount at the going price.

2005 AP Microeconomics Exam
Answer (E) It will not be able to sell any output - I added this, even though you probably haven't had any perfect competition instructions. The fact is that given a graph like the one above showing a perfectly elastic curve could also be given... The perfect elastic curve above shows that at that price (market price) all can be sold,,, Qd is infinite at that price,,, all that they want to sell they can. But any raising of price,, and they will sell nothing/0/nada/zip. 

Why? If it increases its price,, consumers will buy elsewhere at the lower price given by competitors.

2000 AP Microeconomics Exam

  • PED = 0, Demand is perfectly inelastic, change in price leads to no change in Qd.

Perfectly inelastic demand curve (PED = 0) is often used to describe the case of highly addictive goods such as drugs, or pharmaceutical products of which there are no substitutes, (insulin)

You must for the AP exam know how to draw the graphs above and explain them. The AP exam asks very (interesting) questions about elasticity.

Determinants of PED

  • Substitutes: the number and closeness of available substitutes affect PED. The more substitutes there are for a good, and the closer these are, the more easily people will switch to these alternatives when the price of the good rises: the greater therefore will be the PED.
  • Income: the proportion of income spent on the good. The higher the proportion of income spent on a good, the more consumers will be forced to lower consumption when its price rises(the bigger the income effect) and the more price elastic the demand will be. If a small proportion of income is spent on a good (it is insignificant) then a price change will not effect our spending behavior, demand will be price inelastic.
  • Time: if someone is pressed for time (gas light comes on in car) the availability of substitutes are limited. It follows that the longer the time period after a price change, the more price elastic the demand is likely to be.
  • Necessity: whether consumers consider the good or service a necessity. If it is considered a necessity a price change will tend to affect it less than a price change affects another product (luxury).
  • Addictive: substances that are addictive are relatively price inelastic.

Elasticity & Total Revenue

Total Revenue: is the money received by a firm from the sale of a particular quantity of output and is equal to price times quantity sold.
P*Q = TR, or price times quantity sold is total revenue,

Law of Demand states that as price rises, the quantity demanded decreases,, the change in total revenue depends on the price elasticity of demand, PED.

0 < PED < 1, When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

PED > 1, When demand is elastic, an increase in price from P1 to P2 will cause a higher % decrease in Qd from Q1 to Q2. The gain in total revenue from a price increase is lower than the loss in revenue from a quantity decrease.

PED = 1, When demand is unitary elastic,  price and quantity change in the same proportion.

1995 AP Microeconomics Exam
Answer (A) Inelastic - Price rises proportionately more than quantity, the change in price has a bigger effect  on TR (total revenue) than the change in quantity does

2000 AP Microeconomics Exam
Answer (C) A decrease in price will likely lead to an increase in total revenue. - This is an application of the total revenue test.  A good is elastic if total revenue increases when price decreases (arrows move in opposite directions). Remember, the demand curve becomes inelastic when marginal revenue is negative.  And, it’s unit elastic when MR = 0.

2005 AP Microeconomics Exam
Answer (A) inelastic - When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

Impact of price change on total revenue under different PED values.

Welker on PED and total revenue.

Elasticity Cheat Sheet

Welker playlist on elasticity

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