How Markets Work - Elasticity of Demand

Core introductory notes on the concept of elasticity of demand.

What is meant by?

PERFECTLY PRICE ELASTIC DEMAND

Price elasticity of demand is infinity

PERFECTLY PRICE INELASTIC DEMAND

Demand is completely unresponsive to a change in price, the coefficient of PED = zero

PRICE ELASTIC DEMAND

Quantity demanded is highly responsive to a change in price, coefficient of PED >1

PRICE INELASTIC DEMAND

Quantity demanded is not highly responsive to a change in price, coefficient of PED <1

UNITARY ELASTIC DEMAND

The change in quantity demanded is exactly proportional to the change in price, coefficient of PED = 1

Factors affecting price elasticity of demand

List 5 factors that will influence the coefficient (value) of price elasticity of demand (PED):

1. Number of close substitutes in the market
2. Degree of consumer addiction to the product
3. Proportion of income spent on the good or service
4. Level of necessity / need (+ habitual demand)
5. The cost of switching to a rival product following a price change

3-2-1

Identify 3 causes of demand for a good or service being relatively price inelastic:

1. Few close substitutes and high cost of switching
2. Bought out of habit
3. Purchase is only a small percentage of the consumer’s budget

Identify 2 impacts of demand for a product being relatively price inelastic:

1. Firms can raise their price and gain total revenue
2. Volatile prices if market supply changes

Identify 1 action a business might take to reduce price elasticity of demand for their products:

1. Change the product to be less addictive

Income elasticity of demand

Define this!

1. Income elastic demand– when demand is highly & positively responsive to a change in income
2. Income inelastic demand– when demand only responds a little to a change in income
3. Inferior good- a product with a negative income elasticity of demand
4. Normal good– any product with a positive income elasticity of demand
5. Luxury good– a product with a highly positive income elasticity of demand (YED > +1)

Give three examples of goods that are likely to have a high positive income elasticity of demand

• Expensive barista coffee
• Luxury perfumes and clothing
• Organic foods

Give two examples of goods that are likely to have a negative income elasticity of demand

• Own-label economy supermarket food
• Bus transport

Give 1 example of a good that is likely to have an income elasticity of demand close to zero

• Toilet rolls

Give two advantages and two disadvantages for a business if their product is found to have a high coefficient of income elasticity of demand:

ADVANTAGES

• Easy to target consumers with rising income
• Volatile profits if the economy is unstable – demand can become highly cyclical in nature

DISADVANTAGES

• Profits can be very high when the economy is growing and if unemployment is falling
• Difficult to invest / grow if profits are unstable. Unstable demand leads to increased uncertainty.

What am I?

I have a positive cross price elasticity of demand with another product (Substitute)

I have a positive income elasticity of demand (Normal good)

I have a price elasticity of demand of less than 1 in absolute terms (Price inelastic product)

I have a negative income elasticity of demand (Inferior good)

Revenue increases when the price of my product is cut (Price elastic product)

My cross-price elasticity of demand with another good is close to zero (Unrelated good/service)

My income elasticity is positive and greater than 1 (Normal luxury)

My cross-price elasticity with another good is negative (Complement)

When my price changes, total revenue for the seller remains the same (Unitary price elastic)