2.7 Price elasticity of demand (PED)

2.7.1. definition of PED

2.7.2. calculation of PED

2.7.3. determinants of PED

2.7.4. PED and total spending on a product/revenue

2.7.5. significance of PED

By the end of this chapter, students should be able to:

★ defi ne and calculate price elasticity of demand (PED)

★ draw and interpret demand curve diagrams to show different PED

★ understand the determinants of PED

★ explain the relationship between PED and total revenue

★ demonstrate the signifi cance of PED for decision makers.

Calculation of price elasticity of demand

Price elasticity of demand is calculated using the formula:

For example, if a cinema increases its average ticket price from $10 to $11 and this leads to demand falling from 3500 to 3325 customers per week, then the PED for cinema tickets is calculated as:

» Percentage change in quantity demanded = [(3325 − 3500)/3500]  x  100 = −5%

» Percentage change in price = [(11 – 10/10)]   x  100 = +10%

» PED = −5/10 = −0.5

Interpreting demand curve diagrams and price

elasticity of demand

So what does a PED value of −0.5 actually mean? The above example suggests that the demand for cinema tickets is price inelastic — that is, relatively unresponsive to changes in price. This is because a 10 per cent increase in the price (from $10 to $11) only caused quantity demanded to drop by 5 per cent (from 3500 tickets per week to 3325).

The value of PED is negative due to the law of demand (see Chapter 7) — an increase in the price of a product will tend to reduce its quantity demanded. The inverse relationship between price and quantity demanded also applies in the case of a price reduction — a price fall tends to lead to an increase in the quantity demanded.

The calculation of PED generally has two possible outcomes:

However, there are three special cases which are theoretical possibilities:

» If the PED for a product is equal to 0, then demand is perfectly price inelastic — that is, a change in price has no impact on the quantity demanded. This suggests that there is absolutely no substitute for such a product, so suppliers can charge whatever price they like (see Figure 11.3).

» If the PED for a product is equal to infi nity (∞) then demand is perfectly price elastic — that is, a change in price leads to zero quantity demanded. This suggests that customers switch to buying other substitute products if suppliers raise their price (see Figure 11.4).

» If the PED for a product is equal to 1 (ignoring the minus sign), then demand has unitary price elasticity — that is, the percentage change in the quantity demanded is proportional to the change in the price (see Figure 11.5).

Determinants of price elasticity of demand

There are many interlinked determinants of the PED for a product. These factors include the following:

» Substitution — this is the key determinant of the PED for a good or service. In general, the greater the number and availability of close substitutes there are for a good or service, the higher the value of its PED will tend to be. This is because such products are easily replaced if the price increases, due to the large number of close substitutes that are readily available. By contrast, products with few substitutes, such as toothpicks, private education and prescribed medicines, have relatively price inelastic demand.

» Income — the proportion of a consumer’s income that is spent on a product also affects the value of its PED. If the price of a box of toothpicks or a packet of salt were to double, the percentage change in price would be so insignificant to the consumer’s overall income that quantity demanded would be hardly affected, if at all. By contrast, if the price of an overseas cruise holiday were to rise by 25% from $10,000 to $12,500 per person, this would discourage many customers because the extra $2,500 per ticket has a larger impact on a person’s disposable income (even though the percentage increase in the price of a cruise holiday is much lower than that of a box of toothpicks or a packet of salt). Therefore, the larger the proportion of income that the price of a product represents, the greater the value of its PED tends to be. Of course, those on extremely high levels of income (such as Bill Gates, Jeff Bezos and Warren Buffet — the three richest men on the planet) are probably not responsive to any change in the market price of goods and services!

» Necessity — the degree of necessity of a good or service will affect the value of its PED. Products that are regarded as essential (such as food, fuel, medicines, housing and transportation) tend to be relatively price inelastic because households need these goods and services, and so will continue to purchase them even if their prices rise. By contrast, the demand for luxury products (such as Gucci suits, Chanel handbags and Omega watches) is price elastic as these are not necessities for most households. The degree of necessity also depends on the timeframe in question. For example, demand for fresh flowers on Valentine’s Day and on Mothers’ Day is relatively price inelastic compared to other days. The same applies to peak and off-peak times. For example, many countries operate public transport systems that charge more for travelling during peak time. This is partly due to overcrowding problems during such times, but also because the transport operators know that peak-time travel is more of a necessity than off-peak travel.

» Habits, addictions, fashions and tastes — if a product is habit forming (such as tobacco) or highly fashionable, its PED tends to be relatively price inelastic. Similarly, people who are extremely devoted to a particular hobby (such as sports or music) are more willing to pay, even at higher prices. Hence, the demand from these people is less sensitive to changes in price.

» Advertising and brand loyalty — marketing can have a huge impact on the buying habits of customers. Effective advertising campaigns for certain products not only help to shift the demand curve outwards to the right, but can also reduce the price elasticity of demand for the product. Customers who are loyal to particular brands are less sensitive to a change in their prices, partly because these brands are demanded out of habit and personal preference — in other words, they are the default choice over rival brands. Examples of brands with a loyal customer following include Coca-Cola, Apple, Samsung, Chanel, Toyota and Mercedes-Benz.

» Time — the period of time under consideration can affect the value of PED because people need time to change their habits and behavioural norms. Over time, they can adjust their demand based on more permanent price changes by seeking out alternative products. For example, parents with children in private fee-paying schools are unlikely to withdraw their children from school if these establishments raise school fees because this would be very disruptive to their children’s learning. Similarly, owners of private motor vehicles are not likely to get rid of their vehicles simply because of higher fuel prices. However, if there is a continual hike in prices over time, both parents and vehicle owners may seek alternatives. Hence, demand tends to be more price elastic in the long run.

» Durability — some products, such as fresh milk, are perishable (do not last very long) but need to be replaced, so they will continue to be bought even if prices rise. By contrast, if the price of consumer durable products (such as household furniture, 4K televisions and motor vehicles) increases, then households may decide to postpone replacing these items due to the high prices involved in such purchases. Therefore, the more durable a product is, the more price elastic its demand tends to be.

» The costs of switching — there may be costs involved for customers who wish to switch between brands or products. In the case of high switching costs, the demand for the product is less sensitive to changes in price — that is, it tends to be price inelastic. For example, manufacturers of smartphones, laptops and digital cameras make it more difficult for their customers to switch between rival brands by supplying different power chargers, memory cards and software. Similarly, mobile phone users and satellite television subscribers are bound by lengthy contracts, so that switching between rival brands or services is made less easy. Such barriers to switching therefore make customers less responsive to higher product prices.

» The breadth of definition of the product — if a good or service is very broadly defined (such as food rather than fruit, meat, apples or salmon), then demand will be more price inelastic. For example, there is clearly no real substitute to food or housing, so demand for these products will be very price inelastic. However, it is perhaps more useful to measure the price elasticity of demand for specific brands or products, such as carbonated soft drinks, Australian beef and IGCSE textbooks.

Given that demand for laptops in the above example is price elastic, a reduction in price was a sensible business decision. Therefore, it can be seen that knowledge of PED for a product can inform firms about their pricing strategy in order to maximise sales revenues.

The significance of price elasticity of demand for decision makers

Knowledge of PED has implications for decision making by consumers, producers and the government. Essentially, it can provide valuable information about how the demand for different products is likely to change if prices are adjusted. This information can be used in several ways, such as the following:

» Helping producers to decide on their pricing strategy — for example, a business with price inelastic demand for its products is likely to increase prices, knowing that quantity demanded will hardly be affected. Therefore, the firm will benefit from higher sales revenue when selling its products at a higher price.

» Predicting the impact on producers following changes in the exchange rate (see Chapter 38) — for instance, fi rms that rely on exports will generally benefit from lower exchange rates, as exports become cheaper and thus they become more price competitive. This assumes that the PED for exports is price elastic, of course.

» Price discrimination — this occurs when fi rms charge different customers different prices for essentially the same product because of differences in their PED. For example, theme parks charge adults different prices from children and they also offer discounts for families and annual pass holders.

» Deciding which products to impose sales taxes on — taxing price inelastic products ensures the government can collect large sums of tax revenue without seriously affecting the overall demand for the product (so there is minimal impact on sales revenues and jobs). Producers can also decide how much of the tax can be passed onto customers. For example, products such as alcohol, tobacco and petrol are price inelastic in demand, so government taxes on these products can quite easily be passed onto customers without much impact on the quantity demanded.

» Determining taxation policies — knowledge of PED can help governments to determine taxation policies. For example, the government can impose heavy taxes on demerit goods (see Chapter 14), such as petrol and cigarettes, knowing that the demand for these products is price inelastic. As demerit goods are harmful to society as a whole, the government needs to impose very high level of taxes on such products in order to reduce the quantity of demand.