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Price elasticity of demand (PED) shows the relationship between price and
quantity demanded and provides a precise calculation of the effect of a
change in price on quantity demanded.
We can use this equation to calculate the effect of price changes on quantity demanded, and on
the revenue received by firms before and after any price change.
For example, if the price of a daily newspaper increases from 1.00 to 1.20p, and the daily sales
falls from 500,000 to 250,000, the PED will be:
- 50% / + 20%
= (-) 2.5
The negative sign indicates that P and Q are inversely related, which we would expect for most
price/demand relationships. This is significant because the newspaper supplier can calculate or
estimate how revenue will be affected by the change in price. In this case, revenue at 1.00 is
500,000 (1 x 500,000) but falls to 300,000 after the price rise (1.20 x 250,000).
Determinants of PES
How firms respond to changes in market conditions, especially price, is an important
consideration for the firm itself, and to an understanding of how markets work.
The key considerations are:
1. Are resource inputs readily available?
2. Are factors mobile - are workers prepared to move to where they are needed?
3. Can finished products be easily stored, and are there existing stocks?
4. Is production running at full capacity?
5. How long and complex is the production cycle or production process?
c. Income Elasticity of Demand
Income elasticity of demand (YED) shows the effect of a change in income on
quantity demanded. Income is an important determinant of consumer demand, and
YED shows precisely the extent to which changes in income lead to changes in
demand. YED can be calculated using the following equation: Normal goods
When the equation gives a positive result, the good is a normal good. A
normal good is one where demand is directly proportional to income. For
For example, if the price of Cinema Tickets increases from 5.00 to 7.50,
and the demand for Popcorn decreases from 1000 tubs to 700, the XED
between the two products will be:
-30/+50 = (-) 0.6
The negative sign means that the two goods are complements, and the
coefficient is less than one, indicating that they are not particularly
complementary.
3. How do you determine whether a good is elastic, inelastic or unitary? Is it
applicable only to the first two types of elasticity?
Unit elastic - Describes a supply or demand curve which is perfectly responsive to
changes in price. That is, the quantity supplied or demanded changes according to
the same percentage as the change in price. A curve with an elasticity of 1 is unit
elastic. Not really any real life examples.
Inelastic- The demand for an item is relatively unaffected by the change in price. For
example, luxury items on a gasoline.
Elastic- The demand for an item/good is strongly affected by the change in price.
Ms. Fields' cookies are an example because they are not required to live and people
will buy less if the price increases and people will buy more if the price decreases.
4. How do you determine using the elasticity computation whether a good is a
luxury good or a necessity?
5. How do you determine whether a good is normal or inferior?
6. How do you determine whether two related goods are substitutes or
complements?
Normal Goods
Luxury goods and services have an income elasticity of demand > +1 i.e.
demand rises more than proportionate to a change in income for example a
8% increase in income might lead to a 10% rise in the demand for new
kitchens. The income elasticity of demand in this example is +1.25.
Inferior Goods