BOUNOMICS - 2.5.1 PED

--PED: DEFINITION--

PRICE ELASTICITY OF DEMAND (PED) is a measure of the RESPONSIVENESS of QUANTITY DEMANDED of a good to CHANGES IN the PRICE of the good.

--PED: FORMULA--

--HOW TO CALCULATE % CHANGE--

-------METHOD 1-------

For a % increase: [(New Price - Old Price)/Old Price] x 100.

For a % decrease: [(Old Price - New Price)/Old Price] x 100.

-------EXAMPLE-------

Price rises from $5 to $8? $8-$5/$5 * 100 = 60%*

Price rises from $8 to $5? $8-$5/$8 * 100 = 24%*

*Note this method produces DIFFERENT RESULTS DEPENDING ON THE DIRECTION OF CHANGE.

-------METHOD 2: ('THE MIDPOINT METHOD')-------

The midpoint formula computes % changes by DIVIDING the CHANGE by the AVERAGE VALUE (i.e., the midpoint) of the INITIAL and FINAL value. As a result, it produces the SAME RESULT REGARDLESS OF THE DIRECTION OF CHANGE.

-------EXAMPLE-------

Price rises from $5 to $8? $3/$6.5 * 100 = 46%

Price rises from $8 to $5? $3/$6.5 * 100 = 46%

--PED: WHY IS IT ALWAYS A NEGATIVE?--

Since price and quantity demanded are negatively (indirectly) related, the PED IS A NEGATIVE NUMBER. For example, any percentage INCREASE IN PRICE (A POSITIVE DENOMINATOR), means a percentage DECREASE IN QUANTITY DEMANDED (A NEGATIVE NUMERATOR), leading to a NEGATIVE PED and vice versa. It is however common practice is to drop the minus sign and consider PED as a positive number. (In mathematics this is called taking the absolute value.)

--PED VALUES--

If we use '% CHANGE IN PRICE' and '% CHANGE IN QUANTITY DEMANDED' as the units to illustrate elasticity, then:
- INELASTIC curves are STEEP lines.
- ELASTIC curves are SHALLOW lines.
- UNIT ELASTIC curves are 'RECTANGULAR HYPERBOLAS'.
- PERFECTLY INELASTIC curves are PERPENDICULAR TO X-AXIS.
- PERFECTLY ELASTIC curves are PERPENDICULAR TO Y-AXIS.

--DIAGRAMS USING % CHANGE--

If we use '% CHANGE IN PRICE' and '% CHANGE IN QUANTITY DEMANDED' as the units to illustrate elasticity, then:
- INELASTIC curves are STEEP lines.
- ELASTIC curves are SHALLOW lines.
- UNIT ELASTIC curves are 'RECTANGULAR HYPERBOLAS'.
- PERFECTLY INELASTIC curves are PERPENDICULAR TO X-AXIS.
- PERFECTLY ELASTIC curves are PERPENDICULAR TO Y-AXIS.

--DETERMINANTS OF PED--

MORE INELASTIC

MORE ELASTIC

--FEW SUBSTITUTES--

The FEWER SUBSTITUTES a good (or service) has, the MORE INELASTIC is its demand. If the price of a good with few substitutes increases, consumers can't switch to other substitute products, therefore resulting in a relatively small drop in quantity demanded. e.g. petrol
Also if the good is ADDICTIVE, such as tobacco or alcohol, then there are few substitutes, and its demand as a whole will be inelastic.

--CLOSE SUBSTITUTES--

The MORE SUBSTITUTES a good (or service) has, the MORE ELASTIC is its demand. If the price of a good with many substitutes increases, consumers can switch to other substitute products, therefore resulting in a relatively large drop in the quantity demanded. E.g. Coke Cola & Pepsi

--BROAD DEFINITION--

The number of substitutes is also determined by how 'BROADLY THE GOOD IS DEFINED', for example, there are NOT many substitutes for 'FRUIT', making its PED relatively INELASTIC compared to a narrower definition of 'APPLES' which has many substitutes.

--NARROW DEFINITION--

The number of substitutes is also determined by how 'NARROW THE GOOD IS DEFINED', for example, there are many substitutes for 'APPLES', making their PED relatively ELASTIC compared to a more broader definition of 'FRUIT' which has less substitutes..

--NECESSITIES--

NECESSITES are goods or services we consider to be essential or necessary in our lives; and which we cannot do without them. The demand for necessities is usually INELASTIC. For example, the demand for medications/masks tends to be very inelastic because people’s health or life depend on them; therefore, quantity demanded is not very responsive to changes in price. The demand for food is also inelastic, because people cannot live without it.

--LUXURIES--

LUXURIES are goods or services we consider to be NON-essential in our lives; and which we can do without them. The demand for luxuries is usually ELASTIC. For example, the demand for diamonds tends to be very elastic because people do not rely on them for survival.

--LOW % OF INCOME--

The LOWER the proportion of one’s income needed to buy a good, the more INELASTIC the demand.
For example, SALT takes up a SMALL proportion of income, as such a 5% increase in price should result in only a very small fall in demand.

--HIGH % OF INCOME--

The HIGHER the proportion of one’s income needed to buy a good, the more ELASTIC the demand.
For example, BIG SCREEN-TVS takes up a LARGE proportion of income, as such a 5% increase in price should result in only a very small fall in demand.

--SHORT-TERM--

The SHORTER the time period in which a consumer makes a purchasing decision, the more INELASTIC the demand as they don't have the opportunity to consider whether they really want the good, and to get information on the availability of alternatives For example, if there is an increase in the price of heating oil, consumers can do little to switch to other forms of heating in a short period of time, and therefore demand for heating oil tends to be inelastic over short periods.

--LONG-TERM--

The LONGER the time period in which a consumer makes a purchasing decision, the more ELASTIC the demand. As time goes by, consumers have the opportunity to consider whether they really want the good, and to get information on the availability of alternatives to the good in question. As such we can say that the demand for oil is getting more and more ELASTIC over time as alternatives energy sources are being utilised more readily.

REAL WORLD FOCUS 1

Click on the image below to access the article, then EXPLAIN how it relates to the concept of ELASTICITY.

REAL WORLD FOCUS 2

--10-MARK TASK--

--Use the markscheme below to construct a 10-mark answer--

--PED ALONG A LINEAR DEMAND CURVE [HL ONLY]--

WE CAN SEE THAT AS THE PRICE IS LOWERED THE PED VALUES CHANGE FROM ELASTIC, TO UNITARY TO INELASTIC AND VICE VERSA.
AT HIGHER PRICE RNGES THE PED IS ELASTIC
AT LOWER PRICE RANGES THE PED IS INELASTIC

--PAST PAPER TASK--

Explain why, for a linear demand curve, the price elasticity of demand is not represented by the slope of the demand curve. [4] (M16)

--PED & TOTAL REVENUE (TR)--

--WHAT IS TOTAL REVENUE?--

TOTAL REVENUE (TR) is the amount of money received by firms when they sell a good (or service), and is equal to the PRICE (P) of the good times and the QUANTITY (Q) OF THE GOOD SOLD. Therefore,

--TR = P × Q--

--TR ALONG A LINEAR DEMAND CURVE--

WE CAN SEE THAT AS THE PRICE IS LOWERED THE TOTAL REVENUE INITIALLY STARTS TO RISE, THEN PEAKS BEFORE FALLING, AND VICE-VERSA.
WE CAN SEE THAT THERE WILL ALWAYS COME A PRICE LEVEL BEYOND WHICH SELLING A LARGER QUANTITY AT A LOWER PRICE WILL GENERATE LESS TOTAL REVENUE THAN SELLING A SMALLER QUANTITY AT A HIGHER PRICE AND VICE VERSA.

--TOTAL REVENUE & PED--

WE CAN CLEARLY SEE THAT WHEN THE PED IS ELASTIC,...
- LOWERING THE PRICE RESULTS IN INCREASING TOTAL REVENUE, AND
- RAISING THE PRICE RESULTS IN DECREASING TOTAL REVENUE.
WE CAN CLEARLY SEE THAT WHEN THE PED IS INELASTIC,...
- LOWERING THE PRICE RESULTS IN DECREASING TOTAL REVENUE, AND
- RAISING THE PRICE RESULTS IN INCREASING TOTAL REVENUE.

--PRICING DECISIONS WITHIN ELASTIC SECTION--

-CHANGES IN TR WHEN DEMAND IS ELASTIC (PED > 1)-

If the price range is in the ELASTIC PORTION (PED >1)

-IF THE PRICE RISES TR FALLS.

-IF THE PRICE FALLS TR RISES.

--PRICING DECISIONS WITHIN INELASTIC PORTION--

-CHANGES IN TR WHEN DEMAND IS ELASTIC (PED > 1)-

If the price range is in the INELASTIC PORTION (PED <1)

-IF THE PRICE RISES TR RISES.

-IF THE PRICE FALLS TR FALLS.

--DIAGRAMS to ILLUSTRATE TR--

To illustrate an ELASTIC price change we use HIGHER PRICE RANGES.
To illustrate an INELASTIC price change we use HIGHER LOWER RANGES.

--WHY IS KNOWING PED IMPORTANT?--

--FIRMS PRICING DECISIONS--

For FIRMS it is important to know the PED value when they are CONSIDERING WHETHER TO RAISE or LOWER the PRICE of their product as it will help them determine the IMPACT on TOTAL REVENUE.
If PED = ELASTIC it should LOWER its price in order for TR to RISE, ceteris paribus.
If PED = INELASTIC it should RAISE its price in order for TR to RISE, ceteris paribus.
If PED = UNIT ELASTIC it should NOT RAISE or LOWER its price, ceteris paribus.

--GOV'T TAX REVENUES--

For GOVERNMENTS it is important to know the PED value when they are CONSIDERING WHETHER TO RAISE or LOWER the TAX on certain goods (E.g. Cigarettes or alcohol) as it will help them determine the IMPACT on the TAX REVENUE they can collect.
RULE: The more INELASTIC the GREATER the tax revenue collected.

(See 'Tax burden and elasticity')

--4-MARK TASK--

Choose ONE of the following:
- - Using an appropriate diagram explain whether or not you would advise a firm to LOWER ITS PRICE within its INELASTIC PRICE RANGE (4)
  - Using an appropriate diagram explain whether or not you would advise a firm to LOWER ITS PRICE within its ELASTIC PRICE RANGE (4)

--PED OF PRIMARY COMMODITIES & MANUFACTURED GOODS [HL ONLY]--

--PRIMARY COMMODITIES--

--DEFINITION--

PRIMARY COMMODITIES are the output from the PRIMARY SECTOR, whose activities supply unprocessed RAW MATERIALS of agricultural (includes hunting, forestry, and fishing) and mineral origin, along with fuels, for use by other sectors of the economy.

--PED of PRIMARY COMMODITIES--

Many primary commodities have a INELASTIC (LOW) PED, because they are NECESSITIES and have FEW OR NO SUBSTITUTES.
- - - In other words, if PRICE RISES the FALL IN Qd IS RELATIVELY SMALL, as customers have NO ALTERNATIVE CHOICES (CLOSE SUBSTITUTES), thus the shortage will result in price being bid-upwards at a much steeper rate. (E.g Demand for crude Oil)
    - Similarly, if PRICE FALLS the RISE IN Qd IS RELATIVELY SMALL, as because it is a NECESSITY, customers are already consuming at or close to the 'necessary' quantity that they need thus the price has to fall significantly to clear the surplus.

- - - Due to this, ANY CHANGE IN SUPPLY WILL CAUSE LARGE FLUCTUATIONS IN THE PRICE.

--WHY IS THIS A PROBLEM?--

Agricultural OUTPUT depends on many factors beyond the farmer’s control, such as DROUGHT, PESTS, FLOODS, and other such NATURAL DISASTERS, as well as EXCEPTIONALLY GOOD WEATHER CONDITIONS, which occur over short periods of time. These cause frequent and large supply changes (supply curve shifts), meaning PRODUCER'S INCOMES CAN BE VERY UNSTABLE.

--IMPACT ON PRICES--

COMMODITY OUTPUT (Especially agricultural) depends on many factors beyond the farmer’s control, such as DROUGHT, PESTS, FLOODS, and other such NATURAL DISASTERS, as well as EXCEPTIONALLY GOOD WEATHER CONDITIONS, which occur over short periods of time.
Given the inelastic demand for these products any changes in supply will result in LARGE PRICE FLUCTUATIONS which in turn means that PRODUCER'S INCOMES CAN BE VERY UNSTABLE.

--4-MARK TASK--

--Using an appropriate diagram explain why a GOOD HARVEST leads to LOWER REVENUE for FARMERS, while a BAD HARVEST can lead to HIGHER REVENUE for FARMERS--

--MANUFACTURED GOODS--

--PED of MANUFACTURED GOODS--

By contrast, the demand for manufactured products tends to be more PRICE ELASTIC, because these products USUALLY HAVE CLOSE SUBSTITUTES that allows customers to switch easily when prices change.

--IMPACT ON PRICES--

Therefore, given a price change, the quantity demanded is generally more responsive in the case of manufactured products compared with primary commodities.

- - - In other words, if PRICE RISES the FALL IN Qd IS RELATIVELY LARGE, as customers have MANY CLOSE SUBSTITUTES to switch to, thus the extent to which prices will be bid upwards is not so significant. (E.g Demand for toy cars)
    - Similarly, if PRICE FALLS the RISE IN Qd IS RELATIVELY LARGE, as customers of CLOSE SUBSTITUTES will (assuming sub prices don't change), switch to the now cheaper alternative, quickly clearing any surplus.
We can see that any changes in supply have relatively smaller impacts on prices due to the relatively more elastic demand for manufactured goods.

--4-MARK TASK--

--Using an appropriate diagram explain why LOWERING PRICES leads to HIGHER REVENUE for MANUFACTURERS while RAISING PRICES can lead to LOWER REVENUE for MANUFACTURERS--

END OF SECTION MCQ

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