## Unit 2: Microeconomics - Elasticity of Demand (PED) ### Concept of Elasticity Elasticity of demand measures how responsive the quantity demanded of a good is to a change in a factor affecting demand, such as price or consumer income (real disposable income, adjusted for inflation and taxes). Think of elasticity as a measure of sensitivity. How much does demand change when something else changes? Demand is **elastic** if a small change in price or income causes a large change in quantity demanded. It's **inelastic** if a change in price or income has little impact on quantity demanded. A small price increase for a luxury car might drastically reduce demand (elastic), while a similar price increase for gasoline might only slightly reduce demand (inelastic). ### Price Elasticity of Demand (PED) PED measures the responsiveness of quantity demanded to a change in the *product's own price*. Remember, the Law of Demand states that price and quantity demanded are inversely related. Therefore, PED is always negative, but we typically ignore the negative sign when interpreting the value. The formula for PED is: $$ PED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}} $$ Don't forget to calculate percentage changes, not just the difference in quantity and price! * **PED > 1:** Demand is **price elastic**. A percentage change in price leads to a larger percentage change in quantity demanded. * **PED < 1:** Demand is **price inelastic**. A percentage change in price leads to a smaller percentage change in quantity demanded. * **PED = 1:** Demand is **unit elastic**. A percentage change in price leads to an equal percentage change in quantity demanded. ### Examples of Price Elastic and Inelastic Demand **Price Elastic Demand:** Motor vehicles, overseas holidays, fast food, fruits and vegetables, supermarket own-brand goods, chocolate bars. These goods often have readily available substitutes. If the price of Pepsi increases, consumers might easily switch to Coca-Cola. **Price Inelastic Demand:** Salt, safety matches, petrol (gas), medications, alcohol, electricity, examination registration fees, cigarettes, nail clippers. These goods often have few or no close substitutes. Even if the price of gasoline increases significantly, many people will still need to buy it to commute to work. ### Degrees of PED * **Perfectly Price Elastic (PED = ∞):** Demand exists only at one price. Any price increase leads to zero demand. This is theoretical and requires perfect substitutes. Imagine two identical products sold at different prices. Consumers will only buy the cheaper one. * **Perfectly Price Inelastic (PED = 0):** A change in price has no impact on quantity demanded. This is also theoretical and implies no substitutes exist. Life-saving medication might be close to perfectly price inelastic. * **Unit Elastic (PED = 1):** A price change leads to an equal percentage change in quantity demanded. Total revenue remains unchanged. ### Changing PED Along a Linear Demand Curve The PED value changes along a downward-sloping linear demand curve. PED is higher at higher prices and lower at lower prices. At the midpoint of a linear demand curve, PED = 1. * **Above the midpoint:** Demand is price elastic (PED > 1). * **Below the midpoint:** Demand is price inelastic (PED < 1). ### Determinants of PED Four main factors influence PED: * **Number and Closeness of Substitutes:** More substitutes lead to higher PED. * **Degree of Necessity:** Necessities tend to have inelastic demand; luxuries have elastic demand. * **Proportion of Income Spent:** Goods representing a larger proportion of income have more elastic demand. * **Time Period:** Demand becomes more elastic over longer time periods as consumers have more time to adjust. Use the acronym **TINS** to remember these determinants: Time, Income, Necessity, Substitutes. ### Relationship Between PED and Total Revenue (TR) * **Inelastic Demand:** Increasing price increases TR. * **Elastic Demand:** Decreasing price increases TR. ### Importance of PED for Firms and Governments * **Firms:** PED helps determine optimal pricing strategies and allows for price discrimination. * **Governments:** PED informs taxation policies, particularly for demerit goods (e.g., cigarettes, alcohol). High taxes on price-inelastic goods generate significant revenue. ### PED for Primary vs. Manufactured Goods Generally, primary commodities (raw materials) have lower PED than manufactured goods. This is because primary commodities often have fewer substitutes, are necessities in production, represent a smaller proportion of income, and have shorter time horizons for adjustment. Manufactured goods tend to have more substitutes, are less essential, represent a larger proportion of income, and have longer time horizons for adjustment. Understanding PED is crucial for making informed decisions in both business and policy contexts.