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Price elasticity of demandFrom Wikipedia, the free encyclopedia
Not to be confused withPrice elasticity of supply.
PED is derived from the percentage change in quantity (%Qd) and percentage change in price
(%P).
Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness,
orelasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the
percentage change in quantity demanded in response to a one percent change in price (holding constant all the
other determinants of demand, such as income). It was devised byAlfred Marshall.
Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can
lead to ambiguity. Only goods which do not conform to thelaw of demand, such asVeblenandGiffen goods,have a positive PED. In general, the demand for a good is said to be inelastic(or relatively inelastic) when the
PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity
of the good demanded. The demand for a good is said to be elastic(or relatively elastic) when its PED is
greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a
good demanded.
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Revenue is maximised when price is set so that the PED is exactly one. The PED of a good can also be used
to predict theincidence (or "burden") of a taxon that good. Various research methods are used to determine
price elasticity, includingtest markets, analysis of historical sales data andconjoint analysis.
Contents
[hide]
1 Definition
o 1.1 Point-price elasticity
o 1.2 Arc elasticity
2 History
3 Determinants
4 Interpreting values of price elasticity coefficients
5 Effect on total revenue
6 Effect on tax incidence
7 Selected price elasticities
8 See also
9 Notes
10 References
11 External links
[edit]DefinitionPED is a measure of responsiveness of the quantity of a good or service demanded to changes in its
price.[1]
The formula for the coefficient of price elasticity of demand for a good is:[2][3][4]
The above formula usually yields a negative value, due to the inverse nature
of the relationship between price and quantity demanded, as described by the
"law of demand".
[3]
For example, if the price increases by 5% and quantitydemanded decreases by 5%, then the elasticity at the initial price and quantity
= 5%/5% = 1. The only classes of goods which have a PED of greater than
0 areVeblenandGiffengoods.[5]
Because the PED is negative for the vast
majority of goods and services, however, economists often refer to price
elasticity of demand as a positive value (i.e., inabsolute valueterms).[4]
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lasticity_of_demand#cite_note-Png57-0http://en.wikipedia.org/w/index.php?title=Price_elasticity_of_demand&action=edit§ion=1http://en.wikipedia.org/wiki/Price_elasticity_of_demand#External_linkshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Referenceshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Noteshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#See_alsohttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Selected_price_elasticitieshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Effect_on_tax_incidencehttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Effect_on_total_revenuehttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Interpreting_values_of_price_elasticity_coefficientshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Determinantshttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Historyhttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Arc_elasticityhttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Point-price_elasticityhttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#Definitionhttp://en.wikipedia.org/wiki/Price_elasticity_of_demandhttp://en.wikipedia.org/wiki/Conjoint_analysis_(in_marketing)http://en.wikipedia.org/wiki/Marketing_researchhttp://en.wikipedia.org/wiki/Incidence_of_tax 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This measure of elasticity is sometimes referred to as the own-priceelasticity
of demand for a good, i.e., the elasticity of demand with respect to the good's
own price, in order to distinguish it from the elasticity of demand for that good
with respect to the change in the price of some other good, i.e.,
acomplementaryorsubstitute good.[1]The latter type of elasticity measure is
called across-price elasticity of demand.[6][7]
As the difference between the two prices or quantities increases, the accuracy
of the PED given by the formula above decreasesfor a combination of two
reasons. First, the PED for a good is not necessarily constant; as explained
below, PED can vary at different points along thedemand curve, due to its
percentage nature.[8][9]
Elasticity is not the same thing as theslopeof the
demand curve, which is dependent on the units used for both price and
quantity.[10][11]Second, percentage changes are not symmetric; instead,
thepercentage changebetween any two values depends on which one is
chosen as the starting value and which as the ending value. For example, if
quantity demanded increases from10 units to15 units, the percentage
change is 50%, i.e., (15 10) 10 (converted to a percentage). But if quantity
demanded decreases from15 units to10 units, the percentage change is
33.3%, i.e., (10 15) 15.[12][13]
Two alternative elasticity measures avoid or minimise these shortcomings of
the basic elasticity formula: point-price elasticityand arc elasticity.
[edit]Point-price elasticity
One way to avoid the accuracy problem described above is to minimise the
difference between the starting and ending prices and quantities. This is the
approach taken in the definition of point-priceelasticity, which usesdifferential
calculusto calculate the elasticity for an infinitesimal change in price and
quantity at any given point on the demand curve:[14]
In other words, it is equal to the absolute value of the first derivative of
quantity with respect to price (dQd/dP) multiplied by the point's price (P)
divided by its quantity (Qd).[15]
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In terms of partial-differential calculus, point-price elasticity of demand
can be defined as follows:[16]
let be the demand of
goods as a function of parameters price and wealth,
and let be the demand for good . The elasticity of demand
for good with respect to pricepk is
However, the point-price elasticity can be computed only if the
formula for thedemand function,Qd = f(P), is known so its
derivative with respect to price, dQd /dP, can be determined.
[edit]Arc elasticity
A second solution to the asymmetry problem of having a PED
dependent on which of the two given points on a demand curve is
chosen as the "original" point and which as the "new" one is to
compute the percentage change in P and Q relative to
the averageof the two prices and the averageof the two quantities,
rather than just the change relative to one point or the other. Loosely
speaking, this gives an "average" elasticity for the section of the
actual demand curvei.e., the arcof the curvebetween the two
points. As a result, this measure is known as thearc elasticity, in this
case with respect to the price of the good. The arc elasticity is
defined mathematically as:[13][17][18]
This method for computing the price elasticity is also known as
the "midpoints formula", because the average price and average
quantity are the coordinates of the midpoint of the straight line
between the two given points.[12][18]
However, because this
formula implicitly assumes the section of the demand curve
between those points is linear, the greater the curvature of the
actual demand curve is over that range, the worse this
approximation of its elasticity will be.[17][19]
[edit]History
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The illustration that accompanied Marshall's original
definition of PED, the ratio of PT to Pt
Together with the concept of an economic "elasticity"
coefficient,Alfred Marshallis credited with defining PED
("elasticity of demand") in his bookPrinciples of Economics,
published in 1890.[20]
He described it thus: "And we may say
generally: the elasticity (or responsiveness) of demand in a
market is great or small according as the amount demanded
increases much or little for a given fall in price, and diminishes
much or little for a given rise in price".[21]
He reasons this since
"the only universal law as to a person's desire for a commodity
is that it diminishes... but this diminution may be slow or rapid. If
it is slow... a small fall in price will cause a comparatively large
increase in his purchases. But if it is rapid, a small fall in price
will cause only a very small increase in his purchases. In the
former case... the elasticity of his wants, we may say, is great. In
the latter case... the elasticity of his demand is
small."[22]
Mathematically, the Marshallian PED was based on a
point-price definition, using differential calculus to calculate
elasticities.[23]
[edit]DeterminantsThe overriding factor in determining PED is the willingness and
ability of consumers after a price change to postpone immediate
consumption decisions concerning the good and to search for
substitutes ("wait and look").[24]
A number of factors can thus
affect the elasticity of demand for a good:[25]
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Availability ofsubstitute goods: the more and closer the
substitutes available, the higher the elasticity is likely to be,
as people can easily switch from one good to another if an
even minor price change is made;[25][26][27]
There is a strong
substitution effect.[28]If no close substitutes are available the
substitution of effect will be small and the demand
inelastic.[29]
Breadth of definition of a good: the broader the
definition of a good (or service), the lower the elasticity.
For example, Company X's fish and chips would tend to
have a relatively high elasticity of demand if a
significant number of substitutes are available, whereas
food in general would have an extremely low elasticityof demand because no substitutes exist.
[30]
Percentage of income: the higher the percentage of the
consumer's income that the product's price represents, the
higher the elasticity tends to be, as people will pay more
attention when purchasing the good because of its
cost;[25][26]
The income effect is substantial.[31]
When the
goods represent only a negligible portion of the budget the
income effect will be insignificant and demand inelastic,[32]
Necessity: the more necessary a good is, the lower the
elasticity, as people will attempt to buy it no matter the
price, such as the case ofinsulinfor those that need it.[10][26]
Duration: for most goods, the longer a price change holds,
the higher the elasticity is likely to be, as more and more
consumers find they have the time and inclination to search
for substitutes.[25][27]
When fuel prices increase suddenly, for
instance, consumers may still fill up their empty tanks in the
short run, but when prices remain high over several years,
more consumers will reduce their demand for fuel by
switching tocarpoolingor public transportation, investing in
vehicles with greaterfuel economyor taking other
measures.[26]
This does not hold forconsumer
durablessuch as the cars themselves, however; eventually,
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it may become necessary for consumers to replace their
present cars, so one would expect demand to be less
elastic.[26]
Brand loyalty: an attachment to a certain brandeither out
of tradition or because of proprietary barrierscan override
sensitivity to price changes, resulting in more inelastic
demand.[30][33]
Who pays: where the purchaser does not directly pay for
the good they consume, such as with corporate expense
accounts, demand is likely to be more inelastic.[33]
[edit]Interpreting values of priceelasticity coefficients
Perfectly inelastic demand[10]
Perfectly elastic demand[10]
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Elasticities of demand are interpreted as follows:[10]
Value Descriptive Terms
Ed = 0 Perfectly inelastic demand
- 1 < Ed < 0 Inelastic or relatively inelastic demand
Ed = - 1Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic
demand
- < Ed < -1
Elastic or relatively elastic demand
Ed = - Perfectly elastic demand
A decrease in the price of a good normally results in an increase
in the quantity demanded by consumers because of thelaw of
demand, and conversely, quantity demanded decreases when
price rises. As summarized in the table above, the PED for a
good or service is referred to by different descriptive terms
depending on whether the elasticity coefficient is greater than,
equal to, or less than 1. That is, the demand for a good is
called:
relatively inelasticwhen the percentage change in quantity
demanded is less thanthe percentage change in price (so
that Ed > - 1);
unit elastic, unit elasticity, unitary elasticity, or unitarily
elasticdemand when the percentage change in quantity
demanded is equal tothe percentage change in price (so
that Ed = - 1); and
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relatively elasticwhen the percentage change in quantity
demanded is greater thanthe percentage change in price
(so that Ed < - 1).[10]
As the two accompanying diagrams show, perfectly
elasticdemand is represented graphically as a horizontal line,
and perfectly inelasticdemand as a vertical line. These are
the onlycases in which the PED and the slope of the demand
curve (P/Q) are bothconstant, as well as the onlycases in
which the PED is determined solely by the slope of the demand
curve (or more precisely, by the inverseof that slope).[10]
[edit]Effect on total revenue
See also:Total revenue test
A set of graphs shows the relationship between
demand and total revenue (TR) for a linear demandcurve. As price decreases in the elastic range, TR
increases, but in the inelastic range, TR decreases.
TR is maximised at the quantity where PED = 1.
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A firm considering a price change must know what effect the
change in price will have on total revenue. Generally any
change in price will have two effects:[34]
the price effect: an increase in unit price will tend to
increase revenue, while a decrease in price will tend to
decrease revenue.
the quantity effect: an increase in unit price will tend to lead
to fewer units sold, while a decrease in unit price will tend to
lead to more units sold.
Because of the inverse nature of the relationship between price
and quantity demanded (i.e., the law of demand), the two effects
affect total revenue in opposite directions. But in determiningwhether to increase or decrease prices, a firm needs to know
what the net effect will be. Elasticity provides the answer: The
percentage change in total revenue is equal to the percentage
change in quantity demanded plus the percentage change in
price. (One change will be positive, the other negative.)[35]
As a result, the relationship between PED and total revenue can
be described for any good:[36][37]
When the price elasticity of demand for agoodis perfectly
inelastic(Ed = 0), changes in the price do not affect the
quantity demanded for the good; raising prices will cause
total revenue to increase.
When the price elasticity of demand for a good is relatively
inelastic(-1 < Ed < 0), the percentage change in quantity
demanded is smaller than that in price. Hence, when the
price is raised, the total revenue rises, and vice versa.
When the price elasticity of demand for a good is unit (or
unitary) elastic(Ed = -1), the percentage change in quantity
is equal to that in price, so a change in price will not affect
total revenue.
When the price elasticity of demand for a good is relatively
elastic( - < Ed < -1), the percentage change in quantity
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demanded is greater than that in price. Hence, when the
price is raised, the total revenue falls, and vice versa.
When the price elasticity of demand for a good is perfectly
elastic(Edis ), any increase in the price, no matter how
small, will cause demand for the good to drop to zero.
Hence, when the price is raised, the total revenue falls to
zero.
Hence, as the accompanying diagram shows, total revenue is
maximized at the combination of price and quantity demanded
where the elasticity of demand is unitary.[37]
It is important to realize that price-elasticity of demand
is notnecessarily constant over all price ranges. The linear
demand curve in the accompanying diagram illustrates that
changes in price also change the elasticity: the price elasticity is
different at every point on the curve.
[edit]Effect on tax incidence
When demand is more elastic than supply, producers
will bear a greater proportion of the tax burden than
consumers will.
Main article:tax incidence
PEDs, in combination withprice elasticity of supply(PES), can
be used to assess where the incidence (or "burden") of a per-
unit tax is falling or to predict where it will fall if the tax is
imposed. For example, when demand is perfectly inelastic, by
definition consumers have no alternative to purchasing the good
or service if the price increases, so the quantity demanded
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would remain constant. Hence, suppliers can increase the price
by the full amount of the tax, and the consumer would end up
paying the entirety. In the opposite case, when demand
isperfectly elastic, by definition consumers have an infinite ability
to switch to alternatives if the price increases, so they would
stop buying the good or service in question completely
quantity demanded would fall to zero. As a result, firms cannot
pass on any part of the tax by raising prices, so they would be
forced to pay all of it themselves.[38]
In practice, demand is likely to be only relativelyelastic or
relatively inelastic, that is, somewhere between the extreme
cases of perfect elasticity or inelasticity. More generally, then,
the higherthe elasticity of demand compared to PES, the
heavier the burden on producers; conversely, the
more inelasticthe demand compared to PES, the heavier the
burden on consumers. The general principle is that the party
(i.e., consumers or producers) that has feweropportunities to
avoid the tax by switching to alternatives will bear
the greaterproportion of the tax burden.[38]
[edit]Selected price elasticities
Various research methods are used to calculate price elasticities
in real life, including analysis of historic sales data, both public
and private, and use of present-day surveys of customers'
preferences to build uptest marketscapable of modelling such
changes. Alternatively,conjoint analysis(a ranking of users'
preferences which can then be statistically analysed) may be
used.[39]
Though PEDs for most demand schedules vary depending on
price, they can be modeled assuming constant
elasticity.[40]
Using this method, the PEDs for various goods
intended to act as examples of the theory described aboveare
as follows. For suggestions on why these goods and services
may have the PED shown, see the above section on
determinants of price elasticity.
http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/w/index.php?title=Price_elasticity_of_demand&action=edit§ion=9http://en.wikipedia.org/w/index.php?title=Price_elasticity_of_demand&action=edit§ion=9http://en.wikipedia.org/w/index.php?title=Price_elasticity_of_demand&action=edit§ion=9http://en.wikipedia.org/wiki/Marketing_researchhttp://en.wikipedia.org/wiki/Marketing_researchhttp://en.wikipedia.org/wiki/Marketing_researchhttp://en.wikipedia.org/wiki/Conjoint_analysishttp://en.wikipedia.org/wiki/Conjoint_analysishttp://en.wikipedia.org/wiki/Conjoint_analysishttp://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-38http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-38http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-38http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-39http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-39http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-39http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-39http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-38http://en.wikipedia.org/wiki/Conjoint_analysishttp://en.wikipedia.org/wiki/Marketing_researchhttp://en.wikipedia.org/w/index.php?title=Price_elasticity_of_demand&action=edit§ion=9http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37http://en.wikipedia.org/wiki/Price_elasticity_of_demand#cite_note-wall57-37 -
8/3/2019 Velly Economics 1 Q ANS
13/13
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