Factors influencing price elasticity of demand

Price elasticity of demand (PED) measures how much the quantity demanded of a good changes in response to a change in its price. Various factors affect whether demand is elastic or inelastic.

Availability of substitutes

• Demand tends to be more price elastic when there are many close substitutes available, as consumers can easily switch if the price increases.
• For narrowly defined goods, such as a specific type of fruit like bananas, there are often more substitutes, making demand more elastic.
• For broadly defined categories, like all fruits, fewer substitutes exist, leading to more inelastic demand.

Nature of the good or service

• Essential goods, such as vital medicines, usually have inelastic demand because consumers need them regardless of price changes.
• Non-essential items, like luxury fashion, often have elastic demand as consumers can delay or avoid purchases if prices rise.
• Habit-forming products, including caffeine-based drinks, tend to have inelastic demand due to consumer dependency.
• Goods requiring immediate purchase, such as urgent vehicle maintenance, also show inelastic demand.
• Versatile products with multiple applications, like water, generally have inelastic demand.

Proportion of income required for purchase

• Goods that take up a large share of a consumer's budget, such as major appliances, tend to have elastic demand because buyers are more sensitive to price changes and will compare options.
• Items that represent a small portion of income, like basic seasonings, have inelastic demand as price fluctuations have minimal impact on overall spending.

Time period considered

• Over the short term, demand is often more inelastic because consumers have limited options to adjust.
• In the longer term, demand becomes more elastic as people can find alternatives, alter habits, or switch loyalties.

Total revenue and price elasticity of demand

Total revenue is the total income a firm receives from selling its products, calculated as the price per unit multiplied by the quantity sold.

Formula for total revenue

$\text{Total revenue}=\text{price per unit}\times \text{quantity sold}$

Changes in elasticity along a demand curve

• On a straight-line demand curve, elasticity varies: it is highly elastic at high prices with low demand, unitary elastic at the midpoint (PED = -1), and inelastic at low prices with high demand.
• Firms maximise total revenue at the point where PED = -1, which occurs around the midpoint of the demand curve.

Effects on total revenue for elastic demand

• When demand is elastic (PED < -1), lowering the price increases total revenue because the rise in quantity demanded outweighs the price drop.
• Raising the price reduces total revenue for the same reason.

Effects on total revenue for inelastic demand

• When demand is inelastic (-1 < PED < 0), lowering the price decreases total revenue as the small increase in quantity does not compensate for the price reduction.
• Raising the price increases total revenue.

Worked example - Calculating total revenue change with elastic demand

A firm sells a product with a PED of -3. Initially, the price is £10 per unit, and 50 units are sold. If the price drops to £8 per unit, quantity demanded rises to 80 units. Calculate the initial and new total revenue.

Step 1: Identify the values

• Initial price = £10
• Initial quantity = 50 units
• New price = £8
• New quantity = 80 units

Step 2: Calculate initial total revenue

$\text{Initial total revenue}=\pounds 10\times 50=\pounds 500$

Step 3: Calculate new total revenue

$\text{New total revenue}=\pounds 8\times 80=\pounds 640$

Step 4: Interpretation

Total revenue increases from £500 to £640 when price falls, demonstrating the effect of elastic demand.

Worked example - Calculating total revenue change with inelastic demand

A firm sells a product with a PED of -0.4. Initially, the price is £10 per unit, and 50 units are sold. If the price drops to £8 per unit, quantity demanded rises to 54 units. Calculate the initial and new total revenue.

Step 1: Identify the values

• Initial price = £10
• Initial quantity = 50 units
• New price = £8
• New quantity = 54 units

Step 2: Calculate initial total revenue

$\text{Initial total revenue}=\pounds 10\times 50=\pounds 500$

Step 3: Calculate new total revenue

$\text{New total revenue}=\pounds 8\times 54=\pounds 432$

Step 4: Interpretation

Total revenue decreases from £500 to £432 when price falls, showing the impact of inelastic demand.

Income elasticity of demand

Income elasticity of demand (YED) measures how the quantity demanded of a good changes in response to a change in consumer income.

Normal goods

Normal goods have a positive YED (greater than 0), meaning demand rises as income increases.

Categories of normal goods:

• If YED is between 0 and 1, the good is a necessity, with demand growing slower than income.
• If YED is greater than 1, the good is a luxury, with demand increasing faster than income.

Inferior goods

Inferior goods have a negative YED (less than 0), so demand decreases as income rises. Consumers switch to better-quality alternatives when their income grows.

Cross elasticity of demand

Cross elasticity of demand (XED) measures how the quantity demanded of one good changes in response to a price change in another good.

Substitute goods

Substitutes have positive XED values, as a price fall in one reduces demand for the other. Closer substitutes, like different brands of smartphones, have higher positive XED compared to more distant ones, such as smartphones and desktop computers.

Complementary goods

Complements have negative XED values, meaning a price rise in one decreases demand for the other. For example, if the price of printers increases, demand for printer ink falls.

Independent goods

Independent goods have an XED of zero, as price changes in one do not affect demand for the other. Examples include unrelated items like books and sports equipment.