Elasticity of Demand
We have to understand here that for some commodities, a small rise in price will mean a big drop in consumption, but for others, even big changes in price will not change consumption much at all. The slope of the demand curve is an important way to describe the relationship between price and demand (consumption).
Price Elasticity of Demand (PED) measures the responsiveness of demand to a change in price. A steep demand curve shows a good that has price inelastic demand ie demand for it is less responsive to a change in price. A shallow demand curve shows a good that has price elastic demand ie demand is responsive to a change in price. Goods with price inelastic demand tend to have few substitutes, are necessities, and/or can be addictive eg petrol, alcohol, cigarettes. PED is always a negative number. A number between 0 and –1 means demand is price inelastic. A number between –1 and –∞ means demand is price elastic.
It can be calculated using the formula:
% change in demand
% change in price
Income Elasticity of Demand (YED) measures responsiveness of demand to a change in income.
A positive number means the good is normal; a negative number means the good is inferior. It can be calculated using the formula:
% change in demand
% change in income
Cross (price) Elasticity of Demand (XED) measures responsiveness of demand for one good to a change in the price of another good. A positive number means the goods are substitutes; a negative number means the goods are complements. It is measured using the formula:
% change in demand for good
% change in price of good y
The importance of elasticities
PED is important to businesses because it tells them what their pricing strategy should be in order to increase total revenue: if PED is inelastic, then a rise in price increases total revenue and a fall in price reduces total revenue; if PED is elastic, then a rise in price reduces total revenue and a fall in price increases total revenue. PED is also important to governments in terms of understanding the burden (or incidence) of taxation on producers and consumers. The more price inelastic the good, a greater proportion of the sales tax is paid by the consumer than the producer. Similarly, for subsidies (a government grant given to producers in order to encourage production), the more price inelastic the good, the greater the price fall for consumers. Businesses should also be aware of cross price elasticities, because it will tell them how demand for their own product will change following a price change by their competitors or partners.
Source: Adapted from Edexel Tutor Support Materials with some modifications.