2.2. DEMAND: PRICE
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The Demand Function
Economists have come up which an equation for demand and it is known as the functions of demand.
Economists have come up which an equation for demand and it is known as the functions of demand.
A change in the price, certus paribus, results in a movement along a demand curve and a change in any of the other factors causes a shift. The reason why only price is a movement along is because the demand curve is drawn against the variable price (price appears on the y axis).
Price
A change in price results in a movement along a demand curve. Demand curves are various shapes, so the same change in price for different goods/ services will result in different changes in demand.
In the two diagrams below we have two different demand curves. In the market the price in both of these markets changes by the same amount; P1 to P2. However this change in price affects the output demanded in the market in different ways. For market 1, the change in quantity is fairly small. In market two the change in quantity demanded is much larger.
A change in price results in a movement along a demand curve. Demand curves are various shapes, so the same change in price for different goods/ services will result in different changes in demand.
In the two diagrams below we have two different demand curves. In the market the price in both of these markets changes by the same amount; P1 to P2. However this change in price affects the output demanded in the market in different ways. For market 1, the change in quantity is fairly small. In market two the change in quantity demanded is much larger.
Price Elasticity of Demand
We can measure the responsiveness of demand to a change in price by working out the price elasticity of demand. The formula is:
We can measure the responsiveness of demand to a change in price by working out the price elasticity of demand. The formula is:
The coefficient of price elasticity of demand will be negative because of the inverse relationship between price and quantity demanded.
Here are two questions:
1) Apple decides to reduce the price of their iPads from £400 to £350. They predict that their sales of iPads will increase from 200,000 per month to 275,000.
We can work out the price elasticity of demand.
% Change in price = -12.5%
% Change in demand = 37.5%
Coefficient of PED = -3 meaning demand is elastic
Here are two questions:
1) Apple decides to reduce the price of their iPads from £400 to £350. They predict that their sales of iPads will increase from 200,000 per month to 275,000.
We can work out the price elasticity of demand.
% Change in price = -12.5%
% Change in demand = 37.5%
Coefficient of PED = -3 meaning demand is elastic
2) Greggs decide to reduce the price of their sausages rolls from 80p to 60p. This results in sales rising by 10%.
% change in price = -20%
% change in demand = 10%
Coefficient of PED = -0.5 meaning demand is inelastic
% change in price = -20%
% change in demand = 10%
Coefficient of PED = -0.5 meaning demand is inelastic
But what do these values mean?
The diagram below shows what the different demand curves look like.
- If PED = 0 then demand is perfectly inelastic, meaning that demand does not change at all when prices change (ADD IN A DIAGRAM).
- If PED is between 0 and -1 then demand is inelastic. The percentage change in demand is smaller than the percentage change in the price.
- If PED = -1 then demand is unit elastic. It is where the % change in demand is exactly the same as the percentage change in price. A 10% rise in the price would result in a 10% fall in demand.
- If PED < -1 then demand is elastic. Demand responds more than proportionately to a change in price. For example, a 20% rise in the price results in a 30% fall in the quantity demanded (PED = -1.5)
The diagram below shows what the different demand curves look like.
PED & Revenue
It is important for firms to know how responsive demand is to a change in price. This is because revenue will increase or decrease depending on the price elasticity of demand.
It is important for firms to know how responsive demand is to a change in price. This is because revenue will increase or decrease depending on the price elasticity of demand.
- If a firm has inelastic demand (-1 < PED < 0), then if a firm raises its price then total revenue will increase. If we take the extreme case where PED is 0, where supply is perfectly inelastic, an increase in price will not affect the quantity of output that is demanded. This results in the firm selling the same quantity at higher prices, meaning that revenue for the firm increases. If this firm with inelastic demand decreased the price then revenue would fall.
- Now suppose that we have a new firm who have an elastic PED (PED < -1). The demand curve here would be flatter than an inelastic PED demand curve. If the firm chooses to lower their prices then output increases a greater percentage compared to the decrease in price. Therefore, revenue for this firm increases. Alternatively, this firm could raise its prices. This would result in a greater percentage fall in the quantity of output compared to the percentage increase in the price. In this situation, the revenue of the firm will fall.
- We can also have a special case where we have unit elastic (PED = -1). If the firm increases or decreases the price revenue remains constant.
Other Reasons for Knowing PED
There are a variety of other reasons why the price elasticity of demand is interesting for firms to know, in addition to knowing the revenue consequences. Some of these are:
There are a variety of other reasons why the price elasticity of demand is interesting for firms to know, in addition to knowing the revenue consequences. Some of these are:
- The effect of a change in an indirect tax and the quantity demanded. The PED decides who pay more or less of the tax (this will be discussed in more detail later on in the course)
- The PED can be useful if the firm wants to engage in price discrimination. If they know the PED of each market that they segment then they can increase the price in an inelastic market and decrease the price in more elastic markets. This enables the firm to increase their total revenue.