Price elasticity of demand (PED)

Categories: EconomicsPrice

The Price Elasticity of Demand for goods indirectly dictates the function of today’s economy, it does this by using the wants and needs of the consumer and in-turn governs the prices for individual goods. Below, scenarios in which government or firm have to look at the PED are presented and how they react to create the best possible outcome they can achieve.

Firms need to consider the elasticity of demand and, using this, determine the prices of a good; this is seen as a policy in firm’s cases.

The firm needs to consider whether lowering the price will stimulate demand for the product, if so to what extent and whether the firm’s profits will also increase as a result. This can take either one of two outcomes: One, if the increase in sales is more than the reduction in price in proportion, the firm’s total revenue will increase and profits may be higher. Or two, if the increase in demand for the good is less than the fall in price in proportion then revenue will decrease and profits would most certainly decrease.

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In this scenario, the knowledge of PED as it can move the firm towards increasing the price of an inelastic good, which shifts the burden of any additional cost of production onto the consumers, or decreasing the price of an elastic good to increase demand, and if this is done to the right degree of accuracy, can increase a firm’s revenue greatly.

The burden of tax can also be shifted by the firm onto the consumer to compensate for maybe an increased cost of producing a good.

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The knowledge of PED here is so important to the firm as if their good can be seen as a highly inelastic good, they can impose large taxation because they know that people need the good irrespective of price, maybe due to addiction. This extra increase in price just makes the cost of producing the good so much cheaper for the firm, therefore revenue and profits will increase greatly. This is also apparent in the Government’s economic objective; they impose heavy taxation of addictive goods; e.g. tobacco and alcohol, two highly inelastic goods.

What the government do is ‘internalize the negative externality’ which means that they impose taxes on a good for the damage the good does to the people; i.e. the government raise cigarette prices by %20 in taxes, this %20 goes to the NHS to fund the treatment of liver failures and lung cancer for alcohol and cigarettes respectively. In relation to this, the ‘paradox of poverty amidst plenty’ highlights how the elasticity of agricultural goods affects farmers and farming communities; A ‘bumper’ crop (particularly productive harvest yielded) bring poverty to farmers; the increase in supply shifts the curve right, causing a massive decrease in the price consumers pay. The government intervenes here and subsides the farmers for doing their job; they buy up the surplus crop and store it for forthcoming years, a bad crop may come next year, which allows this surplus crop to be used up, showing fluctuation in the production of the good.

The Price Elasticity of Demand justifies the nationalization of public utility services, e.g. bus or train services, electricity, water supply and mail services. These services, by nature, are generally inelastic; if these services were to be run by private firms, the country would see large exploitation of the somewhat already extortionate prices - especially Northern Rail, grinds my gears!! - This is because private firms want to monopolize, or control, the market. Therefore, in the government’s interest of the general public, they own and control said services.

In other words, it is percentage change in quantity demanded by the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity, that is, it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. In simpler words, demand for a product can be said to be very inelastic if consumers will pay almost any price for the product, and very elastic if consumers will only pay a certain price, or a narrow range of prices, for the product.

Inelastic demand means a producer can raise prices without much hurting demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to.

ValueMeaning
Ed = 0Perfectly inelastic.
- 1 > Ed > 0Relatively inelastic.
Ed = – 1Unit (or unitary) elastic.
∞ > Ed > – 1Relatively elastic.
Ed = ∞Perfectly elastic.

A price fall usually results in an increase in the quantity demanded by consumers. The demand for a good is relatively inelastic when the change in quantity demanded is less than change in price. Goods and services for which no substitutes exist are generally inelastic. Demand for an antibiotic, for example, becomes highly inelastic when it alone can kill an infection resistant to all other antibiotics. Rather than die of an infection, patients will generally be willing to pay whatever is necessary to acquire enough of the antibiotic to kill the infection. Various research methods are used to calculate price elasticity:

•Test markets

•Analysis of historical sales data

•Conjoint analysis

Price elasticity is always negative, although analysts tend to ignore the sign. It is always negative due to the very nature of demand, if the price increases, less is demanded, and thus quantity change is negative, leading to a negative price elasticity of demand. Conversely, if price falls, this negative value will lead to a negative price elasticity of demand value.

Determinants

•Substitutes: The more substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made. •Percentage of income: The higher the percentage that the product’s price is of the consumer’s income, the higher the elasticity, as people will be careful with purchasing the good because of its cost. •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 of insulin for those that need it.

•Duration: The longer a price change holds, the higher the elasticity, as more and more people will stop demanding the goods (i.e. if you go to the supermarket and find that blueberries have doubled in price, you’ll buy it because you need it this time, but next time you won’t, unless the price drops back down again) •Breadth of definition: The broader the definition, the lower the elasticity. For example, Company X’s fried dumplings will have a relatively high elasticity, whereas food in general will have an extremely low elasticity (see Substitutes, Necessity above).

Updated: Jul 06, 2022
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Price elasticity of demand (PED). (2016, Apr 15). Retrieved from https://studymoose.com/price-elasticity-of-demand-ped-essay

Price elasticity of demand (PED) essay
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