Price Elasticity of Demand (P.E.D)

The first elasticity (yes there are four types at AS...) is Price Elasticity of Demand or P.E.D.
It is defined as the responsiveness of demand to a change in price.

Here is the formula for calculating P.E.D:

(% Change in quantity demanded) / (% Change in Price)

The figures are usually negative but a rule of thumb is to omit the negative sign.

P.E.D is important in many situations and is particularly significant when considering a change in price. How will demand change when I increase or decrease the price? Is it worthwhile to manipulate the price?

The answer to these questions are determined by whether the product in question is demand elastic or inelastic...

Elastic 

Elastic products are those where demand is extremely sensitive to changes in price. If the price went up by a few pence, we would expect a significant change in demand. The idea here is that people decide not to purchase your product. Products in competitive markets where there are many substitutes will probably be elastic. For example if the chocolate bar you buy increases in price from 50p to 70p you will probably look to buy a cheaper alternative if you budget around 50p per day. The only exception will be extreme brand loyalty when you refuse to buy any other substitute chocolate bar other than your favourite.

If we calculate P.E.D of a product using the above formula and p.e.d >1 then you've got yourself an elastic demand. Groovy.

We can illustrate elastic demand graphically too:

Remembering that demand curves slope downwards most of the time we can see that a small decrease in price from p1 to p2 results in a large increase in quantity demanded (q1 to q2) as a reduced price results in more consumers rushing to buy the product now that it's cheaper. To spot these diagrams look for a D Curve near to the horizontal!

Inelastic

Products that are demand inelastic respond little to a change in price. Therefore if prices increased or decreased significantly demand would stay similar or even the same. This occurs in the commodity markets - a commodity being something that has no direct substitute and if for example Mr Cadbury requires cocoa to make his chocolate he is forced to buy cocoa on the world market whatever the price as there is no alternative. Demand therefore stays similar. In addition other essentials such as petrol for your car is still bought even though prices are going up and up and up...

Even addictive products such as drugs and alcohol have inelastic demand. People are determined to consume these whatever the price and so as you'll see later, putting taxes on these goods is less effective than putting it on an elastic product.

If we calculate P.E.D of a product using the above formula and p.e.d < 1, then the product in question is demand inelastic.

Perhaps you prefer diagrams?

This is characterised by a D Curve near to the vertical. We can see that as price moves from p1 to p2, the change in the quantity demanded between q1 and q2 is small and so represents the fact that with inelastic goods a change in price results in a much smaller movement along the Q axis.

Extremes of P.E.D.

Perfectly Elastic

With a Perfectly Elastic (horizontal) Demand Curve demand is infinite and so there can't be a change in price.

Perfectly Inelastic

With a perfectly inelastic Demand Curve (Vertical) demand stays exactly the same despite changes in price. P.E.D = 0.

Demand and Supply - Page 3

Market Equilibrium 

So, when I say equilibrium it sounds scary right? But we know what equilibrium means. It is derived from the word "equal". Furthermore you have just read the two previous pages on demand and supply. Equilibrium basically combines the demand curve and the supply curve and displays them on one chart. This is why the axes of both curves are always quantity (x axis) and price (y axis).

So, here's what the basic graph looks like:

We can see that equilibrium occurs for this particular market at p1,q1 and this means that the demand for a given product equals the supply of that product. Equilibrium may also be referred to as "Market Clearing" as every unit is sold to a consumer.
 Therefore the supplier neither has a surplus of stock or a shortage. The market aims to achieve equilibrium for this reason and the fact that if the market moves away from this point there will be pressures on price. If a move occurs, the market aims to get back towards equilibrium by either altering the amount of supply to the market or manipulating demand (often by using prices.) This page explores the effects of moving away from market equilibrium.

A market operating outside of Equilibrium

The graph below appears scary, but don't worry it's simple.

NB. The new black lines indicate where the four red points meet the axes and are purely for reference purposes.

So take a point above the equilibrium. We can see that the quantity demanded seems to be a great deal below the quantity supplied to the market. Therefore the supplier cannot sell all of their units so may not break even. This is called a Surplus or a Glut. Naturally there is a need to get back to equilibrium and so there must be an increase in demand (extension) or a decrease in supply (contraction).

We can see that increasing demand is the more logical thing to do here or suppliers can just slow down production so that in the future they don't have as much surplus. The top two purple arrows show the movement along the two curves towards p1,q1 and this of course balances things out. One of the first things we learn as novice economists is that when supply outweighs demand, prices are relatively low (or there is downward pressure on price.) We've all seen retailers sell off unwanted surpluses of stock at discount prices to get rid of them. I should imagine the Justin Bieber album will be going cheap as there is a huge glut and nobody demands his music!

What about points below the equilibrium point?

This time the quantity demanded is greater than the quantity supplied. This is basically the opposite of a market operating above equilibrium. Thus means that there will be a shortage meaning that not everyone will be able to be supplied with the product they demanded and so the free market system uses prices again to sort out the problem.

There will of course be upward pressure on price which makes sense when we look at diamonds. There is lots of demand for diamonds but diamond supplies are extremely scarce which is why they are so expensive to buy.

So, supply needs to be increased (extension) or demand needs to be reduced (contraction) in order to return to operating near to the equilibrium point.


Page 1 - Demand ,  Page 2 - Supply



So, I hoped you enjoyed your introduction to demand & supply. But it's important to note that for policymakers, manipulating demand or supply isn't as easy as you might think. Now if you're ready, you might like to read about elasticity...