PED & YED revision notes
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This document discusses price elasticity of demand and its importance. It provides examples of how price elasticity of demand is used in international trade, government policy formulation, factor pricing, decisions by monopolists, and explaining the paradox of poverty amidst plenty for farmers. It then defines price elasticity of demand mathematically and explains how to calculate it. Finally, it discusses how price elasticity of demand changes based on price, shifts in the demand curve, and income elasticity of demand.
PED & YED revision notes
- 1. PRICE ELASTICITY OF DEMAND - REVISION NOTES Some important points from which you can realize the important of price elasticity of demand! Price elasticity of demand is a very important concept. Its importance can be realized from the following points: 1. International trade: In order to fix prices of the goods to be exported, it is important to have knowledge about the elasticity’s of demand for such goods. A country may fix higher prices for the products with inelastic demand. However, if demand for such goods in the importing country is elastic, then the exporting country will have to fix lower prices. 2. Formulation of Government Policies: The concept of price elasticity of demand is important for formulating government policies, especially the taxation policy. Government can impose higher taxes on goods with inelastic demand, whereas, low rates of taxes are imposed on commodities with elastic demand. 3. Factor Pricing: Price elasticity of demand helps in determining price to be paid to the factors of production. Share of each factor in the national product is determined in proportion to its demand in the productive activity. If demand for a particular factor is inelastic as compared to the other factors, then it will attract more rewards.
- 2. 4. Decisions of Monopolist: A monopolist considers the nature of demand while fixing price of his product. If demand for the product is elastic, then he will fix low price. However, if demand is inelastic, then he is in a position to fix a high price. 5. Paradox of poverty amidst plenty: A bumper crop, instead of bringing prosperity to farmers, brings poverty. This is called the paradox of poverty amidst plenty. It happens due to inelastic demand for most of the agricultural products. When supply of crops increases as a result of rich harvest, their prices drastically fall due to inelastic demand. As a result, their total income goes down. Price Elasticity of Demand (PED): Definition, Calculation and Effects of Change in PED Price elasticity of demand (PED) measures the extent to which the quantity demanded changes when the price of the product changes. The formula used to calculate it is: PED = Percentage change in quantity demanded/Percentage change in price This is often abbreviated to: PED = %ΔQD/%ΔP Calculating PED: To work out elasticity of demand, it is necessary to first calculate the percentage change in quantity demanded and a percentage change in price. To do this, the change in demand is divided by the original demand and multiplied by 100. The same process is used to work out the percentage change in price. For instance, demand may rise from 200 to 240 as a result of price falling from $10 to $9. In this case, the percentage change in quantity demanded is: Change in demand / Original quantity demanded X 100 i.e. 40/200 x 100 = 20% The percentage change in price is: Change in price / Original price X 100 i.e. -$1/$10 X 100 = -10% When these changes have been calculated, the percentage change in quantity demanded is divided by the percentage in price to give the PED. In this case, this is 20%/-10%. Remember that a division involving different signs gives a minus figure. Hence the PED is – 2.
- 3. Interpretation of PED: The PED figure provides two pieces of information. One is given by the sign. In the vast majority of cases, it is a minus. This tells us that there is an inverse relationship between demand and price – a rise in price will cause a contraction in demand and a fall in price will cause an extension in demand. The other piece of information is provided by the size of the figure. This indicates the extent by which demand will extend or contract when price changes. A figure of – 2, for instance, indicates that a 1% change in price will cause a 2% change in quantity demanded. Changes in PED: PED becomes more elastic as the price of a product rises. Consumers become more sensitive to price changes, the higher the price of the product. This is because, for instance, a 10% rise in price when price was initially $10,000 would involve consumers having to spend considerably more (i.e. $1,000) to buy the product. If a supplier was foolish enough to keep raising the price, a point would come when the product would be priced out of the market. At this point, demand would be perfectly elastic. As the price falls, demand becomes more inelastic. For e.g. a 10% fall in price when the price was initially $1 is not very significant and is unlikely to result in much extra demand. If price falls to zero, there will be a limit to the amount people want to consume. At this point, demand is perfectly inelastic. Fig. 3 shows how PED varies over a straight line demand curve. At the mid-point there is unit PED, with the percentage change in quantity demanded matching the percentage change in price. PED also changes when there is a shift in the demand curve. The more consumers want and are able to buy a product, the less sensitive they are to price changes. So a shift in the demand curve to the right reduces PED at any given price. In Fig. 4, PED is initially -5 (50%/ -10%) when price falls from $10 to $9. Then when demand increases to D1D1, PED falls to -2.5 (25%/-10%).
- 4. When demand decreases, consumers become more sensitive to price changes and demand becomes more elastic. Fig. 5 shows PED rising from -5 to -10 (100%/ -10%). =============================================================================
- 5. Income Elasticity of Demand YED This measures the responsiveness of demand to a change in income. e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then the YED = 20/ 5 = 4. YED = % change in Q.D % change in Income Definition of INFERIOR GOOD This occurs when an increase in income leads to a fall in demand. Therefore YED<0. E.g. clothes from charity shops, cheap bread When your income increase you buy better quality goods Defintion of NORMAL GOOD This occurs when an increase in income leads To an increase in demand for the good, Therefore YED>0 Definition of LUXURY GOOD This occurs when an increase in demand causes a bigger % increase in demand, therefore YED > 1. Luxury goods will also be normal goods and we can say They will be income Elastic Income inelastic This means an increase in income leads to a smaller % increase in demand. Therefore 0> YED <1 Firms will make use of YED by producing more luxury goods during periods of economic growth, similarly there will be less demand for inferior goods.