What you need to know: Demand and Price Elasticity of Demand

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Contents

Why is demand important?

Demand is the amount consumers are willing to buy at a given price.

It is a key building block in how economists model different markets. Governments and citizens care about the prices of items and demand is a key determinant of prices (along with supply).

Matters for firms in predicting sales or revenue. If a firm can predict how demand changes, it can forecast future sales.

What determines demand?

Demand depends on:

• (1) Price. Usually as price goes up, we would expect demand to go down. This is called the law of demand and could  be because as the price increases, consumers can afford less of the good or consumers buy other goods instead.
• Another explanation is the idea of diminishing marginal utility. As you consume more units of a good, each extra unit gives less and less extra satisfaction, we assume. This means the consumer is willing to pay less for each extra unit. Hence for the consumer to be willing to buy more units, the price needs to fall.
• Note occasionally there may be goods whose demand increases as price goes up. These are exceptions to the law of demand. This could include goods where the higher price denotes status, for example an expensive watch or car, called “Veblen” goods. 
• There are also “Giffen” goods that are staples such as rice. If the price of rice goes up, then consumers may not have the income to afford luxury food items, so they stop buying the luxury food items and could spend all their budget on rice. Because of this,  consumers could buy more rice when the price is higher.
• (2) Income.
  • For normal goods, as income goes up, demand goes up.
  • However there are other goods, called inferior goods. For these goods, when as income goes up, demand goes down. For example supermarket value ranges or used goods.
• (3) Price of other goods.
  • If the price of Pepsi goes down, the demand for Coca-Cola goes down. These are ‘substitute’ goods.
  • If the price of flights abroad goes down, the demand for hotel rooms abroad will go up. These are ‘complementary goods’. 
• (4) Other factors such as the level of advertising, the quality of the good, etc.

Demand curve

The relationship between demand and price means we can draw a “demand curve”. The demand curve is downward sloping. In other words as price increases, the quantity demanded decreases.

Note if price changes, this leads to a movement along the demand curve. 

But if any other factor changes that influences demand, the demand curve shifts. For example if incomes increase for a normal good, then demand will shift to the right.

Changes to demand: movement along the demand curve

If the price of a good changes, demand changes. If the price falls, we expect demand to increase, other things being equal*.

I show the movement along the demand curve below. The price falls from p to p1 and the quantity demanded increases from q to q1.

*Other things being equal means that other factors such as income, tastes, advertising are assumed to remain the same.

Changes to demand: demand curve shifts

When a factor other than price changes, then the demand curve shifts, other things being equal.

Suppose there is an increase in incomes. This will increase demand for normal goods and decrease demand for inferior goods.

On a diagram, this will mean a demand shift right for normal goods and a demand shift left for inferior goods.

Another way to interpret the shift in demand is: for a given price, demand is lower. For example at the given price p in the diagram, demand has risen from q to q1.

Price elasticity of demand: definition and formula

The price elasticity of demand (PED), in simpler terms, measures how responsive demand is to changes in price.

There is also a formula for the price elasticity of demand:

\[PED=\frac{% change in demand}{% change in price}\]

For example, suppose the price of a good falls 5% and the demand rises 10%. Then the PED is 10/5 = 2.

Why is the price elasticity of demand important?

For firms the price elasticity of demand determines the effect of a price change on their revenue (see below).

Governments and policy advisors care about price elasticity of demand too. The PED tells us about the possible effects of a tax or subsidy on prices, who faces the burden of a tax and so on.

Values and types of price elasticity of demand

We assign different labels to different values of the PED:

Elasticity value	Term	Meaning
0	Perfectly inelastic	Demand does not respond to price changes.
Between 0 and -1	inelastic	Demand responds little to price changes
-1	Unit elastic	If price falls by 1%, demand rises by 1% too.
Below -1	elastic	Demand responds significantly to price changes
Negative infinity	Perfectly elastic	Demand responds in an extreme way to price changes

Price elasticity of demand: elastic and inelastic in simpler terms

While elastic and inelastic have specific meanings as above, one way to remember their rough meanings is as follows:

• Elastic means responsive or sensitive – demand responds a lot when the price changes.
• Inelastic means unresponsive or insensitive – demand responds very little when the price changes.

Different PED graphs

We can also draw graphs to show different PED values. Note generally the PED relates to the slope of the demand curve but it is not exactly the same [technically the slope of the demand curve reflects the relationship between the absolute change in price and demand, while the elasticity reflects the relationships between the percentage change in prices and demand.]

What determines the PED?

Factors that determine the PED:

• If the good is a necessity or addictive, then demand does not change as price changes. So the PED is inelastic.
• If the price of the good is a small percentage of income, then consumers do not notice a change in price, so demand may change little. So the PED is inelastic.
• If there are many substitutes for the good, then demand will be more responsive/elastic when price changes: consumers can easily switch to another good, rather than pay a higher price.
• In the short run, it is more difficult for consumers to change their demand (takes time to realise  the price has change, to escape contracts etc.), so demand is more inelastic. In the long run, as more substitutes emerge and it becomes easier to switch, demand is more elastic.

An example of a good with inelastic PED could be alcohol, as it is addictive. For more on estimates of the PED for alcohol, see the report here.

PED along a linear demand curve

The PED is not the same as the slope of the demand curve. So the PED can vary along a linear demand curve.

Take the linear demand curve in the diagram below.

At low levels of demand and high prices, an increase in price by one unit gives a small percentage change in price.

Yet the demand fall is larger as a percentage of the (original) demand level. So the PED will be elastic overall.

The opposite argument applies for higher demand at lower prices.

So what does a demand curve with constant PED look like?

Compared with the linear demand curve, the demand curve needs to be less elastic at low quantity and more elastic at high quantity. This leads to a curve as shown in the diagram:

PED vs Total Revenue

The total revenue for a firm is the price multiplied by quantity.

Increasing the price has two contrasting effects on total revenue:

• Raising the price increases revenue on goods that are still sold.
• Raising the price means reduced quantity demanded, so reduced revenue.

If the PED is inelastic, then a rise in price leads to a rise in total revenue. This is because the effect of the price increase on revenue outweighs the quantity fall.

If the PED is elastic, then a rise in price leads to a fall in total revenue. This is because the quantity fall is large and the price rise is small.

Note for unit elastic PED, a rise in price has no effect on revenue.

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