Elasticity

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded. 

We can use this equation to calculate the effect of price changes on quantity demanded, and on the revenue received by firms before and after any price change.
For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be:

- 50% / + 20%  

= (-) 2.5

The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’.
PED can also be:

• Less than one, which means PED is inelastic.
  
• Greater than one, which is elastic.
  
• Zero (0), which is perfectly inelastic.
  
• Infinite (∞), which is perfectly elastic.
  

PED along a linear demand curve

PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to right. PED = 1 at the midpoint of a linear demand curve.

PED and revenue

There is a precise mathematical connection between PED and a firm’s revenue.
There are three ‘types’ of revenue:

1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).
   
2. Average revenue (AR), which is found by dividing total revenue by quantity sold (TR/Q). Consider these figures and calculate Total, Marginal and Average Revenue.
   
3. Marginal revenue (MR), which is defined as the revenue from selling one extra unit. This is calculated by finding the change in TR from selling one more unit.
   
   

   PRICE (£)	Qd	TR	MR	AR
   10	1
   9	2
   8	3
   7	4
   6	5
   5	6
   4	7
   3	8
   2	9
   1	10

   
   

Answer
Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue – then answer the following:

1. How are price and average revenue connected?
   
2. What happens to total revenue as output increases?
   
3. What is the connection between total revenue and marginal revenue?
   
4. How are marginal revenue and average revenue connected?
   

Observations

When TR is at a maximum, MR = zero, and PED = 1.

1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P.
2. A curve plotting AR (=P) against Q is also a firm’s demand curve.
3. TR increases, reaches a peak and decreases.

Why does a firm want to know PED?

There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price.

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.

Non-pricing policy

When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity. 

Supply and Demand

The Law of Demand and the Demand Curve

We begin with demand because demand is usually easier to understand from our personal experiences. We are all consumers and we all demand goods and services. Demand is derived from consumers' tastes and preferences, and it is bound by income. In other words, given a limited income (whether it be $30,000 or $5 million), the consumer must decide what goods and services to purchase. Within his budget, the consumer will purchase those goods and services that he likes best. Each consumer will purchase different things because individual preferences and incomes differ. The law of demand holds that other things equal, as the price of a good or service rises, its quantity demanded falls. The reverse is also true: as the price of a good or service falls, its quantity demanded increases. This law is a simple, common sense principle. Think of your trips to the grocery store. When the price of orange juice rises, for example, you buy less of it. When that item is on sale, you purchase more of it. This is all that we mean by the law of demand.

A demand curve is a graphical depiction of the law of demand. We plot price on the vertical axis and quantity demanded on the horizontal axis. As the figure illustrates, the demand curve has a negative slope, consistent with the law of demand.

The Law of Supply and the Supply Curve

Supply is slightly more difficult to understand because most of us have little direct experience on the supply side of the market. Supply is derived from a producer's desire to maximize profits. When the price of a product rises, the supplier has an incentive to increase production because he can justify higher costs to produce the product, increasing the potential to earn larger profits. Profit is the difference between revenues and costs. If the producer can raise the price and sell the same number of goods while holding costs constant, then profits increase.
The law of supply holds that other things equal, as the price of a good rises, its quantity supplied will rise, and vice versa.

Equilibrium: Determination of Price and Quantity

What price should the seller set and how many videos will be rented per month? The seller could legally set any price she wished; however, market forces penalize her for making poor choices. Suppose, for example, that the seller prices each video at $20. Odds are good that few videos will be rented. On the other hand, the seller may set a price of $1 per video. Consumers will certainly rent more videos with this low price, so much so that the store is likely to run out of videos. Through trial and error or good judgement, the store owner will eventually settle on a price that equates the forces of supply and demand.

In economics, an equilibrium is a situation in which:

• there is no inherent tendency to change,
• quantity demanded equals quantity supplied, and
• the market just clears.

At the market equilibrium, every consumer who wishes to purchase the product at the market price is able to do so, and the supplier is not left with any unwanted inventory.

What is 'Microeconomics'

Microeconomics is the branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry).

The field of economics is broken down into two distinct areas of study: microeconomics and macroeconomics. Microeconomics looks at the smaller picture and focuses more on basic theories of supply and demand and how individual businesses decide how much of something to produce and how much to charge for it. People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area.

Macroeconomics, on the other hand, looks at the big picture (hence "macro"). It focuses on the national economy as a whole and provides a basic knowledge of how things work in the business world. For example, people who study this branch of economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6% rate of unemployment is not necessarily a bad thing. Thus, for an overall perspective of how the entire economy works, you need to have an understanding of economics at both the micro and macro levels.