Price Elasticity of Demand and Supply

Transcription

1 CIMA BA1: BA1 Fundamentals of Business Economics Module: 4 Price Elasticity of Demand and Supply

2 1. Introduction Beth and Sam sell sea food out of a small shop. They noticed that if they put the price of crab up by 50p their demand fell dramatically, but if they put the price of lobsters up by 1 there wasn t much change in demand at all (except larger profits!). What was going on? This can all be explained by the price elasticity of demand Price elasticity of demand Overview The price elasticity of demand is the relationship between the price of a product and the demand for it. Put another way, how the demand for a product changes when its price changes. For example, Beth and Sam noticed that when they changed the price of crabs the demand for them seemed to change quite a lot. If demand for something changes a lot due to a change in price, demand is said to be elastic'. However, when Beth and Sam changed the price of their lobsters, they found that demand for them didn t change that much. If the change in demand is low when the price of the product changes, demand is said to be inelastic. Formula Price elasticity of demand is measured by calculating the following: Price elasticity of demand = % change in quantity demanded % change in price There are three variations for working this out. However, you only need to know about two of them! These are the average arc method and the non- average arc method. Why reference to an arc? Well the clue is in the name, demand curve: it's actually more of an arc than a straight line! How do we work these methods out? Let s look at an example: Example So, let s take a look at what s happening with Beth and Sam s lobsters! 74

3 Lobsters sell for 6.00 each, and annual demand is 1,000 units. When they put the price up by 1.00 the annual demand for lobsters fell by 110 to 890. With this in mind, let's try calculating the price elasticity of demand using both the average and the non-average arc method. Answer - Non-average arc method Step 1: Let's identify our numbers Starting level of demand - D1 = 1,000 Demand after price change - D2 = 890 Initial price - P1 = 6.00 Price after change - P2 = 7.00 Step 2: Work out the percentage change in demand using the formula D2 - D1 D ,000 1,000 = - 11% Step 3: Next we need to work out the percentage change in price P2 - P1 P = 17% Step 4: Putting it all together Price elasticity of demand = =

4 Answer Average arc method Step 1: work out the average price between the starting and finishing price To do this we need to add the start and finish price and divide by 2, so: = 6.50 Step 2: work out the percentage change in price using the average price = 15.4% Step 3: work out the average change in demand ,000 2 = 945 Step 4: Work out the percentage change in demand 890-1, = -11.6% Step 5: Putting it altogether for the price elasticity of demand = Well that's that done then. But hang on what does it mean? Elastic and inelastic demand Demand elasticity can be any figure from 0 to minus infinity! 76

5 Outcome 77

6 and Sam's crabs. Let s take a look at a different kind of example: Using the demand curve Remember I said that we often represent demand curves as straight lines to simplify things? Well, that s what we re going to do here. Demand curves can be represented by the straight line formula: Qd = a bp a is the point where the curve starts on the Y (vertical) axis, b is the gradient (slope) of the line, Qd is the quantity demanded and P is the price. Example Let's say that the demand curve for Beth and Sam's mussel sales is: Qd = 100 6P With this in mind, if the price of the product rises from 5.00 to 6.00 what is the effect on the quantity demanded? Also, what is the price elasticity of demand? Answer We know the change in price from the question, so let s use our formula to see what the effect on the quantity demanded will be? Firstly, when the price is 5: Qd = ( 6x5) = 70 When the price rises to 6, it has the following effect on demand: Qd = ( 6x6) = 64 78

7 We now have the change in price and the corresponding change in demand. So, we can put them together to work out the price elasticity of demand using the formula we met earlier: = = So, as this is less than 1, it seems that the sale of mussels is relatively inelastic! Ben and Kath can put their prices up without too much effect on demand. That's should help them increase their profits. 3. Price elasticity and the demand curve We know from earlier studies that demand curves tend to slope down from left to right. Does it make a difference to the curve if the price elasticity is elastic or inelastic? Well the short answer is, yes! Let s look at the extremes: Perfectly elastic 79

8 If a good or service is perfectly price elastic its level of demand is completely sensitive to any change in price. Any increase in price leads to a total loss of demand, meaning all revenue is lost i.e. in the diagram a movement away from P1 means no demand. This might occur where a product has a perfect substitute (another product that people will buy instead if the price goes up). For example, let s say Beth and Sam raise the price of their crab by 10p, even though there s another stall nearby selling the same product. What s going to happen? Well, Beth and Sam will lose their customers because they can get more or less the same product for a cheaper price elsewhere. Elastic If a good or service is price elastic, demand is very responsive to changes in price: any change in price leads to a higher change in demand. If prices are raised, revenue is reduced - e.g. the increase in price from P1 to P2 leads to a more significant fall in demand from Q1 to Q2. This again would be true for products that are near substitutes, such as brands of the same kind of bread or soup. Cola might be another example if Coke put their prices up, people will quickly start switching to Pepsi. Here price elasticity of demand is greater than 1 but less than infinity: -1 < Price elasticity of demand < -, 80

9 Perfectly inelastic If a good or service is perfectly price inelastic, demand is completely unresponsive to changes in price. Any increases in price will result in the same level of demand and increased revenues. Here, Price elasticity of demand = 0 For example, we could set price anywhere on the above graph and the quantity demanded would stay at Q1. This would be true of a product that is an essential, like water. Even if the price doubled most households would still purchase water, and many of them use just as much. However, as for perfectly elastic, no pure example exists in the real world. Even with water some people would start using less as the price increased. The exception is that totally elastic or inelastic demand may be seen over certain price ranges for some products. e.g. the price of water goes up 1 a year and no-one changes the amount they purchase. The majority of products, however, will eventually reach a price point where consumers will begin to think about and alter their consumption levels. Inelastic If a good or service is price inelastic, any change in price to a smaller change in demand, like Beth and Sam s Lobster sales. When this is the case, prices should be raised to increase revenue When the price rises from P1 to P2 for instance, the related fall in the quantity demanded is less significant (Q1 to Q2). The positive impact of the

10 increased price on income is therefore greater than the negative affect of the resultant fall in demand. An example of this sort of product could be petrol: even if prices rise, demand won t be affected to the same level due to the dependency many people have on the car for transport. Here price elasticity of demand is greater than 0 but less than -1: 0 < price elasticity < -1 Unitary price elasticity of demand When the demand for a good or service is unit elastic, (equals 1) change in demand are exactly proportional to change in price. Hence, if prices are raised or lowered, revenue (income) is always at the same level. So how does that work? Well, in the diagram above, the price of clams is currently 1. At this level Beth and Sam sell 10, hence revenue is 10 (1 x 10). If the price changed to 2 they would sell 5. Notice through that the revenue stays at 10 ( 2 x 50. The fall in one is exactly offset by the raise in the others keeping the revenue the same at all price levels. Giffen and Veblen Goods You may have noticed that for all the examples we have done so far there has been a negative price elasticity. That s the normal state of affairs. However, some like Giffen goods and Veblen goods. If you remember, these are goods that increase in sales as price rises e.g. due to a 81

11 perceived improvement in reputation. These have an upwards sloping demand curve, meaning an upward change in price will be net by an increase in demand and vice versa and the price elasticity is positive. 4. Uses of price elasticity of demand So, what is the price elasticity of demand good for? Well, it helps companies make decisions on their goods and services. Let s take a look at some of these: 82

12 Revenue implications Companies can forecast the effect on revenues of a change in price. This will, in turn, help them to work out at what point they will maximise profits. Generally the rules are that: If total revenue increases as a result of a price increase then demand is inelastic - i.e. people continued to buy the same amount despite the price rise, like Beth and Ben's lobster sales. They can put the price up and increase revenue something they might consider doing. If total revenue falls when the price increases, then demand is elastic - i.e. people saw the price rise and decided either, not to buy the product or not to buy as much e.g. Beth and Ben's crab sales. If total revenues falls when prices fall, then demand is inelastic i.e. People bought the same amount at a lower price. Beth and Ben have better not put their lobster prices down! If total revenue increases when prices fall then demand is elastic - i.e. the lower price encourages people to buy more, or swap from a substitute. Beth and Ben might consider reducing the price they are selling their crabs for as revenues are likely to rise. Lastly, if total revenue is unchanged, then the product is demonstrating unitary elasticity of demand - i.e. the fall in price is directly proportional to the change in demand and therefore one offsets the other. Example A table cloth manufacture currently sells its cloths directly to the public for 30 each. At this price, they sell 20,000 units. Having undertaken some research, they know that their price elasticity of demand is If they decided to reduce their price to 20, what would the effect on demand and total revenue be? Answer OK, so what do we know? Well, the price elasticity of demand is between 0 and -1, and so is relatively inelastic. This means that demand shouldn t change too much when price changes. Also the rules we learned earlier would suggest that total revenue should fall when prices fall. This is worth bearing in mind, as it will help us to check our answer! Now, we need to work out how to use the numbers we ve been given. To do that, we need to use our formula: % change in quantity demanded = Price elasticity of demand (PED) 83

13 % change in price We know the start and end price, so we can work out the percentage change in price: = Now, let's put the figures we know into our formula: % change in quantity demanded % change in price = Price elasticity of demand (PED) % change in quantity demanded = -0.6 Let's then rearrange our formula: % change in demand = -0.6 X = Hence, demand will rise to: = 20,000 X 119.8% = 23,960 (Note 1) Note 1 - As our change in demand was calculated as a positive amount, it represented an increase in demand from our previous level. To work out the new level of demand, we need our initial amount plus the increased amount - i.e. 100% of the initial amount plus our 19.8% increase. This is the same as multiplying our original level by 119.8%. So, now we can turn our attention to working out the change in revenue (the amount sold multiplied by the price it was sold at): Revenue before the price change: 20,000 X 30 = 600,000 Revenue after the price change: 23,960 X 20 = 479,200 84

14 OK, so doing our double check we noted that demand was relatively price inelastic. Is that what we saw? Well, it demands when the price fell, but not too dramatically, so our answer looks reasonable. Revenue also fell. We would also expect this from a relatively inelastic demand as the amount demanded has increased, but not significantly. Production/purchases As companies can forecast the effect on demand of a change in price, they can use this information to choose a level of production or purchases. If Beth and Sam put the price of crabs down they will sell a lot more and so will need to ensure that they buy more to meet the demand increases. Taxation Governments can forecast the effect on sales tax revenue (e.g. VAT) of a change in tax on a good/service. For example, if a product is very price elastic, an increase in a sales tax such as VAT, which causes prices to rise for the consumer, will result in a more significant reduction in demand and therefore revenue. Often governments choose to put taxes on goods such as petrol or cigarettes as these have inelastic demand meaning that the quantity sold will stay very similar and the amount of tax raised will be high. 5. Factors influencing price elasticity of demand Tap water. How much does it cost? Do you even think about it? Most of us probably don't but just turn on the tap for a drink, wash, shower knowing that whatever the current price is we'll just pay it! So, here we have a relatively price inelastic product. If the price got too high we'd maybe seek out alternatives, drink milk or maybe cut back, perhaps having fewer baths. But the rise would no doubt have to be quite high before any significant effect on demand was seen. Why is this? It's a necessity one of the factors influencing the price elasticity of demand. Here's a list of a range of factors.

15 Let s look at them in a little more detail... Percentage of income spent on the good/service If spending on the company s good or service only represents a small percentage of a consumer s income, then demand for such goods is likely to be inelastic (demand does not change much as prices change). Consumers don t spend too much time thinking about whether or not to buy such goods and services as it won t impact too much on all the other things they could buy instead. Examples include salt and ball point pens. If the price of a ball point pen rises from 10p to 20p people will probably still buy it just because it's remains a small outlay. If spending represents a high percentage of consumer income, demand for such goods is likely to be elastic. Consumers will think very hard about these purchases because they will affect any other spending decisions. Rises in price may soon get to the point where they would rather use the money for other things. Cars and holidays are good examples of this. If the average car doubles in price from say 12,000 to 24,000 a lot of people will not buy a new car because they cannot afford it. The availability of substitutes OK, so what if Beth and Sam decided to put the price of their products up by 50p? For most products they would probably see a significant fall in demand as consumers would turn to the other nearby seafood stall. Such a fall in demand would be even worse if there were a number of other nearby seafood stalls. Most products would have elastic demand. This is because as the number of substitutes for a product or service increases, the price elasticity is likely to rise, too. If the number of substitutes is low or the company has a monopoly of the market (is the only manufacturer, or one of few manufacturers of the product), the price elasticity of that good is likely to be inelastic. Product status necessity or luxury Goods can be classified as necessities or luxury items. Demand for necessities is likely to be relatively inelastic as consumers need the good regardless of the price - e.g. medicine. Demand for luxuries is likely to be relatively elastic as a large part of the demand is made of want rather than need! - e.g. sports cars and holidays. 85

16 Time since price changed Demand will become more elastic as time passes. If the price of the good has only just increased, consumers may be unaware of the increase or of available cheaper substitutes. Therefore, the demand is likely to be relatively inelastic in the short term. The more time that passes, the more likely consumers will realise that the price has increased and have more time to look for alternatives. Brand loyalty If consumers are very loyal to a particular brand, price increases are likely to have a relatively low influence on demand. Therefore, demand is likely to be relatively price inelastic - e.g. designer clothing, Apple. If consumers do not have much or any brand loyalty for a particular product, price increases are likely to have more of an effect on demand as customers quickly switch to alternatives. Therefore, demand is likely to be relatively price elastic. Competitor pricing Beth and Sam notice that Bob's Seafood, the a nearby stall, has just put the price of crab down. They have a choice do they put their price down too or keep it the same? If they decide not to put their price down they may experience a decrease in demand due to Bob's product being cheaper. If competitors do not decrease prices in light of a competitor decreasing theirs, the company with the higher prices is likely to encounter elastic demand for its goods at the higher price. Habit Some goods are habit-forming, such as tobacco and gambling products. These goods fall into a similar category to necessities, as consumers can become dependent on the product. Demand for habit-forming goods is likely to be inelastic, because the dependency means consumers will likely buy at any price - e.g. cigarettes. Definition of the market The broader the definition, the less elastic the demand often will be. For example, if you define the clothes market in totality the total number of items sold in the market is likely remain similar, even if all clothes go up in price (it is inelastic) as people just switch from more to less expensive shops. 86

17 If we consider just one clothes shop as our 'market', then that shop is far more likely to be affected if they put prices up as people can switch to other shops (demand is elastic). 6. Price elasticity of supply Beth and Sam were really determined to make a good go of running their seafood shop. Sometimes, they seemed to run short of a few different types of fish, which was annoying because they felt that they could have made the sales (and hence the profit!) if only they had had the stock. Unfortunately, their suppliers seemed unwilling to give them more. Having seen what had happened with sales when they had put prices up, they wondered if there would be a similar effect if they offered more money to their suppliers. So they tried it! They decided to increase the prices offered to suppliers by 20% across the range. Interestingly, some suppliers couldn t seem to get enough boxes through the door, whereas it didn t seem to make much difference to others. Sam and Beth weren t quite sure why that was. Well, in the same way that there is price elasticity of demand, there is price elasticity of supply. This is defined as the sensitivity of the level of supply to any change in price. Again we have a formula: % change in quantity supplied % change in price = Price elasticity of supply And this will be worked out using the following: Q2 -Q1 Q1 P2 -P1 P1 = Price elasticity of supply Let s work through an example. Example Never Forget Ltd is a company that makes sticky note pads. When their supply price is 0.10 they will supply 100,000 units. If their supply price were to increase to 0.15, they would supply 150,000 units. What is their price elasticity of supply? 87

18 Answer Step 1: Work out which numbers are which! Q1 100,000 Q2 150,000 P P Step 2: Insert numbers into formula 150, , , = 1 88

19 Meaning of the price elasticity of supply Description So, in our example above the result was 1, so sticky note pads reflect unit supply elasticity with respect to price - i.e. a 1% rise in price will cause a 1% rise in supply and vice versa. Using the supply curve The formula for a supply curve is given in the format: Qs = C + dp C is the point where it starts on the X axis (usually a negative figure) and d gives us the gradient of the line. P is price. Let s look at another type of example, this time using this supply curve formula. Example If the formula for the supply curve for Mugs Galore Ltd is: Qs = P if the price rises from 2 to 3 what is the price elasticity of supply? 89

20 Answer OK, well we have the change in price, but we don t have the change in quantity supplied. We can work this out using our equation. Let s start with the price of 2. At this price the quantity supplied will be: Qs = -4 + (41 x 2) Qs = Qs = 78 Now let s consider what happens when the price rises to 3: Qs = -4 + (41 x 3) Qs = 119 OK so working out the price elasticity of supply we ll have: = = Price elasticity of supply - extremes As we saw for price elasticity of demand, we have some extreme versions for price elasticity of supply. 90

21 Perfectly inelastic supply In the above diagram, no matter how the price changes, the level of supply will remain the same. This would be true of something like the sale of mobile telephone bandwidth, because this is something that cannot be made, therefore there is a finite amount of it regardless of the price we attribute to it. Perfectly elastic supply Here, at price P1 the supplier will make as much as is required available, but move either above or below this price and they will supply nothing! 91

22 This situation is rare in the real world that's why it's an extreme case! 7. Factors affecting the price elasticity of supply So, what determines whether goods or services are more price elastic or inelastic? Going back to our fish sellers, Beth and Sam, why did some suppliers not react as much as others when they offered to pay them more? Well, it could be because of one or more of the following factors... Availability of inputs If the raw materials are readily available, a company will be able to change production levels quite easily if there is a change in price. This means that the supplier is relatively elastic e.g. soft drinks manufacturers. If not (e.g. mining diamonds) the quantity provided will remain very similar (inelastic). Availability of factors of production Similarly, if the factors of production (labour, land, enterprise and capital) are readily available, supply levels can be easily changed in response to a price change - e.g. elastic supply. If factors of production are not readily available then it will be hard to increase quantities supplied. e.g. a shortage of skilled labour, necessary machinery or funding. 92

23 Stock If a supplier keeps reasonable stocks of finished goods or semi-finished components, they can easily be provided to the market, meaning supply will be relatively elastic. A watch manufacturer can hold watches in stock as long as they wish before releasing them to the market and so supply can be increased or reduced as they wish. The opposite is also true. For example, a farmer supplying milk will have a relatively inelastic supply as they have a set number of cows in the short term and a given amount of milk that each provides. The product is also perishable, so no stock will be kept. Number of competitors Considering the industry as a whole, if there is a large number of suppliers - such as in the food industry - supply is likely to be elastic because some will always be able to fill the additional supply requirements through stock or production changes. In industries where set up costs are low - e.g. window cleaning, pet grooming and garden design services - this will be particularly true as new suppliers may well be attracted to the industry by expected price rises that lead to increased profit margins. These new entrants and the increased production that they bring will therefore ensure that any increased supply requirements can be met. Developments in technology In extreme cases, advancements in technology could change supply from being inelastic to elastic. For example, the use of robots in manufacturing processes (e.g. car manufacturing) mean that supply is not restricted by the availability of skilled labour or determined by traditional working patterns. If a process is mechanised, supply can easily respond to changes in price. Long run vs short run There could possibly be a difference in price elasticity of supply between the short term and the long term. For example, supply could be not increased in the short term because of a shortage of factories producing a product. In the long term more factories can be built increasing supply. Similarly, with our milk example, in the long term the farmer could increase their herd, thereby being able to produce more milk. Therefore, when discussing price elasticity of supply, a distinction should be made as to whether we are considering the short or the long term. 93

24 Production capacity As for resources, if a supplier is not using all their production capacity it is easier for them to respond to price changes. For example, if a manufacturer didn t have all their production lines operating, they could activate those that are dormant should the need arise. Therefore supply will be elastic with respect to price. The opposite will also be the case if all potential capacity is already being used. Definition of the market Again, as we described for price elasticity of demand, the level of supply elasticity will also be related to the market we are discussing. For example, the supply of food products will be fairly elastic due to the large number of suppliers, available factors of production, potential levels of stock and spare capacity. However, should we narrow our definition to ostrich meat, the number of suppliers may be fewer and their ability to increase supply in the short term will be restricted to the amount of birds they have. Therefore supply will be relatively inelastic. 94