Understanding Price Elasticity of Demand

Hi everybody. The basic law of demand states when the price goes up, quantity demand will decrease. When the price goes down, quantity demand will increase. Yeah, but how much exactly? That's much more important information to know, isn't it? Well, that's where price elasticity of demand comes in. The definition is this, it measures the responsiveness of quantity demanded given a change in price. And we can actually use an equation to get a number for PED. Here is the equation. So PED equals the percentage change in quantity demanded over the price of the product. the percentage change in price. And it's very important, you remember, it's that way around. Quantity and demand are on the top, price on the bottom. Just remember, you queue before you pee. I was with my wife the other day, we were going to a theater, and she had to queue ages before she managed to get to the loo. Same when we went to Orlando, we were doing all the theme parks in Orlando, great times. But again, every time she'd leave the loo, she had to queue before she peed, right? Queue before you pee. Especially if you're a female, that's just like a given thing. So just queue before you pee, happy days. Well, not happy days necessarily. but at least you'll get the equation right, and that's the most important thing. We need to work with percentage changes here. So in case we have raw numbers and they need to be converted to percentage change, it's the difference between the two numbers divided by the original number and times by 100. Then stick in the numbers into this equation and we'll get a number at the end. The number at the end for PV will always be negative because of the law of demand. If price goes up, positive, quantity of demand will fall, negative, we get a negative number. Whereas if price goes down, negative. negative, quantity demand will go up. Positive, we get a negative number at the end. So the negative sign isn't really that important. When we get our final number, you can almost ignore the sign. Well, you can ignore the sign. Still write it in, but then forget about it. Just look at the number and then use this to help you interpret the number. So if that number is greater than one, demand is price elastic. And that means that for any given price change, there is a greater proportionate change in quantity demand. So for example, price might fall by 5%. but quantity demanded goes up by, I know, 15%. You see, quantity demanded is changed by more than the price change. That means that demand is price elastic. The figure is less than 1, demand is price inelastic, which means that when the price changes, quantity demanded will change but proportionally less than the change in price. So take the same price decrease of 5%, quantity demanded will increase maybe only by 1%, right? If it's 0, demand is perfectly price inelastic, which means regardless of the price change, quantity demanded... it won't change at all. If it's infinity, these are two extremes by the way, if it's infinity demand is perfectly priced elastic and if it's one demand is unit price elastic. Okay so these these two extremes one isn't really that important but useful when we're looking at total revenue. The key are the first two right here. So let's now use all of this that we've learned so far and do some calculations. Let's go with the first example we've got the price of a pack of cigarettes increasing from four pounds to five pounds. Let's immediately convert that to percentage change. Remember our equation for percentage change. The difference between the two numbers here is 1 pound, divided by the original, which is 4, times by 100. That's a 25% increase in price. Quantity demanded of cigarettes in packages goes down from 150 to 135. The difference is 15 divided by the original, 150, times by 100. That's a 10% decrease in quantity demanded. Do this calculation and we get a final figure of minus 0.5. for. Now, given the numbers that we've already learned, that means that demand is price inelastic. In words, what does that mean? It means that as the price of cigarettes goes up in this case, quantity demanded goes down, but proportionately less than the increase in price. That's what demand is price inelastic means. What about number two? Price of a sofa goes down from £1,000 to £800. Well, immediately I can tell you that's a 20% decrease in price. If you can't see that immediately, you see. the equation. The difference is 200 divided by 1,000 times by 100. You'll get 20% decrease. Always a good idea to keep the negative in the equation. That way you will always get the negative at the end. You'll write that down, which is important. Quantity demanded of sofas now goes up from 2,000 to 3,800. Let's convert that to percentage change. The difference is 1,800 divided by 2,000 times by 100, and that will give you 90%. That's a 90% increase in quantity demanded. Work that out. when we compute that, we get a final figure of minus 4.5. Remember when we interpret the figure, we can ignore the minus sign. The figure is greater than 1, which means demand is price elastic. Demand for sofas here is price elastic, meaning as the price of sofas goes down in this case, quantity demanded increases, but proportionally more than the decrease in price, 90% compared to a 20% drop in price. So demand increases proportionally more than the decrease in price. Good to have a go at some numbers. Let's go back. Now I understand more theory. So we know how to do the calculations. How do we then draw demand curves depending on elasticity of demand? Well, if we work out that demand is price inelastic, you have to draw a steep-looking demand curve. And it's very clear. If you look at this steep demand curve, whenever we change price, the change in quantity demanded will be proportionately less, no matter whether price goes up or down. If demand is price elastic, you draw the demand curve shallow, like that there. And that means for any change in price, the proportionate change... change in quantity demand will be much greater. So a shallow demand curve. For the extremes, for perfectly priced inelastic demand, vertical line. For perfectly priced elastic demand, horizontal line like that. Simple stuff. Learn those shapes. Very easy to apply. So then the next question is when is demand for a good or service price elastic or price inelastic? Just remember SPLAT. What a useful memory device. I tell you. To the day I still use SPLAT. It's so helpful. Let's understand. The S stands for substitute, specifically the number of substitutes. The more substitutes there are, the more price-elastic demand is going to be. The less substitutes, the more price-inelastic demand is going to be. Think of primary commodities like coffee, like rubber, like copper, like oil, all of these things. There are very few substitutes available, which makes demand for them very price-inelastic. The percentage of income that a price change takes, the greater the percentage of income that a price change takes. takes the more price elastic demand is going to be. The smaller the percentage of income of price change takes the more price elastic demand is going to be. So let's take a 10% increase in the price of cars versus a 10% increase in the price of an apple. Well a 10% increase in the price of an apple could be something like 5 pence. Well that's not going to affect our demand. Usually demand is going to be priced inelastic for that reason. Whereas a 10% increase in the price of cars could be like a £2000 increase in price. That's a huge chunk of our income. So demand is going to be more pricey elastic for cars. Is it a luxury or necessity? Luxuries tend to have more price elastic demand. Necessity is more price inelastic demand. I think that's pretty clear. Is the good addictive or is it habit forming? If it's addictive, again, the price goes up, quantity demanded will fall, but maybe not by very much. So demand is price inelastic if the good is addictive. Think cigarettes, think alcoholic drinks. Is it habit forming good, like stamp collecting? Again, demand will be price inelastic. inelastic if that's the case. And then think of the time period. In the short run, demand is price inelastic because there are a few substitutes available. Consumers maybe don't have much time to look for alternatives even if they do exist. Whereas in the long run, demand is much more price elastic as more substitutes become available. So that covers PED perfectly. Stay tuned for the next video, guys, when we look at the link between PED and total revenue. Very important for a business. Hopefully now you can smash PED. I'll see you in the next video.

Hi everybody. The basic law of demand states when the price goes up, quantity demand will decrease. When the price goes down, quantity demand will increase. Yeah, but how much exactly?

That's much more important information to know, isn't it? Well, that's where price elasticity of demand comes in. The definition is this, it measures the responsiveness of quantity demanded given a change in price. And we can actually use an equation to get a number for PED.

Here is the equation. So PED equals the percentage change in quantity demanded over the price of the product. the percentage change in price.

And it's very important, you remember, it's that way around. Quantity and demand are on the top, price on the bottom. Just remember, you queue before you pee.

I was with my wife the other day, we were going to a theater, and she had to queue ages before she managed to get to the loo. Same when we went to Orlando, we were doing all the theme parks in Orlando, great times. But again, every time she'd leave the loo, she had to queue before she peed, right? Queue before you pee. Especially if you're a female, that's just like a given thing.

So just queue before you pee, happy days. Well, not happy days necessarily. but at least you'll get the equation right, and that's the most important thing.

We need to work with percentage changes here. So in case we have raw numbers and they need to be converted to percentage change, it's the difference between the two numbers divided by the original number and times by 100. Then stick in the numbers into this equation and we'll get a number at the end. The number at the end for PV will always be negative because of the law of demand. If price goes up, positive, quantity of demand will fall, negative, we get a negative number. Whereas if price goes down, negative.

negative, quantity demand will go up. Positive, we get a negative number at the end. So the negative sign isn't really that important. When we get our final number, you can almost ignore the sign. Well, you can ignore the sign.

Still write it in, but then forget about it. Just look at the number and then use this to help you interpret the number. So if that number is greater than one, demand is price elastic. And that means that for any given price change, there is a greater proportionate change in quantity demand.

So for example, price might fall by 5%. but quantity demanded goes up by, I know, 15%. You see, quantity demanded is changed by more than the price change.

That means that demand is price elastic. The figure is less than 1, demand is price inelastic, which means that when the price changes, quantity demanded will change but proportionally less than the change in price. So take the same price decrease of 5%, quantity demanded will increase maybe only by 1%, right? If it's 0, demand is perfectly price inelastic, which means regardless of the price change, quantity demanded...

it won't change at all. If it's infinity, these are two extremes by the way, if it's infinity demand is perfectly priced elastic and if it's one demand is unit price elastic. Okay so these these two extremes one isn't really that important but useful when we're looking at total revenue. The key are the first two right here. So let's now use all of this that we've learned so far and do some calculations.

Let's go with the first example we've got the price of a pack of cigarettes increasing from four pounds to five pounds. Let's immediately convert that to percentage change. Remember our equation for percentage change. The difference between the two numbers here is 1 pound, divided by the original, which is 4, times by 100. That's a 25% increase in price.

Quantity demanded of cigarettes in packages goes down from 150 to 135. The difference is 15 divided by the original, 150, times by 100. That's a 10% decrease in quantity demanded. Do this calculation and we get a final figure of minus 0.5. for. Now, given the numbers that we've already learned, that means that demand is price inelastic. In words, what does that mean?

It means that as the price of cigarettes goes up in this case, quantity demanded goes down, but proportionately less than the increase in price. That's what demand is price inelastic means. What about number two? Price of a sofa goes down from £1,000 to £800. Well, immediately I can tell you that's a 20% decrease in price.

If you can't see that immediately, you see. the equation. The difference is 200 divided by 1,000 times by 100. You'll get 20% decrease. Always a good idea to keep the negative in the equation. That way you will always get the negative at the end.

You'll write that down, which is important. Quantity demanded of sofas now goes up from 2,000 to 3,800. Let's convert that to percentage change.

The difference is 1,800 divided by 2,000 times by 100, and that will give you 90%. That's a 90% increase in quantity demanded. Work that out.

when we compute that, we get a final figure of minus 4.5. Remember when we interpret the figure, we can ignore the minus sign. The figure is greater than 1, which means demand is price elastic. Demand for sofas here is price elastic, meaning as the price of sofas goes down in this case, quantity demanded increases, but proportionally more than the decrease in price, 90% compared to a 20% drop in price.

So demand increases proportionally more than the decrease in price. Good to have a go at some numbers. Let's go back.

Now I understand more theory. So we know how to do the calculations. How do we then draw demand curves depending on elasticity of demand? Well, if we work out that demand is price inelastic, you have to draw a steep-looking demand curve.

And it's very clear. If you look at this steep demand curve, whenever we change price, the change in quantity demanded will be proportionately less, no matter whether price goes up or down. If demand is price elastic, you draw the demand curve shallow, like that there.

And that means for any change in price, the proportionate change... change in quantity demand will be much greater. So a shallow demand curve. For the extremes, for perfectly priced inelastic demand, vertical line. For perfectly priced elastic demand, horizontal line like that.

Simple stuff. Learn those shapes. Very easy to apply. So then the next question is when is demand for a good or service price elastic or price inelastic? Just remember SPLAT.

What a useful memory device. I tell you. To the day I still use SPLAT. It's so helpful.

Let's understand. The S stands for substitute, specifically the number of substitutes. The more substitutes there are, the more price-elastic demand is going to be.

The less substitutes, the more price-inelastic demand is going to be. Think of primary commodities like coffee, like rubber, like copper, like oil, all of these things. There are very few substitutes available, which makes demand for them very price-inelastic. The percentage of income that a price change takes, the greater the percentage of income that a price change takes.

takes the more price elastic demand is going to be. The smaller the percentage of income of price change takes the more price elastic demand is going to be. So let's take a 10% increase in the price of cars versus a 10% increase in the price of an apple.

Well a 10% increase in the price of an apple could be something like 5 pence. Well that's not going to affect our demand. Usually demand is going to be priced inelastic for that reason.

Whereas a 10% increase in the price of cars could be like a £2000 increase in price. That's a huge chunk of our income. So demand is going to be more pricey elastic for cars.

Is it a luxury or necessity? Luxuries tend to have more price elastic demand. Necessity is more price inelastic demand. I think that's pretty clear.

Is the good addictive or is it habit forming? If it's addictive, again, the price goes up, quantity demanded will fall, but maybe not by very much. So demand is price inelastic if the good is addictive.

Think cigarettes, think alcoholic drinks. Is it habit forming good, like stamp collecting? Again, demand will be price inelastic.

inelastic if that's the case. And then think of the time period. In the short run, demand is price inelastic because there are a few substitutes available. Consumers maybe don't have much time to look for alternatives even if they do exist.

Whereas in the long run, demand is much more price elastic as more substitutes become available. So that covers PED perfectly. Stay tuned for the next video, guys, when we look at the link between PED and total revenue. Very important for a business.

Hopefully now you can smash PED. I'll see you in the next video.

Transcript for:Understanding Price Elasticity of Demand

Transcript for:
Understanding Price Elasticity of Demand