Page 23 - Microsoft Word - 00 BA3 IW Prelims STUDENT.docx

Macroeconomics II –The market system

Elasticity of demand

3.1 Price elasticity of demand (PED)

 PED explains the responsiveness of demand to changes in price.

PED = % change in demand

% change in price

 Usually negative – assume this in questions unless otherwise indicated

 Different methods of calculation:

– Arc method – non-average and average methods

– Point method

 >1 is “elastic”. A price drop should increase revenue. (%∆Q > %∆P)

 <1 is “inelastic”. A price increase should increase revenue. (%∆Q < %∆P)

3.2 Factors affecting PED

 Substitutes availability of substitutes → more elastic

 Necessity or habit necessity or habit → less elastic

 Time frames More inelastic in the short term

 Loyalty/brand strength customer loyalty → less elastic

 Proportion of income less elastic if a small proportion of one’s total income

 Definition of the market Wide definition → fewer alternatives → less elastic

17