When demand for the product increases with the increases in advertisement expenditure it is called?

Elasticity of demand is an important variation on the concept of demand. Demand can be classified as elastic, inelastic or unitary.

An elastic demand is one in which the change in quantity demanded due to a change in price is large. An inelastic demand is one in which the change in quantity demanded due to a change in price is small.
The formula for computing elasticity of demand is:

(Q1 – Q2) / (Q1 + Q2)     
(P1 – P2) / (P1 + P2)

If the formula creates an absolute value greater than 1, the demand is elastic. In other words, quantity changes faster than price. If the value is less than 1, demand is inelastic. In other words, quantity changes slower than price. If the number is equal to 1, elasticity of demand is unitary. In other words, quantity changes at the same rate as price.

Elastic Demand

Elasticity of demand is illustrated in Figure 1. Note that a change in price results in a large change in quantity demanded. An example of products with an elastic demand is consumer durables. These are items that are purchased infrequently, like a washing machine or an automobile, and can be postponed if price rises. For example, automobile rebates have been very successful in increasing automobile sales by reducing price.

Close substitutes for a product affect the elasticity of demand. If another product can easily be substituted for your product, consumers will quickly switch to the other product if the price of your product rises or the price of the other product declines. For example, beef, pork and poultry are all meat products. The declining price of poultry in recent years has caused the consumption of poultry to increase, at the expense of beef and pork. So products with close substitutes tend to have elastic demand.

An example of computing elasticity of demand using the formula is shown in Example 1. When the price decreases from $10 per unit to $8 per unit, the quantity sold increases from 30 units to 50 units. The elasticity coefficient is 2.25.

Inelastic Demand

Inelastic demand is shown in Figure 2. Note that a change in price results in only a small change in quantity demanded. In other words, the quantity demanded is not very responsive to changes in price. Examples of this are necessities like food and fuel. Consumers will not reduce their food purchases if food prices rise, although there may be shifts in the types of food they purchase. Also, consumers will not greatly change their driving behavior if gasoline prices rise.

An example of computing inelasticity of demand using the formula above is shown in Example 2. When the price decreases from $12 to $6 (50%), the quantity of demand increases from 40 to only 50 (25%). The elasticity coefficient is .33.

This does not mean that the demand for an individual producer is inelastic. For example, a rise in the price of gasoline at all stations may not reduce gasoline sales significantly. However, a rise of an individual station’s price will significantly affect that station’s sales.

Unitary Elasticity

If the elasticity coefficient is equal to one, demand is unitarily elastic as shown in Figure 3. For example, a 10% quantity change divided by a 10% price change is one. This means that a 1% change in quantity occurs for every 1% change in price.

Don Hofstrand, retired extension value added agriculture specialist,

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.

The following equation enables PED to be calculated.

% change in quantity demanded% change in price

We can use this equation to calculate the effect of price changes on quantity demanded, and on therevenue 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 this 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.

Revenue is measured in threee ways:

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). Average revenue is also the revenue per unit sold, which is also the price.

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.

   Consider these figures and calculate Total, Marginal and Average Revenue.

   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.

PED = 1PED < 1PED > 1PricedecreasePriceincreaseElasticity and revenueRevenuefallsRevenuefallsRevenuerisesRevenuerisesRevenueconstantRevenueconstant

Non-pricing policy

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

Determinants of PED

There are several reasons why consumers may respond elastically or inelastically to a price change, including:

The number and ‘closeness’ of substitutes

A unique and desirable product is likely to exhibit an inelastic demand with respect to price.

The degree of necessity of the good

A necessity like bread will be demanded inelastically with respect to price.

Whether the good is habit forming

Consumers are also relatively insensitive to changes in the price of habitually demanded products.

The proportion of consumer income which is spent on the good

The PED for a daily newspaper is likely to be much lower than that for a new car!

Whether consumers are loyal to the brand

Brand loyalty reduces sensitivity to price changes and reduces PED.

Life cycle of product

PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms
launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common.

Test your knowledge with a quiz

Firms may use persuasive advertising by to win new customers and retain the loyalty of existing ones.

Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic.

There are three extreme cases of PED. 

1. Perfectly elastic, where only one price can be charged.

2. Perfectly inelastic, where only one quantity will be purchased.

3. Unit elasticity, where all the possible price and quantity combinations are of the same value. The resultant curve is called a rectangular hyperbola.

   

   Go to: point elasticity of demand

   PED can also be illustrated through indifference curve analysis