Price Elasticity of Demand: The 3 Curves

Price Elasticity of Demand (PED) can look like one of the three graphs shown below:

So what is the diagram above?

The diagram above shows the three different shapes you may expect to see a demand curve – remember that a demand curve can look like anything though. As I say in my theory of demand video, theoretically demand could even be upward sloping if for example we are looking at an antique painting or designer handbag where as price increases so does the demand. 

What different PEDs do the demand curves represent?

D0 – This represents the standard demand that most products have which is that demand falls from the highest prices the curve is elastic. This is because when prices fall more people are able to afford it (income effect). Then as we go to that bendy bit in the middle (sorry to write in such an informal manner) we see unitary elasticity where the percentage changes in demand are equal to the percentage changes in prices. The last vertical but shows inelasticity. When prices are low to begin with there is a limit to how much demand can increase when prices fall further. Compare the difference when a price falls from £20 to £10 and that of £2.50 to £1.25. 

D1 – This is an absolutely inelastic demand curve. No matter how much price changes demand is not affected. This is a more theoretical concept than one that exists in real life. An example of a good which has almost zero elasticity like this curve is the class A drug Heroin. No matter how much price increases demand is not likely to be affected because people are addicted and are prepared to pay the premium. However, even the demand for heroin is not absolutely inelastic simply because the price will affect the demand from those who want to try the drug for the first time. [Please note I am not trying to encourage drug abuse – I’m simply using it to prove a point] 

D2 – This is the opposite to D1. This is an infinitely elastic demand curve. What this means is that any changes in price will kill all the demand as demand is only present for that particular price. Again this is a more theoretical abstract concept than one that actually exists in real life. For example, a good may be valued at £5 and any increase even £5.01 will kill demand 100% because people are not prepared to pay even a pence more. It is the same if the price were to fall to £4.99. The demand is absolutely elastic meaning that it is 100% affected by changes in price.

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The Graphical Representation of PED

Price Elasticity of Demand (PED) can look like one of the three graphs shown below:

 
So what is the diagram above?

The diagram above shows the three different shapes you may expect to see a demand curve – remember that a demand curve can look like anything though. As I say in my theory of demand video, theoretically demand could even be upward sloping if for example we are looking at an antique painting or designer handbag where as price increases so does the demand.

What different PEDs do the demand curves represent?

D0 – This represents the standard demand that most products have which is that demand falls from the highest prices the curve is elastic. This is because when prices fall more people are able to afford it (income effect). Then as we go to that bendy bit in the middle (sorry to write in such an informal manner) we see unitary elasticity where the percentage changes in demand are equal to the percentage changes in prices. The last vertical but shows inelasticity. When prices are low to begin with there is a limit to how much demand can increase when prices fall further. Compare the difference when a price falls from £20 to £10 and that of £2.50 to £1.25.

D1 – This is an absolutely inelastic demand curve. No matter how much price changes demand is not affected. This is a more theoretical concept than one that exists in real life. An example of a good which has almost zero elasticity like this curve is the class A drug Heroin. No matter how much price increases demand is not likely to be affected because people are addicted and are prepared to pay the premium. However, even the demand for heroin is not absolutely inelastic simply because the price will affect the demand from those who want to try the drug for the first time. [Please note I am not trying to encourage drug abuse – I’m simply using it to prove a point]

D2 – This is the opposite to D1. This is an infinitely elastic demand curve. What this means is that any changes in price will kill all the demand as demand is only present for that particular price. Again this is a more theoretical abstract concept than one that actually exists in real life. For example, a good may be valued at £5 and any increase even £5.01 will kill demand 100% because people are not prepared to pay even a pence more. It is the same if the price were to fall to £4.99. The demand is absolutely elastic meaning that it is 100% affected by changes in price.

Price Elasticity of Demand

Price elasticity of demand = PED

What is price elasticity of demand?
It is the responsiveness/sensitivity of demand to a change in price.

 

How do economists calculate price elasticity of demand?
PED = % Change in Quantity Demanded
              —————————————–
                       % Change in Price

 

How do we interpret price elasticity of demand values?
Price elasticity of demand values are always negative because the show that price and demand have an inverse relationship.

 

If PED is < -1 :
If PED is smaller than minus one then this implies that the demand is elastic.  For example, if the price of a good rose by 10% the quantity demanded  would decrease by more than 10%. Airline tickets are a good example because they are elastic.

 

If PED is between 0 and -1 :
This means that the demand is inelastic. For example if the price of a good increased by 10% then the quantity demand would decrease by less then 10%. A good example of this is food as they have relatively inelastic demand.

 

If PED = -1 :

Then this means the demand is unitary elastic. This is the rarest out of all the elasticities. It means that if a price of the good rises by 10% the quantity demanded will decrease by 10%
To understand the graphical representation of PED, please see my post on the three types of elasticities.

Test yourself (Answers found at the bottom)

 

1. If price increases from 10 to 12 pence and the price elasticity of demand is -0.5. The quantity demanded was 500 units. What will it be now?
a) 550 units
b) 500 units
c) 450 units
d) 490 units
2.If price elasticity of demand is unit then a fall in price:
a) Reduces revenues
b) Increases revenues
c)Leaves revenues unchanged
d) Reduces costs

 

ANSWERS!

 

1. c) This means that any given percentage fall in price leads to an increase in quantity demanded that is half as much; a 20% price increase will reduce the quantity demanded by 10%. This means the  quantity demanded will be 450 units.
2. c) This means the percentage change in quantity demanded equals the percentage change in price so price changes will not alter the revenue.

A great video to help you with this: http://www.youtube.com/watch?v=4oj_lnj6pXA&feature=related 

Also why not check out some further notes in pdf style (not I have not created this file) : http://www.osc-ib.com/ib-revision-guides/pdf/economics-hl-1.pdf