Skip to main content

Price Elasticity of Demand (PED)

Introduction:

Price Elasticity of Demand (PED) is a fundamental concept in microeconomics that measures the responsiveness of the quantity demanded of a good or service to a change in its price. It's a crucial tool for businesses to understand how price changes will affect their total revenue and for policymakers to analyze the impact of taxes and subsidies. Understanding PED helps predict consumer behavior and make informed decisions.

Key Points:

  • PED measures the percentage change in quantity demanded in response to a percentage change in price.
  • PED is usually negative, reflecting the law of demand (price and quantity demanded move in opposite directions).
  • The magnitude (absolute value) of PED indicates the degree of responsiveness: elastic, inelastic, or unit elastic.
  • PED is not the same as the slope of the demand curve, although they are related.
  • PED can vary along a single demand curve.
  • PED help to find revenue.

Main Content:

1. Calculating Price Elasticity of Demand

The basic formula for PED is:

PED = (% Change in Quantity Demanded) / (% Change in Price)

More formally:

PED = [(Q2 - Q1) / Q1] / [(P2 - P1) / P1]

Where:

  • Q1 = Initial quantity demanded
  • Q2 = New quantity demanded
  • P1 = Initial price
  • P2 = New price

Midpoint (Arc) Elasticity Formula: To avoid getting different elasticity values depending on whether we consider a price increase or decrease, we often use the midpoint or arc elasticity formula:

PED = [(Q2 - Q1) / ((Q1 + Q2)/2)] / [(P2 - P1) / ((P1 + P2)/2)]

Or,

PED = [(Q2 - Q1) / (Q1+Q2)] / [(P2-P1) / (P1+P2)]

This formula uses the average of the initial and new quantities and prices as the base for calculating percentage changes.

2. Interpreting PED Values

The absolute value of the PED coefficient tells us about the elasticity:

  • |PED| > 1: Elastic Demand. Quantity demanded is highly responsive to price changes. A small percentage change in price leads to a larger percentage change in quantity demanded. Total revenue moves in the opposite direction of the price change. (If price increases, total revenue decreases; if price decreases, total revenue increases). Example: Luxury goods, goods with many substitutes.

  • |PED| < 1: Inelastic Demand. Quantity demanded is not very responsive to price changes. A large percentage change in price leads to a smaller percentage change in quantity demanded. Total revenue moves in the same direction as the price change. (If price increases, total revenue increases; if price decreases, total revenue decreases). Example: Necessities like gasoline (in the short run), salt, life-saving medications.

  • |PED| = 1: Unit Elastic Demand. Quantity demanded changes by the same percentage as the price. Total revenue remains constant when the price changes.

  • |PED| = 0: Perfectly Inelastic Demand. Quantity demanded does not change at all when the price changes. The demand curve is a vertical line. Example: A life-saving drug with no substitutes, for a person who absolutely needs it.

  • |PED| = ∞ (infinity): Perfectly Elastic Demand. Any price increase will cause quantity demanded to drop to zero. Consumers are infinitely sensitive to price. The demand curve is a horizontal line. Example: A single, perfectly identical wheat farmer in a massive, perfectly competitive wheat market.

3. Graphical Representation of PED

graph LR
    subgraph Demand Curves
        A[Perfectly Inelastic - Vertical Line] --> B(Inelastic - Steep Curve)
        B --> C(Unit Elastic - Specific Curve)
        C --> D(Elastic - Flat Curve)
        D --> E[Perfectly Elastic - Horizontal Line]
    end
  • Steeper Demand Curves: Tend to be more inelastic.
  • Flatter Demand Curves: Tend to be more elastic.
  • Vertical Demand Curves: Perfectly Inelastic.
  • Horizontal Demand Curves: Perfectly Elastic

It's crucial to remember that elasticity varies along a straight-line demand curve. A straight-line demand curve has a constant slope, but the PED changes because the percentage changes in price and quantity are different at different points.

4. Determinants of Price Elasticity of Demand

Several factors influence the price elasticity of demand for a good or service:

  • Availability of Substitutes: The more close substitutes available, the more elastic the demand. If the price of one good rises, consumers can easily switch to alternatives.

  • Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries tend to have elastic demand.

  • Proportion of Income Spent: Goods that represent a larger proportion of a consumer's income tend to have more elastic demand. A small price change significantly impacts the budget.

  • Time Horizon: Demand tends to be more elastic in the long run than in the short run. Consumers have more time to adjust their behavior and find alternatives.

  • Definition of the Market: Narrowly defined markets tend to have more elastic demand than broadly defined markets.

5. PED and Total Revenue

The relationship between PED and total revenue (TR = Price x Quantity) is critical for businesses:

  • Elastic Demand (|PED| > 1):

    • Price increase → TR decrease
    • Price decrease → TR increase

  • Inelastic Demand (|PED| < 1):

    • Price increase → TR increase
    • Price decrease → TR decrease

  • Unit Elastic Demand (|PED| = 1):

    • Price change → TR remains constant

Conclusion:

Price elasticity of demand is a powerful tool for understanding consumer behavior. It helps businesses make informed pricing decisions to maximize revenue and allows policymakers to anticipate the impact of price-related policies. The key takeaways are the formula for calculating PED, the interpretation of different PED values (elastic, inelastic, unit elastic), the factors that determine PED, and the crucial relationship between PED and total revenue.

Back to top