Price Elasticity of Demand

Price Elasticity of Demand (PED) is defined as the responsiveness of quantity demanded to a change in price. The demand for a product can be elastic or inelastic, depending on the rate of change in the demand with respect to the change in the price.

What does Price Elasticity mean?

Demand is said to be elastic demand has a greater proportionate response to a smaller change in price. On the other hand, demand is inelastic when there is little movement in demand with a big change in price.

Price Elasticity of Demand is also the slope of the demand curve. We can calculate the slope as “rise over run.”

For example, if I increase the price of a phone from $300 to $500, then how much can I expect my demand to fall? This answer will depend on various factors mentioned below that will help the firm calculate its Price Elasticity of Demand.

Factors Affecting Price Elasticity of Demand

Factors Affecting the Price Elasticity of Demand

Once a manufacturer or producer knows the Price Elasticity of Demand for their product, it can help them determine their change in Total Revenue if they have to change the price of the product. Total revenue is the number of goods they sell multiplied by the Price its sold at. The change in total revenue depends on the elasticity.

1. Substitutes

If there is a greater availability of substitutes, then the good is likely to be more elastic. For example, if the price of one soda brand goes up, people can turn to other brands. So, a small change in price is likely to cause a greater fall in quantity demanded.

2. Necessities

If a good is a necessity, then the demand tends to be inelastic. For example, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity.

3. Time

Over time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes. For example, if the price of gasoline goes up, over time people will adjust for the change, i.e., they may drive less or use public transportation or form carpools.

4. Habit

The demand for addictive or habitual products is usually inelastic. This is because the consumer has no choice but no pay whatever the producer is demanding. For example, if the price for a pack of cigarettes goes up, it will likely not have any effect on demand.

Uses of Price Elasticity of Demand

  • Allows a firm or business to predict the change in total revenue with a projected change in price.
  • Firms can charge different prices in different markets if elasticities differ in income groups. This practice is known as price discrimination. For example, airlines have segmented airplane seats into different classes – economy, business and first in order to charge the less price sensitive customer a higher price for premium seats.
  • Allows a firm to decide how much tax to pass on to a consumer. If a product is inelastic, then the firm can force the customer to the pay tax. This is a common tactic used by cigarette manufacturers who pass on any health tax directly to the consumer.
  • Enables the government to predict the impact of taxation policies on products.

Price Elasticity of Demand Formula

If you’re looking for how to calculate price elasticity of demand, simply follow this formula.

price elasticity of demand formula

%∆ in Qd = Percentage Change in Quantity Demanded. The Percentage Change in Quantity Demanded is the New Quantity Demanded minus the Old Quantity Demanded divided by the Old Quantity Demanded.

%∆ in P = Percentage Change in Price. This is the New Price minus the Old Price divided by the Old Price.

PED = %∆ in Qd / %∆ in P

The value of Price Elasticity of Demand (PED) is always negative, i.e. price and demand have an inverse relationship. This is because the ratio of changes of the two variables is in opposite directions, so if the price goes up, demand goes down and the change will end up negative.

Price Elasticity of Demand Examples

For our examples of price elasticity of demand, we will use the price elasticity of demand formula.

Widget Inc. decides to reduce the price of its product, Widget 1.0  from $100 to $75. The company predicts that the sales of Widget 1.0 will increase from 10,000 units a month to 20,000 units a month.

To calculate the price elasticity of demand, first, we will need to calculate the percentage change in quantity demanded and percentage change in price.

% Change in Price = ($75-$100)/($100)= -25%

% Change in Demand = (20,000-10,000)/(10,000) = +100%

Therefore, the Price Elasticity of Demand = 100%/-25% = -4.

This means the demand is relatively elastic.

Price Elasticity of Demand on a Demand Curve

We can represent all the different values of price elasticity of demand on a demand curve as seen below.

Price Elasticity of Demand
PED Along a Demand Curve

5 Types of Price Elasticity of Demand

1. Perfectly Inelastic Demand, (PED = 0)

With a perfectly inelastic demand, there is no change in the demand for a product with a change in its price. This means that the demand remains constant for any value of price. The demand curve is represented as a straight vertical line.

It is practically impossible to find a product that has perfectly inelastic demand. The closest thing could be essentials like water or certain food products.

This is the effect on total revenue with a change in price:

  • Price ↑ → Total Revenue ↑
  • Price ↓ → Total Revenue ↓

Perfectly Inelastic Demand

2. Relatively Inelastic Demand, (PED = 0 < x < 1)

Relatively inelastic demand occurs when the percentage change in demand is less than the percentage change in the price of a product.

For example, if the price of a product increases by 15% and the demand for the product decreases only by 7%, then the demand would be called relatively inelastic.

The demand curve of relatively inelastic demand is rapidly sloping.

This is the effect on total revenue with a change in price:

  • Price ↑ → Total Revenue ↑
  • Price ↓ → Total Revenue ↓

Relatively Inelastic Demand

3. Unit Elastic Demand, (PED = 1)

Demand is said to be unit elastic when the proportionate change in demand produces the same change in the price. The quantity demanded changes by the same percentage as the change in price.

This is the effect on total revenue with a change in price:

  • Price ↑ → No Change in Total Revenue
  • Price ↓ → No Change in Total Revenue

Unit Elastic Demand

4. Relatively Elastic Demand, (PED = 1 < x < ∞)

Relatively elastic demand is defined as the proportionate change produced in demand is greater than the proportionate change in the price of a product. The quantity demanded changes by a larger percentage than the change in price.

For example, if the price of a product increases by 10% and then the demand for the product decreases by 15%, then the demand would be relatively elastic.

The demand curve of relatively elastic demand is gradually sloping. It is less steep than relatively inelastic demand.

This is the effect on total revenue with a change in price:

  • Price ↑ → Total Revenue ↓
  • Price ↓ → Total Revenue ↑

Relatively Elastic Demand

5. Perfectly Elastic Demand, (PED = ∞)

In Perfectly Elastic Demand, a small rise in price will result in a fall in demand to zero, while a small fall in price will result in the demand to become infinite. Consumers will buy all available at some price, but none at any other price. This is a theoretical concept because it requires perfect competition where the slightest price increase results in zero demand.

In a perfectly elastic demand, the demand curve is represented as a horizontal straight line.

This is the effect on total revenue with a change in price:

  • Price ↑ → 0 Total Revenue
  • Price ↓ → 0 Total Revenue

Perfectly Elastic Demand

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