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 higher proportionate
response to a smaller change in price. On the other hand, demand is
inelastic when there is little movement in demand with a significant
difference 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
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 pay the tax.
This is a common tactic used by cigarette manufacturers who pass on
any health tax directly to the consume
Enables the government to predict the impact of taxation polici on
products.
Price Elasticity of Demand Formula
If you’re looking for how to calculate price elasticity of demand, simply
follow this formula.
%∆ in Q = 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 Q / %∆ 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.
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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.
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 ↓
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 ↓
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
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 ↑
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
Significance of Price Elasticity of Demand
1. Useful for Business:
It enables the business in general and the monopolists in particular to
fix the price.
Studying the nature of demand the monopolist fixes higher prices for
those goods which have inelastic demand and lower prices for goods
which have elastic demand. In this way, this helps him to maximize his
profit.
2. Fixation of Prices:
It is very useful to fix the price of jointly supplied goods. In the case of
joint products like paddy and straw, the cost of production of each is
not known. The price of each is then fixed by its elastic and inelastic
demand.
3. Helpful to Finance Minister:
It helps the Finance Minister to levy tax on goods. After levying taxes
more and more on goods which have inelastic demand, the
Government collects more revenue from the people without causing
inconvenience to the people. Moreover, it is also useful for the
planning.
4. Fixation of Wages:
It guides the producers to fix wages for labourers. They fix high or low
wages according to the elastic or inelastic demand for the labour.
5. In the Sphere of International Trade:
It is of greater significance in the sphere of international trade. It helps
to calculate the terms of trade and the consequent gain from foreign
trade. If the demand for home product is inelastic, the terms of trade
will be profitable to the home country.
6. Paradox of Poverty:
It explains the paradox of poverty in the midst of plenty. A bumper crop
instead of bringing prosperity may result in disaster, if the demand for
it is inelastic. This is specially so, if the products are perishable and not
storable.
7. Effect on Employment:
The effect of machines on employment opportunities depends on
elasticity of demand for the goods produced by such machines. In the
initial stage, use of such machines cause unemployment and prices will
also fall. But when demand for such commodities is more elastic, then
fall in prices will generate more increase in its demand.
As a result, demand will stimulate greater production and hence more
employment. If demand for commodities produced by these machines
is inelastic, then even fall in price will not increase demand as well as
employment.
8. Significant for Government Economic Policies:
The knowledge of elasticity of demand is very important for the
government in such matters as controlling of business cycles, removing
inflationary and deflationary gaps in the economy. Similarly, for price
stabilization and the purchase and sale of stocks, information about
elasticity of demand is most useful.
9. Incidence of Taxation:
Incidence of tax lies on the person who ultimately pays the tax. The
incidence is on the buyer, if demand is perfectly inelastic. He will go on
buying as much as before despite the price rise. Thus, the government
has to keep the watch on the ultimate burden of the tax, which
depends on the elasticity of demand of the commodity taxed. If
necessaries, which have less elastic demand are taxed the burden will
fall more on the poor sections of society. Therefore, principle of justice
in taxation is based on elasticity of demand.
10. Changes in Rate of Exchange:
Rate of exchange between two currencies can be changed through
devaluation or overvaluation of one currency in relation to other
currencies. A country while deciding for such a course of action will
take into consideration the elasticity of demand for its exports and
imports. If the government devalues the currency without considering
the elasticity of demand for its exports and imports it may not be able
to correct unfavorable balance of payments. Under these
circumstances the demand both for its exports and imports turns out to
be inelastic.
11. Joint Products:
The concept of elasticity of demand plays an important role in
determining the price of joint products. In case of joint products like
skin and meat of goat, separate costs are not known. The producer will
be guided mostly by demand and its nature while fixing his price. For
instance, when goat is bought, it is not kept in mind the separate costs
of skin and meat.
When the seller sells the skin and meat, the seller keeps in mind the
elasticity of demand of skin and meat. If elasticity of demand for meat
is less elastic, in that case the price of meat will be higher. On the other
hand if elasticity of demand for skin is more elastic, in that case the
price of the skin will be low and vice versa.
12. International Trade:
The concept of elasticity of demand also plays a significant role in the
international trade or the terms of trade. It is the nature of demand
which is helpful in determining the amount of gain being enjoyed by
different countries. The terms of trade would be favourable in case of
those countries, whose exports are of the nature of more elastic
demand. On the other hand, the terms of trade would be un-favourable
if the exports of a country are of the nature of less elastic demand.
13. Market forms:
The concept of elasticity of demand is also useful is knowing the different market forms. If cross
elasticity of demand is infinite, in that case there is perfect competition in the market. If cross elasticity
is zero (or Ec = 0) it is a case of absolute or pure monopoly. If cross elasticity of demand is less than one
(or Ec < 1), in that case there is relative monopoly. And if cross elasticity of demand is greater than one
(or Ec >1), in that case, there is monopolistic competition or imperfect competition.
14. Determination of Price of Public Utilities:
This concept is significant in the determination of the prices of public utility services. Economic welfare
of the society largely depends upon the cheap availability of the essential products like water,
electricity, cooking gas, transportation etc. For such commodities, demand is inelastic and these should
be controlled by the government.
The government will distribute these products at fair price. Therefore. Government helps to fix the
prices of necessities of life. Thus, elasticity of demand is a very important tool of analysis and it plays an
important role in economic analysis.