ECONOMICS: PRICE ELASTICITY OF DEMAND (PED)
Key Terms
Elasticity: The sensitivity of changes in a quantity with respect to changes in another quantity.
Price Elasticity of Demand (PED): An economic metric designed to measure how sensitive the quantity demanded is to a change in the price of a good/service.
Elastic: Sensitive to changes in price. (As well as a term used when the price elasticity of demand is greater than -1 but less than infinity)
Inelastic: A term used when high changes in price results in small changes in quantity demanded, can be used to describe products with price elasticity of demand less than 1 but greater than 0.
Unit Elastic: The term used when the price elasticity of demand (PED) is equal to exactly -1.
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What is Elasticity?
In economics good and services are often prone to price changes. These price changes usually result in a change in quantity demanded (or another quantity). This is known as elasticity - the sensitivity of changes in a quantity with respect to changes in another quantity.
Price Elasticity of Demand (PED)
Price elasticity of demand measures the sensitivity of quantity demanded in respect to a change in price. The formula to work this out is the percentage change in quantity demanded divided by the percentage change in price as is demonstrated by this formula:
If, however you are not given the percentage change you may work it out using the following formula:
The answer given must always be negative as the demand curve is always down sloping:
What is Price Elastic Demand?
A good or service that is price elastic will usually have a PED of -1 and over (but still negative (as PED is always negative!)). This means that a change in price will result in a significant change in quantity demanded in comparison to the change in price.
Examples of price elastic goods and services are usually those with a lot of substitutes such as chocolate. Imagine, you like a specific chocolate brand that usually costs £1 and at that price 50 people buy it. Next suppose the price decreases to 80p (20% decrease) and this leads to another 50 people buying the chocolate, hence increasing the quantity demanded to 100 people (100% increase). Working out the PED would give us -5, a highly elastic good. Similar scenario is demonstrated on the graph above.
What is Price Inelastic Demand?
A good or service that is price inelastic usually has a PED of 0 to -1. This means that a change in price will result in a minor change in quantity in comparison to the change in price.
Examples of price inelastic goods are usually those with few substitutes, such as diamonds. Additionally strong compliments may also be price inelastic, as is the case with printers and printer ink. Products that are highly addictive are also price inelastic as people cannot stop consuming them as easily.
For example, if price goes up for cigarettes significantly, demand will not fall as much due to people being addicted. This can be seen demonstrated in the graph above.
Price Elasticity of Demand in Terms of Revenue
We can also look at price elasticity of demand in terms of revenue, when price elasticity is inelastic, we can see revenue increasing as firms make more money form the higher price. In contrast when price elasticity becomes more elastic total revenue decreases.
Extreme Cases of Price Elasticity of Demand
The price elasticity of demand can also be demonstrated in extreme cases known as perfectly price elastic or inelastic.
The graph below demonstrates perfectly inelastic demand, where despite price increase demand remain constant. Such scenario is very difficult to find in real life, with economist arguing that the only time this will be true is when oxygen and air is restricted. However, the closest that we have to this might be medication however even for that the demand might not be perfectly inelastic.
The other extreme is perfectly price elastic. With a perfectly price elastic good or service, the price is the same despite the change in quantity. If price increase slightly then quantity will fall to zero. Once again, such scenarios are not as easy to find in real life but closest you can come to is luxury goods and high-end cars, but once again could be argued they are not ‘perfectly elastic’.
Factors Affecting Price Elasticity of Demand
There are multiple factors that influence price elasticity of demand. These factors are:
Substitutes – If there are a lot of substitutes for a product demand tends to be more elastic in comparison to good or service that has no substitutes which is inelastic.
Necessity or Luxury Good? – Necessities tend to be more price inelastic as we need them for our welfare whilst luxury items are just wants and we can do without them meaning they have a more elastic demand.
Good/Service as Part of Overall Expenditure – Depending on how expensive the good or service is in comparison to our normal expenditure we are more likely to view it as elastic, such as a vehicle purchase.
Addictive Goods – Goods that are addictive such as tobacco and alcohol, also tend to be inelastic as it is difficult for people to stop consuming them.
Inexpensive Goods – Goods that are inexpensive, such as salt and sugar also tend to be inelastic as we don’t usually notice price increases as the usual price in itself is quite small.
Time – Most importantly time needs to be considered as demand may change over long durations of time as people find better alternatives. For example, an increase in petrol may be price inelastic in the short-term but long-term people may switch to electric vehicles in order to reduce that cost.
Why is Price Elasticity of Demand Important?
The price elasticity of demand serves important roles for government and firms by allowing an insight into consumer decision making processes. If they know that their good is regarded as an elastic good, they may be more hesitant to reduce prices as it will significantly shrink their revenue.
It may also assist the government, by providing it with information of areas it could achieve taxes such as addictive products like tobacco and alcohol which are inelastic.
However, it is important to note that PEDs are only estimates and the validity of the data can be debated, furthermore, PED does not take into account external factors that might influence decision making (ceteris paribus).
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References/Further Reading
Price Elasticity of Demand (PED) – Wikipedia - https://en.wikipedia.org/wiki/Price_elasticity_of_demand