Price Elasticity of Demand (PED) (Copy)

2.7.1 Definition of PED

• Price Elasticity of Demand (PED): A measure of the responsiveness of quantity demanded to a change in the price of a good or service.
• Formula:

  PED=% change in quantity demanded% change in pricePED = frac{% text{change in quantity demanded}}{% text{change in price}}

• Interpretation of PED values:
  • PED > 1: Demand is price elastic (quantity demanded responds strongly to price changes).
  • PED = 1: Demand is unit elastic (percentage change in demand = percentage change in price).
  • PED < 1: Demand is price inelastic (quantity demanded responds weakly to price changes).
  • PED = 0: Perfectly inelastic (demand does not change at all).
  • PED = ∞: Perfectly elastic (demand falls to zero with even the smallest price increase).

2.7.2 Calculation of PED

• Step 1: Work out % change in quantity demanded.
• Step 2: Work out % change in price.
• Step 3: Apply formula.

Example:

• Price rises from $10 to $12 (20% increase).
• Demand falls from 100 units to 80 units (20% decrease).
• PED = (−20%) ÷ (+20%) = −1.0 → Unit elastic demand.

Note: PED is often written as an absolute value (ignore minus sign).

2.7.3 Determinants of PED

• Availability of substitutes: More substitutes → more elastic demand.
• Necessity vs luxury: Necessities → inelastic; luxuries → elastic.
• Proportion of income spent: Higher proportion → more elastic.
• Time period: Demand is more elastic in the long run as consumers adjust.
• Addictiveness/Habit: Addictive goods like cigarettes → highly inelastic.
• Brand loyalty: Strong loyalty makes demand inelastic.

2.7.4 PED and Total Spending/Revenue

• Total revenue (TR) = Price × Quantity.
• Relationship:
  • If demand is elastic (PED > 1): Price ↑ → TR ↓; Price ↓ → TR ↑.
  • If demand is inelastic (PED < 1): Price ↑ → TR ↑; Price ↓ → TR ↓.
  • If demand is unit elastic (PED = 1): Price change does not affect TR.

Diagram 1: Elastic vs Inelastic Demand

Price
 |
 |
 | 
 |         Elastic (PED > 1)
 |   
 |    ___________________
 |
 |
 | 
 |  
 |   
 |    
 |     
 |       Inelastic (PED < 1)
 +----------------------------- Quantity

• Elastic demand curve: Flatter → large change in Q for a small change in P.
• Inelastic demand curve: Steeper → small change in Q for a large change in P.

Diagram 2: PED and Total Revenue

Elastic demand (PED > 1):

 Price ↑  →  TR ↓
 Price ↓  →  TR ↑


Inelastic demand (PED < 1):

 Price ↑  →  TR ↑
 Price ↓  →  TR ↓

Numerical Example

• Demand is elastic (PED = 2):
  • Price falls from $10 → $9 (−10%).
  • Quantity demanded rises from 100 → 120 (+20%).
  • TR: $10×100 = $1000 → $9×120 = $1080 (TR rises).
• Demand is inelastic (PED = 0.5):
  • Price falls from $10 → $9 (−10%).
  • Quantity demanded rises from 100 → 105 (+5%).
  • TR: $1000 → $945 (TR falls).

2.7.5 Significance of PED

• For producers/businesses:
  • Pricing strategy depends on PED.
  • If demand is elastic → lower price to increase revenue.
  • If demand is inelastic → raise price to increase revenue.
  • Helps in marketing, advertising, and planning output.
• For consumers:
  • Understanding PED helps anticipate price sensitivity.
  • For necessities, even large price rises may not reduce demand.
• For government:
  • Taxation policy: Goods with inelastic demand (e.g. tobacco, fuel) are taxed heavily since demand won’t fall much.
  • Subsidy policy: Subsidies may be more effective where demand is elastic.

Key Takeaways

• PED shows sensitivity of demand to price changes.
• Its value influences pricing, taxation, and consumer spending decisions.
• Elastic vs inelastic demand curves are crucial in analysis.
• PED directly affects total revenue outcomes for firms.

Special Extreme Cases of PED

1. Perfectly Inelastic Demand (PED = 0)

• Quantity demanded does not change regardless of price.
• Example: life-saving medicines (e.g. insulin).

Price
 |
 |     |
 |     |
 |     |   Demand (Perfectly Inelastic)
 |     |
 |     |
 +----------------- Quantity

2. Perfectly Elastic Demand (PED = ∞)

• Consumers are infinitely responsive to price.
• At one given price, they buy any quantity.
• If price rises even slightly, demand falls to zero.

Price
 |
 |---------
 |         Demand (Perfectly Elastic)
 |
 +----------------- Quantity

3. Relatively Inelastic Demand (0 < PED < 1)

• Quantity demanded changes only a little when price changes.
• Example: cigarettes, petrol.

Price
 |
 |
 | 
 |  
 |   
 |    
 |     
 |          Relatively Inelastic
 +----------------------------- Quantity

4. Relatively Elastic Demand (PED > 1)

• Quantity demanded changes significantly when price changes.
• Example: luxury holidays, restaurant meals.

Price
 |
 |
 | 
 |  
 |   
 |    ____________________
 |                          Relatively Elastic
 +------------------------------------- Quantity

5. Unitary Elastic Demand (PED = 1)

• % change in price = % change in quantity demanded.
• Total revenue remains constant when price changes.

Price
 |
 | 
 |  
 |   
 |    
 |     
 +------------------ Quantity
       
        
         
  Demand curve where every % change in P
  causes an equal % change in Q → TR unchanged

Consolidated Table: Cases of PED