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What is Price Elasticity of Demand (PED)?
Definition: PED measures the responsiveness of consumers demand to changes in the price of a good or service.
- It helps economists and businesses understand how much quantity demanded changes when prices change.
When we think about the word "elastic," we picture something that can stretch, like a rubber band. Now, imagine the demand for a product being like that rubber band.
When we talk about PED, we are thinking about how much the demand stretches or changes when prices go up or down.
- If the demand stretches a lot (like a very stretchy rubber band), we say it's elastic.
- If it doesn't stretch much (like a stiff rubber band), it's inelastic.
š PED helps us understand how sensitive people are to price changes for different products.
Elasticity affects the slope of a product's demand curve:
An elastic demand occurs when a change in price leads to a large change in the quantity demanded.
- A smaller slope means a flatter demand curve and more elastic product.
- Example: If the price of a laptop goes down by 15% and the demand for laptops is elastic, this means that the quantity demanded for laptops will increase by more than 15%.
An inelastic demand happens when a change in price results in only a small change in the quantity demanded.
- A greater slope means a steeper demand curve and more inelastic product.
- Example: If the price of a laptop goes down by 15% and the demand for laptop is inelastic, this means that the quantity demanded for laptops will increase by less than 15%.
Graph interpretation
When the price drops from P1 to P2, the effect on quantity demanded is different for elastic and inelastic demand curves.
- For the elastic demand curve, which is flatter, the quantity demanded increases significantly from Q1 to Q2.
- In contrast, for the inelastic demand curve, which is steeper, the same price decrease from P1 to P2 results in a much smaller increase in quantity demanded from Q1 to Q2.
Tip: To help you remember how to draw the difference between elastic and inelastic demand curves, think of the letter "I" from the word āInelasticā (which is vertical). A perfectly inelastic curve is a straight vertical line. The more inelastic the demand, the more it looks like an "I.ā
How to calculate PED?
The formula for PED is important to understand the elasticity of demand for a product.
- PED = 1: This means the product has unit elasticity.
- If the price goes up or down by a certain percentage, the quantity demanded will go up or down by the same percentage.
- If the price of a t-shirt goes up by 10%, the quantity demanded will decrease by 10%. Similarly, if the price drops by 5%, the quantity demanded will increase by 5%. š
- PED > 1: This means the product is elastic.
- People are very sensitive to price changes, so if the price changes, the quantity demanded changes a lot.
- If the price of movie tickets increases by 20%, the quantity demanded might drop by 30% because people find alternative entertainment options easily. š«
- PED between 0 and 1: This means the product is inelastic.
- People are not very sensitive to price changes, so if the price changes, the quantity demanded changes only a little.
- If the price of gasoline rises by 15%, the quantity demanded might only decrease by 5% because people still need to drive to work and school. ā½ļø
PED values shown here are absolute, focusing on their size without considering whether they are positive or negative i.e ignoring whether there is a + or - sign
- Additionally PED is a unit free measure so the answer is expressed as a number
Practice calculating the price elasticity of demand in these following examples:
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What are factors that can influence the PED of a product?
Letās explore each factors in more detail:
Durability
Durable goods tend to have more elastic demand. These are items like smartphones, cars, or furniture that last a long time and don't need frequent replacement.
Example: Apple Iphoneš±
When Apple launches a new iPhone, it usually comes with a higher price due to new features.
Impact on Demand:
šµ Price Increase:Ā When Apple increases the price of its new iPhone model, let's say from Ā£800 for the previous model to Ā£1000 for the new model, consumers face a higher cost if they want to upgrade.
š Consumer Response:
- Elastic Demand:Ā Many consumers may choose to delay upgrading their iPhone or stick with their current model for longer because the price increase makes the new iPhone less affordable.
- Some might wait for discounts or promotions instead of buying the new Iphone immediately.
š Quantity Demanded Decrease:Ā The delay in purchasing the new iPhone or sticking with the older model illustrates elastic demand.
- The quantity demanded for the new iPhone decreases significantly when the price increases because consumers have the option to postpone their purchase.
When discussing durable goods and elasticity of demand, we are considering how consumers respond to price changes, particularly in relation to new models or versions of products like smartphones, cars, or appliances.
Habit-Forming Goods
Goods that people are addicted to or have strong habits around tend to have inelastic demand. This means that even if prices go up, people will still buy them.
- For example, cigarettes have inelastic demand because smokers will continue to buy them despite price increases.
- Similarly, alcohol also has inelastic demand because people who regularly drink will continue to purchase it even if prices rise. šŗ
Think about your favourite snack š«
If the price of your favourite chocolate bar or soda increased, would you stop buying it, or would you pay the higher price to keep enjoying it during lunch or after school?
- Habit-forming goods like these often have inelastic demand because people will continue to purchase them to maintain their daily routines and satisfy their cravings.
Availability of substitutes
The more substitutes a good has, the more elastic its demand is. This means that if the price of that good goes up, people can easily switch to a different product.
Example: Think about soft drinks š„¤
There are many brands and flavours of soft drinks available and various store brands, providing plenty of substitutes.
š If the price of Coca-Cola increases, people might buy Pepsi or another soft drink instead
- This means the quantity demanded for Coca-Cola would decrease significantly because consumers have many other choices.
š On the other hand, if a good doesn't have a lot of substitutes, people won't have many choices if the price goes up.
- For example, life-saving medications like insulin have very few substitutes. If the price of insulin increases, the quantity demanded wouldn't change much because consumers don't have other options to turn to. This makes the demand for such goods less elastic. š
Percentage of Income Spent
PED can be influenced by the proportion of a consumer's income spent on a good.
š If a product takes up a small percentage of income, its demand tends to be inelastic.
šIf a product takes up a large percentage of income, its demand is more elastic.
Examples:
- Inelastic Demand:Ā Items like a pack of pens have low prices relative to income. A price increase from Ā£2 to Ā£3 (a 50% rise) seems significant, but it's only an extra Ā£1. Most consumers will still buy the pack of pens as usual, so the quantity demanded doesn't change much. šļø
- Elastic Demand:Ā A family vacation takes up a large portion of income.Suppose a family vacation costs Ā£3,000. If the price of the vacation increases by 10%, it would now cost Ā£3,300āan additional Ā£300.
- For many families, this Ā£300 increase is significant because it represents a noticeable part of their annual income. This substantial cost increase will likely lead to a decrease in the quantity demanded, as many families may decide to cancel or postpone their vacation plans due to the higher price. šļø
Degree of Necessity
Essential goods, known as necessities, typically haveĀ inelastic demand. These are items that people need regardless of price changes.
The level of necessity for a good determines its elasticity:
- More Necessity, Less Elasticity:Ā The greater the necessity for a product, the less sensitive its demand is to price changes. Consumers prioritise purchasing necessary items, such as critical medications, even if prices rise because these goods are crucial for their health or daily life. š
- Luxury products, on the other hand, often haveĀ greater elasticity. These are items that people can choose to buy or not based on their disposable income and preferences. š
Other factors that can affect PED:
Other factors:
Frequency of PurchaseĀ š
- If a product is bought frequently, people may be less responsive to price changes because they need it regularly.
- Example: Sofas are not bought often, so people can delay buying them if the price goes up.
Brand LoyaltyĀ ā¤ļø
- When consumers prefer a particular brand, they might not respond to price changes because they trust and like that brand.
- Example: If people love Nike shoes, they might keep buying them even if the price increases.
Time Period Since Price ChangeĀ ā³
- Over a longer time period, consumers have more time to find alternatives and adjust their buying habits.
- Example: If the price of oil-fired heating goes up, over time people might switch to heat pumps š„āāļø.
How Widely Defined a Good IsĀ š
- The broader the definition of a product, the less responsive consumers are to price changes.
- Example: If the price of "crisps" goes up, people might still buy different brands of crisps. But if only "Walkers crisps" increase in price, consumers might switch to another brand.
Price Elasticity of Demand and Total Revenue
Understanding PED helps determine the best pricing strategy to maximise revenue for both the government and businesses:
For example, letās consider Taylor Swiftās concert in a stadium with 67,000 seats. Suppose all ticket prices are the same and Taylor keeps all the money from ticket sales.
- If ticket prices are too high, fewer people will buy them, leading to lower sales.
- If ticket prices are too low, all tickets might sell out, but revenue might be less than it could be with higher prices.
Taylor needs to find the optimal price to maximise her revenue. Should she sell tickets at a lower price to fill more seats, or at a higher price but sell fewer tickets? PED helps answer this question.
Consider a government's decision to impose a tax on sugary beverages to promote public health.
- If the tax is too low, it may not reduce consumption significantly, leading to minimal health benefits and tax revenue.
- Conversely, if the tax is too high, consumers may switch to other products, resulting in decreased sales and potential revenue loss.
Understanding PED helps governments predict how changes in taxes or tariffs will affect consumer behaviour and overall revenue.
Total revenue and Demand
Total Revenue (TR) is calculated as price times quantity demanded (TR = P x Qd).
Total revenue can increase or decrease depending on both whether
š demand is inelastic or elastic
š AND whether there is a price increase or decrease.
Letās consider an example of where demand is elastic and there is a price DECREASE:
Letās consider an example of where demand is elastic and there is a price INCREASE:
Letās now consider an example of where demand is inelastic and there is a price DECREASE:
Letās now consider an example of where demand is inelastic and there is a price INCREASE:
Letās now consider an example of where demand is unit elastic:
Summary:
We know it may be confusing at first to remember the effects of PED on total revenue, but here's a simple thought process to go about it:
- Is the demand elastic or inelastic?
- Is there a price increase or decrease?
- šĀ If the price increases:Ā Demand will decrease.
- šĀ If the price decreases:Ā Demand will increase.
- By how much does demand increase or decrease?
- Elastic Demand:
- Changes in quantity demanded are larger than changes in price.
- Inelastic Demand:
- Changes in quantity demanded are smaller than changes in price.
The Fraser of Allander Institute studied a proposed levy on non-domestic rates for alcohol retailers in Scotland. A levy is a type of tax businesses pay based on their property value. Non-domestic rates refer specifically to these taxes for businesses.
They found that a 13p levy on every Ā£1 of property value could generate about Ā£57 million annually. This demonstrates how governments plan to increase revenue, considering that alcohol tends to have price inelastic demandāmeaning people will generally buy it even if the price increases, affecting how taxes like this are designed and their impact on government income.
Knowledge checkpoint: Answer these actual Higher Economics exam questions:
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