Definition & Calculation of PED:
→ Definition → Price Elasticity of Demand (PED) measures the responsiveness of quantity demanded to a change in price
→ Formula → PED = % change in quantity demanded ÷ % change in price
→ % Change in Quantity Demanded → [(New Quantity – Old Quantity) ÷ Old Quantity] × 100
→ % Change in Price → [(New Price – Old Price) ÷ Old Price] × 100
→ Interpretation of PED Values → Standard values reflect varying degrees of consumer sensitivity to price changes
→ Perfectly Inelastic (PED = 0) → Quantity demanded does not respond to price changes at all (vertical demand curve)
→ Inelastic (0 < PED < 1) → % change in quantity demanded is smaller than % change in price (steep demand curve)
→ Unitary Elasticity (PED = 1) → % change in quantity demanded equals % change in price (rectangular hyperbola curve)
→ Elastic (1 < PED < ∞) → % change in quantity demanded is greater than % change in price (shallow/gentle demand curve)
→ Perfectly Elastic (PED = ∞) → Any price increase causes quantity demanded to drop to zero (horizontal demand curve)
Example:
→ If a bus company raises ticket prices by 10% and passenger journeys fall by 5%, PED = -5% ÷ +10% = -0.5 (Inelastic demand; minus sign is usually ignored)
Analysis:
→ Negative Sign Rule → PED is almost always negative due to the inverse law of demand, but economists focus on the numerical absolute value
→ Curve Slope Distinction → Steeper curves indicate lower elasticity (inelastic), while flatter curves indicate higher elasticity (elastic)
Evaluation:
→ PED values along a single straight-line demand curve vary from elastic at high prices to inelastic at low prices
→ Historical sales data used to calculate PED may become inaccurate if market conditions shift rapidly
Determinants of Price Elasticity of Demand:
→ Availability of Substitutes → More close substitutes available makes demand more elastic; fewer substitutes makes demand inelastic
→ Proportion of Income Spent → Items taking a large share of income (e.g., cars) have elastic demand; small income shares (e.g., salt) have inelastic demand
→ Necessity vs. Luxury → Basic necessities (e.g., water, basic foods) are price inelastic; luxury goods (e.g., holiday trips) are price elastic
→ Addictive / Habit-Forming Goods → Habitual consumption (e.g., tobacco, coffee) leads to highly price inelastic demand
→ Time Period → Demand is more elastic in the long run as consumers find substitutes, but inelastic in the short run
Example:
→ Petrol has few immediate substitutes and is a necessity for commuters, making its short-term demand highly inelastic
Analysis:
→ Substitute Switching → Easy access to alternatives allows consumers to switch brands rapidly if prices rise, driving up PED
→ Budget Impact → Price increases in high-cost goods force households to adjust buying behavior immediately due to budget constraints
Evaluation:
→ Branding and customer loyalty can make elastic goods act like inelastic goods by reducing perceived substitutes
→ Classification as a necessity or luxury varies across different income levels and country contexts
PED, Consumer Expenditure & Firms’ Revenue:
→ Total Revenue (TR) & Consumer Expenditure (CE) → TR = Price × Quantity; Consumer expenditure exactly equals firm total revenue
→ Inelastic Demand (PED < 1) → Price and Total Revenue move in the same direction
→ Price Increase → Results in a smaller % fall in quantity demanded → Total Revenue rises
→ Price Decrease → Results in a smaller % rise in quantity demanded → Total Revenue falls
→ Elastic Demand (PED > 1) → Price and Total Revenue move in opposite directions
→ Price Increase → Results in a larger % fall in quantity demanded → Total Revenue falls
→ Price Decrease → Results in a larger % rise in quantity demanded → Total Revenue rises
→ Unitary Elastic Demand (PED = 1) → Price changes leave Total Revenue completely unchanged
Example:
→ A price increase from 10 to 12 (20% rise) reduces quantity from 100 to 90 units (10% fall). Revenue increases from 1,000 to 1,080 because demand is inelastic
Analysis:
→ Inelastic Revenue Mechanics → Gain in revenue per unit sold outweighs the loss in revenue from lower sales volume
→ Elastic Revenue Mechanics → Loss in revenue per unit sold is offset by a much larger expansion in sales volume
Evaluation:
→ Raising prices on inelastic goods increases total revenue, but firms must check if high prices damage brand reputation
→ Competitor reactions must be considered; if competitors do not follow a price rise, elastic demand becomes even higher
Significance of PED for Economic Decision-Makers:
1. Producers / Firms:
→ Pricing Strategies → Inelastic goods should be priced higher to raise total revenue; elastic goods require price cuts to boost volume and revenue
→ Tax Pass-Through → Firms can pass indirect tax burdens onto consumers if demand for the product is inelastic
2. Governments:
→ Taxation Policy → Indirect taxes (e.g., excise duties) are placed on inelastic goods (fuel, tobacco) to maximize tax revenue without reducing sales volume drastically
→ Subsidies & Price Controls → PED guides how effectively subsidies lower market prices and expand consumer consumption
3. Consumers & Workers:
→ Consumers → Understand how price movements impact overall spending choices and household budgets
→ Workers → Trade unions leverage wage demand power if worker skills or products manufactured have inelastic demand
Analysis:
→ Government Revenue Generation → High tax on inelastic items generates stable fiscal revenue with minimal impact on total employment in that industry
→ Business Profitability → Aligning pricing structure with PED estimations prevents disastrous falls in firm profit margins
Evaluation:
→ Governments placing taxes on inelastic demerit goods may raise revenue, but fail to eliminate harmful consumption entirely
→ Estimates of PED are based on past observations and may change as economic conditions or consumer tastes shift