2.4 - Price Elasticity of Demand
The concept of elasticity and price elasticity of demand
Elasticity examines how one economic variable responds to a change in another, assuming all other factors remain constant. It is expressed as a numerical coefficient that shows the degree of responsiveness.
Elastic and inelastic relationships
- When a minor adjustment in price or income leads to a substantial shift in quantity demanded, the demand is described as elastic.
- When a major adjustment in price or income results in only a minor shift in quantity demanded, the demand is inelastic.
Price elasticity of demand
Price elasticity of demand (PED) assesses how much the quantity demanded of a good changes in response to an alteration in its price.
How to calculate price elasticity of demand
PED is determined by comparing the percentage change in quantity demanded to the percentage change in price. The result is typically negative due to the inverse relationship between price and demand, but the negative sign is often disregarded when discussing the value.
Formula for price elasticity of demand
Worked example - Calculating price elasticity of demand
A product's price rises from $50 to $55, causing quantity demanded to fall from 200 units to 170 units. Calculate the PED.
Step 1: Identify the values
- Original price = $50
- New price = $55
- Original quantity demanded = 200 units
- New quantity demanded = 170 units
Step 2: Calculate percentage changes
% change in quantity demanded = ((170 - 200) / 200) × 100 = -15%
% change in price = ((55 - 50) / 50) × 100 = 10%
Step 3: Apply the PED formula
Step 4: Interpretation
Ignoring the negative sign, PED = 1.5, indicating elastic demand.
Special values of price elasticity of demand
PED can take specific values that describe the nature of demand responsiveness.
Key PED values
- PED = 0 - Perfectly inelastic demand, where quantity demanded does not change at all with price variations.
- PED = ∞ - Perfectly elastic demand, where even a tiny price change causes an infinite shift in quantity demanded.
- PED = 1 - Unit elastic demand, where the percentage change in quantity demanded matches the percentage change in price exactly.
Factors that affect price elasticity of demand
Several elements influence the level of PED for a product, determining how sensitive consumers are to price shifts.
Availability and appeal of substitutes
Goods with numerous close alternatives generally exhibit higher PED, as buyers can easily switch if prices rise. For instance, various brands of fizzy drinks are interchangeable, so a slight price increase in one could lead to a major drop in its sales.
Narrowness of market definition
A tightly defined market, such as a particular brand of tea, tends to have higher PED compared to a broader category like all hot drinks, because consumers have more specific options to choose from.
Additional influences on substitutability
- Information quality - Better access to details about alternatives increases PED.
- Necessity versus luxury - Essential items often have lower PED, while non-essential luxuries have higher PED.
- Addictive nature - Products with habit-forming qualities, like tobacco, typically show lower PED.
- Brand loyalty - Strong branding can reduce PED by making consumers less likely to switch.
Proportion of income spent on the product
Items that account for a significant share of a buyer's budget usually have higher PED, as price changes have a bigger impact on overall spending.
Time frame considered
- Short run - PED is often lower over brief periods, as habits are hard to break quickly.
- Long run - PED rises over extended periods, as people adjust behaviours and discover substitutes if prices stay elevated.
Variation of price elasticity of demand along a demand curve
On a straight-line demand curve that slopes downwards, PED is not constant but changes at different points.
PED changes by price level
- Higher prices - Demand tends to be elastic (PED > 1), with quantity demanded highly sensitive to price shifts.
- Midpoint - Demand shows unit elasticity (PED = 1), balancing responsiveness.
- Lower prices - Demand becomes inelastic (PED < 1), with quantity demanded less affected by price adjustments.