2.12 - Determinants of PED
Factors influencing price elasticity of demand
Price elasticity of demand (PED) measures how much the quantity demanded of a good or service changes in response to a change in its price.
Availability and similarity of substitutes
The presence of alternatives significantly affects PED:
- High number of close substitutes - Leads to elastic demand; a price increase causes a large drop in quantity demanded.
- Few or no close substitutes - Results in inelastic demand; quantity demanded falls only slightly with a price rise.
- Broader vs narrower definitions - Wider categories have fewer substitutes and more inelastic demand, while specific items have more substitutes and elastic demand.
- Closeness matters - A herbal infusion is a closer substitute for tea than a fizzy drink is for coffee.
Characteristics of the good
The type of product influences how responsive demand is to price changes:
- Necessities - Demand is typically inelastic because consumers continue buying regardless of price.
- Addictive or habit-forming goods - These have inelastic demand as it's hard for users to cut back.
Proportion of income allocated to the good
The share of a consumer's budget spent on a product affects PED:
- Low proportion of income - Demand is inelastic; price hikes have little impact.
- High proportion of income - Demand becomes elastic; consumers react strongly to price changes.
- Income level variations - For low-income individuals, everyday items represent a larger budget share, making demand more elastic.
Duration of the time period
Time allows consumers to adapt, altering PED:
- Short-term effects - Demand is inelastic as habits and alternatives are hard to change quickly.
- Long-term effects - Demand becomes elastic as people find substitutes or modify behaviour.
The relationship between PED and total revenue
Total revenue is the income a business earns from selling goods or services
Formula for total revenue:
Where:
- Total revenue (TR) = Overall income from sales (£)
- Price (P) = Selling price per unit (£)
- Quantity demanded (Q) = Number of units sold
Note that total revenue differs from profit, which subtracts costs from revenue.
Effects of price increases on revenue
Price rises impact revenue differently depending on PED:
- Elastic demand (PED > 1) - Quantity demanded falls more than the price rises, reducing total revenue.
- Inelastic demand (0 < PED < 1) - Quantity demanded falls less than the price rises, increasing total revenue.
- Unit elastic demand (PED = 1) - The fall in quantity demanded matches the price rise, leaving total revenue unchanged.
Effects of price decreases on revenue
Price cuts also vary in their revenue outcomes based on PED:
- Elastic demand (PED > 1) - Quantity demanded rises more than the price falls, boosting total revenue.
- Inelastic demand (0 < PED < 1) - Quantity demanded rises less than the price falls, decreasing total revenue.
- Unit elastic demand (PED = 1) - The rise in quantity demanded matches the price fall, keeping total revenue the same.
Key patterns in PED and revenue maximisation
On a straight-line demand curve, total revenue peaks at the midpoint where PED equals 1.