11. Price Elasticity of Demand

1. Definition of Price Elasticity of Demand

Price Elasticity of Demand (PED) measures how the quantity demanded of a good responds to a change in its price, assuming all other factors remain constant (ceteris paribus). It helps businesses and policymakers understand how price changes impact consumer behavior and revenue.

2. Formula for PED

The formula for calculating PED is:

Where:

• % Change in Quantity Demanded =
• % Change in Price =
• If PED > 1, demand is elastic (demand responds significantly to price changes).
• If PED < 1, demand is inelastic (demand responds weakly to price changes).
• If PED = 1, demand is unitary elastic (proportional change in demand to price).

3. Types of Price Elasticity of Demand

a. Perfectly Elastic Demand (PED = ∞)

• • Even a tiny increase in price leads to zero demand.
  • Example: Highly competitive markets where identical products are sold at the same price.
  • Graph: A horizontal demand curve.

b. Perfectly Inelastic Demand (PED = 0)

• Demand remains unchanged despite price fluctuations.
• Example: Essential medicines like insulin or life-saving drugs.
• Graph: A vertical demand curve.

c. Relatively Elastic Demand (PED > 1)

• A small change in price leads to a larger percentage change in demand.
• Example: Luxury goods, such as designer clothes or high-end cars.

Graph: A flatter demand curve.

d. Relatively Inelastic Demand (PED < 1)

• A change in price results in a smaller percentage change in demand.
• Example: Necessities like salt, water, and electricity.
• Graph: A steeper demand curve

e. Unitary Elastic Demand (PED = 1)

• The percentage change in price leads to an equal percentage change in demand.
• Example: Some standard household goods where spending remains proportionate.
• Graph: A curved demand curve where total revenue remains unchanged.

4. Factors Affecting Price Elasticity of Demand

Several factors determine whether demand for a product is elastic or inelastic:

1. Availability of Substitutes
• More substitutes → More elastic demand (e.g., soft drinks, as Coke and Pepsi are interchangeable).
• Fewer substitutes → More inelastic demand (e.g., fuel).
2. Necessity vs. Luxury
• Necessities (food, rent, medicines) → Inelastic demand.
• Luxuries (jewelry, vacations) → Elastic demand.
3. Proportion of Income Spent on the Product
• Expensive products (e.g., cars, electronics) → Elastic demand.
• Inexpensive items (e.g., chewing gum, salt) → Inelastic demand.
4. Time Period
• Short run → Demand is more inelastic because consumers take time to adjust.
• Long run → Demand becomes more elastic as people find alternatives.
5. Brand Loyalty
• Strong brand loyalty reduces elasticity because customers stick to their preferred brand despite price changes.
6. Definition of the Market
• A broad category (e.g., food) → Inelastic demand.
• A narrow category (e.g., organic milk) → Elastic demand.

5. Revenue and Price Elasticity of Demand

Revenue is significantly affected by PED:

1. Elastic Demand (PED > 1)
• If price increases, total revenue decreases (because demand drops significantly).
• If price decreases, total revenue increases (because demand rises significantly).
2. Inelastic Demand (PED < 1)
• If price increases, total revenue increases (because demand only drops slightly).
• If price decreases, total revenue decreases (because demand rises only slightly).
3. Unitary Elastic Demand (PED = 1)
• A price change does not affect total revenue because the percentage change in demand offsets the percentage change in price.

6. Calculation Example of PED

Let’s calculate PED using given data:

• Old Price = 9, New Price = 10
• Old Quantity = 150, New Quantity = 110

1. % Change in Quantity Demanded
2. % Change in Price
3. PED Calculation
• Since the absolute value is greater than 1, demand is elastic.

7. Elasticity along the Demand Curve

• Upper part of the demand curve → Demand is more elastic.
• Midpoint of the demand curve → Unitary elasticity.
• Lower part of the demand curve → Demand is more inelastic.

8. Real-World Applications of PED

• Business Pricing Strategies
• Firms with elastic products use promotional pricing to attract customers.
• Firms with inelastic products (e.g., pharmaceuticals) can increase prices without losing many customers.
• Government Taxation
• Governments tax inelastic goods (like tobacco and gasoline) to generate revenue without drastically reducing consumption.
• Wage and Labor Market
• Understanding wage elasticity helps determine how wage changes impact employment rates in different industries.
• Agricultural Policies
• Many agricultural products have inelastic demand, leading to government intervention to stabilize prices.