2.7 Price Elasticity of Demand

What is price elasticity of demand?

Price elasticity of demand refers to the responsiveness of the quantity demanded to a change in price. Also denoted as PED, it is calculated by dividing the percentage change in quantity demanded by the percentage change in price.

Interpreting PED

• When PED is higher than 1, the demand for that product/service is considered relatively elastic.
• When PED is lower than 1, the demand for that product/service is considered relatively inelastic.
• When PED is 1, demand for the product/service is considered unitary elastic.
• When PED is 0, the demand for that product/service is considered perfectly inelastic.
• When PED is infinite, the demand for that product/service is considered perfectly elastic.

Determinants of PED

• Substitutes- If there are many close substitutes, then PED will be elastic
• Proportion of Income- The higher proportion of income a product takes, the greater PED will be
• Luxury or Necessity- PED will be elastic if it is a luxury
• Addictive or Not- Addictive products tend to have lower PEDs
• Time- The time from the change in price also determines the PED, as time passes, consumers will search for cheaper alternatives

Impact of shift in demand on PED

On a demand diagram, when demand shifts to the right, consumers have a greater incentive to purchase a product/service and therefore reduces PED at any given price.

When demand shifts to the left, consumers have a lower incentive to purchase product/service and therefore increase PED at any given price.

PED and Total revenue

Total revenue is the amount of money a producer generates from sales of a product/service. Total revenue is highest when PED =1. As PED increases or decreases, so does the total revenue. Therefore to maximise revenue:

• A producer can raise prices on a product with inelastic demand
• A producer can lower prices on a product with elastic demand.