Price Elasticity of Demand

What is the 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 PEDs will be elastic
• Proportion of Income: The higher the proportion of income a product takes, the greater the 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 reduce PED at any given price.

When demand shifts to the left, consumers have a lower incentive to purchase products/services 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.