Definition of PED

Price elasticity of demand is the responsiveness of quantity demanded for a good to a change in its price.

It is measured by the equation: % change in Qd / % change in P

For example, if the price of a soft drink rises from $2.00 to $2.20 and the quantity demanded falls from 600,000 units to 480,000 the PED would be:

-20% QD / +10% P = -2 or +2 (PED). This is shown in diagram 2.50.

The value of PED is normally negative because of the law of demand. The negative value is often ignored because the PED value is nearly always negative. 

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Price elastic demand

If the PED value is greater than 1 then the good’s demand is price elastic.  This means a change in price leads to a proportionately greater change in quantity demanded.  

Theoretically, the demand curve can be perfectly horizontal or perfectly elastic. This gives a PED of infinity.  

Unitary elasticity of demand 

If the PED value is 1 then PED is unitary. This means that for every 1% change in price, the quantity demanded changes by 1%. 

Price inelastic demand

If the demand for a good has a PED value of less than 1 then it is price inelastic.  This means that a change in the price of a good leads to a less than proportionate change in quantity demanded. 

Demand curves with differing elasticities

Diagram 2.51 shows demand curves of different slopes to represent different PEDs.

• Horizontal demand curve is perfectly elastic (D)
• Relatively flat gradient is price elastic (D1)
• Relatively steep gradient is price inelastic (D2)
• Vertical demand curve is perfectly inelastic (D3)

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  All demand curves (except the perfect ones) have a PED that changes from elastic to inelastic as the price of the good decreases; this is shown in diagram 2.52.  

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Number and closeness of substitutes

The greater the number of close substitutes a product has the more price elastic its demand tends to be because consumers can easily swap between alternatives when the price of the good changes. 

Luxury or necessity

Necessity goods tend to be more price inelastic because consumers need to keep buying necessity goods when their price increases.

Luxury goods tend to be more price elastic because consumers do not need to keep consuming luxury products when their prices increase.  

Proportion of income 

The demand for goods that account for a smaller (larger) proportion of household income tends to be more price-inelastic (elastic). This is because any change in price will have a relatively small impact on household income. 

Type of consumer

High-income consumers tend to be less responsive to price changes for goods than people on lower incomes. This is because any price change will have a smaller real income effect on high-income consumers compared to low-income consumers.

Time

Over time PED tends to become more price elastic because consumers can alter their consumption patterns in response to a price change. 

 

Definition of revenue

Revenue is the value of income a business receives from selling a good. It is calculated by: price x quantity = total revenue

Firms can use an understanding of PED to increase their total revenue. 

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Relationship between PED and revenue

When the demand for a good is price elastic, total revenue increases when the price is decreased and decreases when the price is increased.

When the demand for a good is inelastic, total revenue increases when the price is increased and decreases when the price decreases. 

Diagram 2.52 shows how revenue rises when price decreases when demand is price elastic and revenue falls when price decreases when demand inelastic. 

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The demand for commodities tends to be relatively inelastic because they are often necessities and have fewer close substitutes compared to manufactured goods. 

The demand for manufactured goods tends to be relatively elastic because they are often relative luxuries, and there are a greater number of substitutes relative to commodities

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The limitations of PED

• It can change over time as consumer behaviour changes. 
• PED is based on the ceteris paribus assumption that price is the only variable that is changing. In reality, a number of factors can change at the same time as price such as income.
• When a firm changes price there is always going to be uncertainty about how consumers will react.

b. Using a real-world example, evaluate the usefulness of price elasticity of demand for producers trying to increase their revenues by raising prices. [15]

Answers might include:

• Definitions of PED and revenues.
• A diagram to show an increase in revenues as the price of oil rises.
• An explanation that if producers increase the price of oil this will lead to an increase in revenue because the demand for oil is price inelastic. As the price of oil increases in the diagram the revenue producers receive from selling oil increases from area ABCD to area BGEF.

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• An example of OPEC increasing the price of oil by cutting its supply to increase revenue.
• Evaluation/synthesis might include the problem of accurately measuring the PED of oil which makes forecasting the change in revenue difficult to predict. In addition, changes in non-price factors such as income might be affecting demand and oil revenues. PED also tends to become more elastic in the long run which will have an impact on revenues.

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