Price elasticity of demand (PED) Revision Notes

Price elasticity of demand (PED) is a measure that shows how sensitive the quantity demanded of a product is to a change in its price. It quantifies the percentage change in quantity demanded resulting from a one percent change in price. This concept helps us understand consumer behaviour when prices fluctuate.

• PED = Percentage change in quantity demanded ÷ Percentage change in price
• It is a ratio without units, as it compares percentage changes

The value of PED indicates the degree of responsiveness:

If PED is greater than 1, demand is elastic, meaning consumers respond strongly to price changes.

If PED is less than 1, demand is inelastic, meaning consumers respond weakly to price changes, often because the good is a necessity or lacks substitutes.

• Elastic demand (PED > 1): Quantity demanded changes proportionally more than price.
• Inelastic demand (PED < 1): Quantity demanded changes proportionally less than price.
• Unitary elasticity (PED = 1): Quantity demanded changes proportionally equal to price change.

To calculate PED, use the formula: PED = (% change in quantity demanded) ÷ (% change in price).

For example, if the price of a coffee rises from £2.00 to £2.20 (a 10% increase) and the quantity demanded falls from 100 cups to 90 cups (a 10% decrease), then:

% change in price = ((2.20 - 2.00) / 2.00) × 100 = 10% increase,

• % change in quantity demanded = ((90 - 100) / 100) × 100 = -10%
• PED = |-10%| ÷ 10% = 1.0
• This means demand is unit elastic: quantity demanded changes by the same percentage as price.

Understanding PED helps businesses and policymakers predict how changes in price will affect sales and revenue. For example, if demand is elastic, a price increase may lead to a proportionally larger drop in quantity demanded, reducing total revenue. Conversely, if demand is inelastic, raising prices might increase total revenue because quantity demanded falls only slightly.

• Businesses use PED to set prices strategically.
• Governments consider PED when imposing taxes to predict effects on consumption.

Although detailed factors are covered elsewhere, it is useful to note that PED depends on:

Availability of close substitutes: More substitutes make demand more elastic.

Necessity versus luxury: Necessities tend to have inelastic demand, luxuries more elastic demand.

• Proportion of income spent on the good: Higher proportion usually means more elastic demand.
• Time period: Demand tends to be more elastic over longer periods as consumers find alternatives.

Price elasticity of demand (PED) quantifies how much the quantity demanded of a good changes in response to a change in its price. It is a ratio of percentage changes, which standardises the measure regardless of the units used.

The formula for PED is: \[ \text{PED} = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}} \]

To calculate the percentage changes, use the formula: \[ \% \text{ change} = \frac{\text{New value} - \text{Original value}}{\text{Original value}} \times 100 \] For example, if the price of a coffee falls from £2.00 to £1.80 (a 10% decrease), and the quantity demanded rises from 100 cups to 120 cups (a 20% increase), then: \[ \text{PED} = \frac{20\%}{-10\%} = -2 \] The negative sign indicates the inverse relationship between price and quantity demanded, but PED is usually expressed as an absolute value for interpretation purposes.

• PED measures responsiveness of demand to price changes.
• Formula: PED = % change in quantity demanded ÷ % change in price.
• Calculate percentage changes using (New - Original) ÷ Original × 100.
• Example: Price drops 10%, quantity demanded rises 20%, PED = 2 (elastic).

The absolute value of PED determines the type of demand elasticity:

If PED > 1, demand is elastic: quantity demanded changes proportionally more than price. Consumers are sensitive to price changes.

If PED < 1, demand is inelastic: quantity demanded changes proportionally less than price. Consumers are less sensitive to price changes, often due to necessity or lack of substitutes. If PED = 1, demand is unitary elastic: quantity demanded changes by the same percentage as price changes, so total revenue remains constant when price changes. For example, luxury goods often have elastic demand because consumers can delay or avoid purchase if prices rise. Basic food items tend to have inelastic demand because they are essential and have fewer substitutes.

• PED > 1: Elastic demand, high sensitivity to price changes.
• PED < 1: Inelastic demand, low sensitivity to price changes.
• PED = 1: Unitary elasticity, proportional responsiveness.
• Elastic goods: luxury items, many substitutes.
• Inelastic goods: necessities, few substitutes.

A demand curve plots price on the vertical axis and quantity demanded on the horizontal axis. Movements along the curve show how quantity demanded changes as price changes.

To illustrate different PED levels, draw three demand curves:

Elastic demand curve: relatively flat slope, showing large quantity changes for small price changes. For example, a small price drop causes a big increase in quantity demanded. Inelastic demand curve: steep slope, showing small quantity changes for large price changes. For example, even a big price increase causes only a small drop in quantity demanded. Unitary elastic demand curve: intermediate slope where percentage changes in price and quantity demanded are equal, so total revenue remains unchanged when price changes. Label the axes as Price (P) and Quantity Demanded (Q). Mark points before and after price changes to show movements along the curve and calculate PED from these changes.

• Demand curve: Price (vertical) vs Quantity demanded (horizontal).
• Elastic demand curve: flat slope, large quantity response.
• Inelastic demand curve: steep slope, small quantity response.
• Unitary elastic curve: intermediate slope, equal % changes.
• Use points on curve to calculate PED from price and quantity changes.

Suppose the price of a cinema ticket rises from £10 to £12, and the number of tickets sold falls from 500 to 400.

Step 1: Calculate percentage change in price: \[ \frac{12 - 10}{10} \times 100 = 20\% \text{ increase} \]

Step 2: Calculate percentage change in quantity demanded: \[ \frac{400 - 500}{500} \times 100 = -20\% \text{ decrease} \] Step 3: Calculate PED: \[ \text{PED} = \frac{-20\%}{20\%} = -1 \] Ignoring the negative sign, PED = 1, indicating unitary elasticity. This means the percentage drop in quantity demanded equals the percentage increase in price, so total revenue (price × quantity) remains roughly the same. This information helps the cinema decide that raising prices will not increase total revenue because fewer tickets will be sold proportionally.

• Calculate % changes in price and quantity demanded.
• Divide % change in quantity by % change in price to find PED.
• Interpret absolute PED value to determine elasticity.
• Example: Price ↑ 20%, quantity ↓ 20%, PED = 1 (unitary).
• Total revenue remains stable with unitary elasticity.

Understanding PED helps producers, consumers, and policymakers make informed decisions:

Producers can predict how a price change affects sales and revenue. For elastic demand, lowering prices may increase total revenue; for inelastic demand, raising prices may increase revenue.

Consumers understand how sensitive their purchasing behaviour is to price changes, influencing budgeting and consumption choices. Governments use PED to estimate the impact of taxes or subsidies on consumption and tax revenue. For example, taxing goods with inelastic demand (like cigarettes) tends to raise revenue without greatly reducing consumption. Accurate PED calculations and demand curve analysis are essential tools for these decisions.

• Producers use PED to set prices and forecast revenue.
• Consumers adjust spending based on price sensitivity.
• Governments assess tax impacts using PED.
• Elastic demand: price cuts can boost revenue.
• Inelastic demand: price rises can increase revenue.

Price elasticity of demand (PED) measures how much the quantity demanded of a product changes in response to a change in its price. If demand changes a lot when price changes, demand is elastic; if demand changes little, demand is inelastic. Understanding what determines this responsiveness is essential for producers, consumers, and policymakers to make informed decisions.

One of the most important factors affecting demand elasticity is the availability of close substitutes. When many alternatives exist, consumers can easily switch if the price of one good rises, making demand more elastic.

For example, if the price of a particular brand of coffee increases, consumers may switch to other brands or tea, so the quantity demanded for that brand falls significantly. Conversely, if there are few or no substitutes, demand tends to be inelastic because consumers have limited options.

• More substitutes → more elastic demand
• Fewer substitutes → more inelastic demand

Whether a good is a necessity or a luxury also influences elasticity. Necessities are goods that consumers need and will buy regardless of price changes, such as basic food items or essential medicines. Demand for these goods tends to be inelastic.

Luxuries, like designer clothes or holiday trips, are not essential and can be postponed or forgone if prices rise, so their demand is more elastic.

For example, if the price of electricity rises, households still need to use it, so demand changes little. But if the price of a luxury car increases, many potential buyers may delay or cancel their purchase.

• Necessities → inelastic demand
• Luxuries → elastic demand

Goods that take up a large portion of a consumer’s income usually have more elastic demand. This is because price changes significantly affect the consumer’s budget, encouraging them to reduce consumption or seek alternatives.

In contrast, goods that cost very little relative to income tend to have inelastic demand, as price changes have minimal impact on overall spending.

For example, a rise in the price of a house (a large expense) will greatly affect demand, while a small increase in the price of salt (a minor expense) will not.

• Large income proportion → elastic demand
• Small income proportion → inelastic demand

The elasticity of demand can vary depending on the time consumers have to adjust to price changes. In the short run, demand is often more inelastic because consumers need time to find substitutes or change habits.

Over the long run, demand tends to become more elastic as consumers adapt, find alternatives, or change consumption patterns.

For example, if petrol prices rise suddenly, drivers may initially continue buying similar amounts, but over months or years they might switch to more fuel-efficient cars or public transport, increasing elasticity.

• Short run → more inelastic demand
• Long run → more elastic demand

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

The formula is: PED = (% change in quantity demanded) / (% change in price).

For example, if the price of a product falls by 10% and the quantity demanded rises by 20%, then PED = 20% / 10% = 2, indicating elastic demand.

• PED > 1: Elastic demand (quantity demanded changes proportionally more than price).
• PED < 1: Inelastic demand (quantity demanded changes proportionally less than price).
• PED = 1: Unitary elasticity (quantity demanded changes proportionally equal to price).

Total revenue (TR) is the total income a firm receives from selling a product. It is calculated by multiplying the price per unit by the quantity sold: TR = Price × Quantity.

Changes in price affect total revenue depending on the PED of the product.

For example, if a firm sells 100 units at $5 each, total revenue is $500. If the price changes, total revenue will change according to how quantity demanded responds.

• Total revenue = Price × Quantity demanded.
• Understanding TR helps firms decide whether to raise or lower prices.

When demand is elastic (PED > 1), a decrease in price causes a proportionally larger increase in quantity demanded, so total revenue rises.

When demand is inelastic (PED < 1), a decrease in price causes a smaller increase in quantity demanded, so total revenue falls.

When demand is unitary elastic (PED = 1), a change in price does not affect total revenue; it remains constant.

• Elastic demand: Price ↓ → Quantity ↑ proportionally more → TR ↑.
• Inelastic demand: Price ↓ → Quantity ↑ proportionally less → TR ↓.
• Unitary elasticity: Price change → TR unchanged.

Demand curves can be drawn to show different elasticity regions. A flatter demand curve segment indicates elastic demand, while a steeper segment indicates inelastic demand.

Total revenue can be represented graphically as the area under the demand curve at a given price and quantity.

By shifting price along the demand curve, students can observe how total revenue changes depending on elasticity.

• Elastic demand curve segment is flatter.
• Inelastic demand curve segment is steeper.
• Total revenue area = Price × Quantity on the graph.

Suppose the price of a product falls from $10 to $8 (a 20% decrease), and quantity demanded rises from 50 to 70 units (a 40% increase).

Calculate PED: PED = 40% / 20% = 2 (elastic demand).

Calculate initial total revenue: $10 × 50 = $500. Calculate new total revenue: $8 × 70 = $560. Total revenue has increased, consistent with elastic demand.

• Calculate percentage changes carefully.
• Use PED to predict direction of total revenue change.
• Check calculations for accuracy.

Price elasticity of demand (PED) quantifies the responsiveness of quantity demanded to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price:

PED = (% change in quantity demanded) ÷ (% change in price)

For example, if the price of a product rises by 10% and the quantity demanded falls by 20%, then PED = -20% ÷ 10% = -2. The absolute value (2) indicates elastic demand, meaning consumers are quite responsive to price changes. Conversely, if quantity demanded changes little despite a price change, demand is inelastic (PED less than 1 in absolute value). Understanding whether demand is elastic or inelastic helps predict how consumers will react to price changes.

• PED formula: percentage change in quantity demanded divided by percentage change in price.
• Elastic demand: PED > 1 (quantity demanded changes more than price).
• Inelastic demand: PED < 1 (quantity demanded changes less than price).

Consumers use knowledge of PED to make purchasing decisions. When demand for a good is elastic, consumers are sensitive to price changes and may switch to substitutes or reduce consumption if prices rise. For example, if the price of a particular brand of cereal increases significantly, consumers might buy a cheaper brand instead.

In contrast, for goods with inelastic demand, such as essential medicines, consumers continue to buy similar quantities despite price increases because alternatives are limited or the good is necessary.

Thus, consumers adjust their spending patterns based on how sensitive their demand is to price changes, helping them manage their budgets effectively.

• Elastic demand leads consumers to reduce quantity demanded when prices rise.
• Inelastic demand means consumers maintain purchases despite price changes.
• Consumers may seek substitutes if demand is elastic.

Producers rely on PED to set prices that maximise revenue. When demand is elastic, a price increase causes a proportionally larger drop in quantity demanded, reducing total revenue. Therefore, producers may lower prices to increase sales volume and total revenue.

For example, a smartphone manufacturer may reduce prices during a sale to attract more buyers if demand is elastic.

Conversely, if demand is inelastic, producers can increase prices without losing many sales, raising total revenue. For instance, a utility company may raise prices knowing consumers have few alternatives and will continue to purchase similar amounts.

• Elastic demand: lowering price can increase total revenue.
• Inelastic demand: raising price can increase total revenue.
• Producers use PED to predict revenue changes from price adjustments.

Governments consider PED when imposing taxes or subsidies. If demand is inelastic, a tax increase on a good (like tobacco) will reduce quantity demanded only slightly but raise significant tax revenue and discourage consumption.

For example, heavy taxes on cigarettes exploit their inelastic demand to reduce smoking rates and generate revenue.

If demand is elastic, a tax increase may cause a large drop in quantity demanded, reducing tax revenue and possibly harming producers. Subsidies on goods with elastic demand can encourage consumption effectively, such as subsidies on public transport to increase ridership.

• Taxes on inelastic goods raise revenue and reduce consumption moderately.
• Taxes on elastic goods may reduce revenue due to large demand drops.
• Subsidies on elastic goods effectively increase consumption.

Understanding PED helps all economic agents make better decisions: consumers manage spending and substitution; producers optimise pricing and revenue; governments design effective taxes and subsidies.

For example, a producer knowing demand is elastic will avoid price hikes that reduce revenue, while a government taxing an inelastic good can raise funds without large consumption drops.

In all cases, recognising the degree of elasticity guides strategies that balance objectives such as profit, welfare, and market efficiency.

• PED informs consumer spending and substitution choices.
• Producers use PED to maximise revenue through pricing.
• Governments apply PED to design taxes and subsidies for policy goals.