Price elasticity and the gradient of a demand curve

The steeper the gradient of the demand curve, the lower the co-efficient of price elasticity of demand (PED). For the common price reduction, P to P1 in the graph, the increases in demand are smallest when the demand curve is the steepest.

PED variations

What determines PED?

Price elasticity of demand will vary according to the following factors:

  1. The degree of necessity - the greater the need for the product the lower the PED.
  2. Whether substitutes are available - the larger the number of close substitutes, the greater the price elasticity of demand
  3. The significance of brand and loyalty - the more significant the brand in the mind of the consumer, the lower the PED.
  4. The influence of habit - the greater the purchasing habit the lower the PED.
  5. The price of the product in relation to income - the higher the price-income ratio, the more elastic the demand.

These factors can combine or they can counterbalance each other. For example, purchasing a property will involve a high percentage of income, but a home is a necessity - hence the price-income ratio is balanced by the degree of necessity.

The significance of PED variations

The significance of PED variations is that decisions taken by firms or by governments can be more effectively taken when an assessment of PED has been made.

For example, a firm may increase price in the hope of increasing revenue (and profits) but this will only be achieved if PED is inelastic - if PED is elastic, raising price would achieve the opposite, and undesired, effect.

Similarly, for government, the decision to raise taxes or provide subsidies requires an assessment of the price elasticity of demand for those paying the tax or receiving the subsidy. If the need to raise tax revenue is the most significant, then a PED <1 (inelastic) would be more beneficial.

However, if the objective is to reduce consumption (say of a demerit good) then a PED > 1 (elastic) would be the most desirable.

Video on price elasticity of demand

PED and the monopolist's profit maximising price

If a monopolist sets a price to maximise revenue, it will produce up to the output where marginal revenue (MR) equals marginal cost (MC). This will always occur in the elastic portion of the monopolists demand curve (known in the theory of the firm as the average revenue - AR - curve).

PED for a monopolist

PED formula

How is PED calculated?

PED formula
Equilibrium

How is equilibrium determined?

Equilibrium
Elasticity of supply

What determines supply elasticity?

Supply elasticity

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