PED formula

PED measures the response of consumer demand to a change in price. PED can be calculated by using the following formula:

The formua for PED

Example

The following table is a demand schedule showing how demand responds to different prices. If we apply the formula to two different price changes (2 to 3, and 5 to 6) we can calculate the PED result (co-efficient).

PED example

PED falls in value as we move down the demand curve, from left to right. In the example, the price range 5 to 6 give a PED value of (-) 1.67, and this falls to (-) 0.4 as we move down the demand curve to the price range 2 to 3.

Range of values of PED

PED can vary from perfectly elastic, which occurs when the initial quantity demanded is zero, and where any drop in price which leads to even the smallest increase in quantity demanded will have an infinite (in this case, meaning immeasurable) percentage value, and PED is 'infinity'.

In the example above, the price change 8 to 7 results in an increase in quantity demanded from 0 to 200 - this is an infinite percentage change. (In this instance, infinite means immeasurable, as we need to start with a number to be able to calculate a percentage.)

Price elasticity of demand - extreme cases

PED can also be zero, which is where any change in price has no effect on quantity demanded.


Video on price elasticity of demand
PED - extreme values

Between these two extremes, PED can be 'elastic' which means it has a value greater than proportionate (with a value of >1) or 'inelastic', where the value is <1. When the PED value is exactly 1 PED is 'unit' or 'unitary'.

PED down a demand curve

At the midpoint of the demand curve, PED equals ‘one’, and is called 'unitary' or 'unit' PED

The importance of PED

Firms need to have as much information as possible about how consumers will respond to price changes. For example, costs may rise as a result of an unforeseen change in import prices, or through a change in the exchange rate, and firms need to make a judgment about whether to raise (or lower) price.

The primary reason for this is that price changes affect a firm's total revenue. In the above example, the two price changes have very different effects on revenue, as shown below.

PED and revenue

When PED is inelastic, a rise in price results in an increase in revenue, and when PED is elastic, a rise in price causes a fall in revenue.

When firms are faced with two different demand scenarios for a single product, then, when possible it can set two different prices. This practice is called price discrimination.

Determinants of price elasticity of demand

Several factors affect the extent to which consumers will and can respond to a price change - these are shown below:

PED determinants

It should be noted that these factors do not always 'pull' in the same direction. For example, in terms of changes in house prices, while a large percentage of income is allocated to house purchases, and there might be a range of options, indicating an elastic response to price, housing is a necessity, which would reduce house buyers response to price changes.

Also, these factors are not equally weighted, and for some goods parrticular determinants might be more dominant - such as when goods are habit forming.


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