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