Price Elasticity of Demand (PED)

Price Elasticity of Demand (PED) measures the responsiveness of quantity demand for a good to a change in its price.

PED is usually negative due to the fact that if price of a product increases, demand for it falls and if price falls then demand rises. However, in exceptional circumstances PED may not be negative (if you’re interested, see Giffen goods).
If the PED value is less than 1 – ignoring any minus signs, then the good is relatively price inelastic and so the demand curve is steeper.
An example would be petrol, even a relatively large change in price would result in a relatively small change in demand as it is a necessity for many. The demand curve for inelastic products is steep as a change in price causes a relatively smaller change in demand.

Relatively price inelastic demand

If the PED value is greater than 1 (ignoring any minus signs), the good is relatively price elastic and so the demand curve is flatter.

An example of a good which is price elastic might be a holiday to Benidorm – there are many substitute locations to go on holiday to. Thus, even a small increase in price would put off a lot of travellers from going to Benidorm and so demand falls drastically.

In elastic goods, a change in price results in a relatively larger change in demand and hence the shape of the curve.

Relatively price elastic demand

If the PED value is equal to ±1 then the good has a unit price elasticity (any % change in demand is equivalent to the % change in price), if the PED value is ±∞ (infinity) then the good is perfectly elastic (any increase in price results in zero demand) and if the good has a PED value of 0 then it is perfectly inelastic (quantity demanded isn’t affected by changes in price at all).

Factors that affect PED

Availability of substitutes – A lot of substitutes makes the product relatively price elastic. E.g. chocolate bars. Depends on how closely the good is defined.
Luxury and necessity goods – If the good is a luxury it is relatively price elastic whereas if it’s a necessity then people would be willing to pay higher prices because they need the good and so its relatively price inelastic. E.g. high end cars for luxury goods, and water being a necessity.
Proportion of income spent on the good - if the good is a small proportion of your income then it’s more likely to be price inelastic as the change in price may be negligible for the consumer. On the contrary, if the good is a large portion of your income it is more likely to be price elastic as even a small change in price results on you spending a large sum of your earnings. E.g. a house is going to be more price elastic than a pack of gum.
Addictive and habit-forming substances – Demand for goods such as cigarettes or alcohol is relatively price inelastic as people are not affected by price as much due to the fact that these goods have almost become a necessity to the consumer.
Time period – Long run demand tends to be more price elastic due to it becoming easier to switch to substitutes as brand loyalties (see next) change and consumers have time to search for better deals.
Brand loyalty – If it is a brand you have been accustomed to for a long time then a change in price is unlikely to make you buy the same good from a different company. Therefore, a loyal customer base makes the good relatively price inelastic as an increase in price would only result in a relatively small decrease in demand, e.g. Coca-Cola.

Goods which are relatively inelastic tend to be able to increase revenue by increasing prices. Revenue = price x quantity – the quantity sold doesn’t decrease as significantly when there is a relatively large price increase, therefore the revenue increases. The opposite happens with elastic goods, even a relatively small increase in price will result in a relatively large decrease in revenue as the quantity sold decreases significantly when price rises.

Governments can use the inelasticity of some goods to increase indirect tax revenue. For example, due to the inelasticity of cigarettes, instead of the primary aim of indirect taxation on their production being to reduce demand, it is to increase tax revenue from their sales which can then be spent on healthcare for smoking-related illness. This internalises the negative externalities of smoking (to an extent). There’s more on externalities in the Market Failure topic.

More on taxation and PED

Elastic PED

Effect of an indirect tax when demand is price elastic

Firms selling goods with elastic demand will take most of the tax burden onto themselves, as otherwise an increase in price will cause a drop in demand; lowering their revenue.

However, this is not as effective for increasing government revenue, but if the government aims to decrease the demand of a good, then it is very effective, demand will fall from Qₑ to Q₁.

Effect of an indirect tax when demand is price inelastic.

Firms selling goods with inelastic demand will place most of the tax burden upon the consumer, which is because they know it will not affect the demand for their product. This is most effective at increasing government revenue.
However, as the product has price inelastic demand, this is not effective at decreasing demand for a product.

Inelastic PED

Elasticity of demand and subsidies

A subsidy is a grant from the government to firms to encourage the production or consumption of a good or service.

If a product has price elastic demand, then the gain of a subsidy is mainly placed upon the producer. This is because a small drop in price causes a large increase to demand

If a product has price inelastic demand, then the gain of the subsidy is mainly placed upon the consumer. This is because a large drop in price only causes a small increase to demand.

Elastic PED

Inelastic PED

The relationship between PED and Total Revenue (TR)

Total Revenue = Price per unit x Quantity sold
TR = P x Q

Elasticity of demand changes along a straight-line demand curve:

-∞ at high price and zero demand; -1 at midpoint, 0 at free price and high demand.
Total revenue changes are shown on the n-shaped graph below as we move along the demand curve.
TR is maximised at PED = ±1.

A firm's revenue will increase when:

It raises the price of its inelastically demanded goods
It lowers the price of its elastically demanded goods

A firm's revenue will decrease when:

It lowers the price of its inelastically demanded goods
It raises the price of its elastically demanded goods