Price Elasticity of Demand

P.E.D
The tool through which we measure the price sensitivity of the consumers is called
Price ELASTICITY of Demand.

PED is a measure of the degree of responsiveness of quantity demanded of a

product following a change in price.

We can understand this responsiveness via rubber bands- one which is tight & the
other which is loose such that for the same amount force, one stretches less while
the other stretches more.

Similarly, due to a small change in price, some sensitive consumers will react a lot by
changing their quantity demanded by a significant amount whereas some
consumers may not respond at all and keep demanding the same quantity.
 Sensitivity/Reaction of Consumers explained
• Extremely sensitive/reactive consumers: if a price of a good increased by a small
amount but consumers decreased their quantity demanded by a lot. Example: A young
students who buys milk in college as his parents ask him to.

• Not so sensitive/reactive consumers: price of a good increased by a small amount but

consumers but consumers also decreased their quantity demanded by a small amount.
Milk bought by a middle aged man.

• Insensitive/non-reactive consumers: price of a good increased by a small amount but

consumers did not change their quantity demanded at all. Milk bought for feeding
babies.

However these are VAGUE statements, so to be precise, we can measure elasticity and
reach a more precise conclusion.
 Calculation of P.E.D
P.E.D is calculated as % change in quantity / % change in price

- We take % so that we get free of the unit & get a

pure number which helps us compare elasticities
across goods & services

- PED is not equal to slope though they both are reflecting the steepness of the
curve because a slope reflects an absolute change (Δq/Δp) whereas elasticity
reflects a relative change through %

- We see that the PED had a negative sign– it means that the dd curve is
downward sloping– because qty demanded is decreasing

- The range of PED varies from 0 to ∞

Let’s assume that the price of milk changed from B 20 to B 25. Thus P0=20 & P1=25
Now, let’s take different cases of consumer sensitivity/Reaction:
1. Rich consumer→ Q0= 10lts & Q1=9 lts
P.E.D= (-)0.4→ Highly Inelastic

2. College Student→ Q0= 5lts & Q1= 3lt

P.E.D= (-)1.6→ Highly Elastic

3. Baby→ Q0=3lts Q1=3lts lts Then P.E.D= 0→ Perfectly Inelastic (0 divided by anything is
zero)

4. School Student→ Q0= 8 lts & Q1= 6lts Then P.E.D=(-)1→ Unitary elastic

5. Perfectly Elastic is when PED= infinity

E
goods with perfectly elastic demand are ones
where demand goes down to zero with any
increase in price no matter how small i.e.
quantity demanded goes through an infinite
change

It is an extreme case and real life examples are

rare in such a scenario as it would happen in
markets with PERFECT Competition.

Vegetable/ Fruit Vendors located on a street. - So

here all these vendors have to keep an almost
same price to get the demand; if any of them
would increase their price people would tend to
move to another vendor. So such vendor faces a
perfectly elastic demand curve.
This shape of
demand curve
is also known
as
Rectangular
Hyperbola
PED & Total Revenue
Price Change Inelastic Unitary Elastic
Increase Revenue Revenue Revenue
rises remains falls
same
Decrease Revenue Revenue Revenue
falls remains rises
same
 PRACTICE
https://mru.org/practice-questions/calculating-elasticity-demand-practice-questions

Question 1
Work out the PED for each, and comment on your result.

a. The price of a smartphone is currently £200, and the quantity demanded is 4m. Next
year the price falls to £180 and the quantity demanded rises to 6m.

b. The price of pens today is £1, and the quantity demanded is 1m. Next year the price
rises to £1.10 and the quantity demanded falls to 950,000.

c. The price of a daily newspaper today is £1.50p, and the quantity demanded is 2m.
Next year the price falls by 30p and the quantity demanded rises to 2.2m
Question 2
RCO Manufacturing is an electronics manufacturer and retailer. Its main products are ultrabook
computers, PCs and calculators. The current price of the ultrabook is £500, the PC is £800 and the
calculator is £40. This year the firm sold 10,000 ultrabooks, 20,000 PCs and 1 million calculators.

In an attempt to improve revenue the managers of the firm have decided to increase all prices by
10%. Market research has suggested that the price elasticity of demand for each product is:

Ultrabook: (-) 1.5; PC : (-) 2.5; calculator: (-) 0.6

You have been asked to evaluate the planned price increases.

Comment on the planned price changes.

Would a 10% price reduction have been better for some or all of the products?
What benefit (if any) would advertising bring to the firm?

(You should support any arguments with calculations.)

 Uses/Importance of PED
1. Helps make business decisions as revenues at different price points can
be estimated
Price Change Inelastic Unitary Elastic

Increase Revenue rises Revenue remains Revenue falls

same
Decrease Revenue falls Revenue remains Revenue rises
same

2. Helps a monopolist to charge differently in different markets ( high price

in inelastic demand & low in elastic market) Market for sticky rice is
highly elastic in Thailand but can be highly inelastic in some part of India
as not many substitutes would be available
3. If a firm produces a product with elastic demand then it would not be able to increase
wages as it would lead to increase in the cost of production which would further lead
to an increase in price. This would lead consumers to shift to substitute products. The
firm may however fire some workers & thereby increase wages of the rest such that
they get motivated to produce more but then this would lead to rise in
unemployment in the economy.
(write for inelastic product)

4. It helps govt take decision on taxes-

a. Determine the amount of tax: high taxes on inelastic goods and low taxes on elastic
goods
b. Determine tax burden/incidence of taxation- if inelastic then most of the tax burden
will fall on consumers but if elastic then most of the tax burden will fall on producers.
 Factors affecting PED
1. Availability of substitutes- Airlines, Nescafe vs Bru, Butter & Jam

2. Nature of commodity- necessity (food, fuel, medicines) or luxury (perfumes,

Audi car)

3. Proportion of income spent on the good- small (soap, salt- even a high % Δin
price doesn’t affect the qty demanded much); large (overseas holiday- even a
small %Δ in price can affect qty dd highly)

4. Breadth of definition of the product- food, clothes then very inelastic as no

real substitute is available but Zara, H&M etc. would have high no. of
substitutes
5. Time at which good is sold- fresh flowers on valentine’s day & mother’s day

6. Time under consideration- more price elastic in long run- over time consumers may
develop taste of organic food such that its dd rises and thus substitutes in the market
rise. At one point of time there was no substitute for sugar for diabetic people but now
there is sugar free tablets

7. Durability of a good which has possibility of postponing the consumption- TV v/s

perishable goods like fruits

8 Habits, addictions, fashion & tastes along with marketing/advertising- tobacco,

smartphones & brand loyalty- inelastic