Price Elasticity of Demand

Price Elasticity of Demand

The responsiveness of quantity demanded to a given change in price

Price Elasticity of Demand equation

PED = (%∆Qd)/(%∆P) = (ΔQd/Qd)/(ΔP/P)

What shape is PED

negative and downward sloping

A rise in price will always lead to a fall in quantity demanded and vice versa.

Price Elastic

PED >1 - (e.g. (-)1.5, (-)5)
% change in demand is greater than the % change in price
Change in Qd is proportionately greater than change in Price
Extreme: if PED = ∞, then it is perfectly elastic

Price Inelastic

PED <1 - (e.g. (-)0.5, (-)0.1)
% change in demand is less than the % change in price
Change in Qd is proportionately less than change in Price
Extreme: if PED = 0, then it is perfectly inelastic

Unit elasticity

PED = (-)1
% change in demand is the same as the % change in price
Change in Qd is proportionately equal to change in Price

PED diagram inelastic

PED diagram elastic

Factors determining PED

The availability of close substitutes
Branding
Luxury of necessity
The proportion of income spent on the product
Whether the purchase can be postponed
The time period under consideration

The availability of close substitutes

If the price of a product goes up people will look to switch to alternative products
The more substitutes available for a product, the greater the PED
The closer the substitutes, the greater the PED

Branding

The stronger the brand image, the greater the brand loyalty
Hence the less likely other g/s will be seen as acceptable substitutes
Requires substantial advertising, sponsorship, etc

Luxury or necessity

how essential a product is will determine its PED
Luxuries have a more price elastic demand as they do not have to be consumed
Necessities must be consumed, and are therefore inelastic

The proportion of income spent on the product

The larger the expense, the greater the effect on an individual's remaining real income
Consumers will notice price rises on products which take more of their income (e.g. petrol) - hence demand will be elastic
But they may not notice, nor be too concerned about, price rises on cheap products which are bought infrequently (e.g. salt) - hence demand will be inelastic

Whether the purchase can be postponed

How urgent the purchase is affects PED
Consider buying a new TV or car to replace an old one
If not an emergency, consumers can delay the purchase while they seek cheaper alternatives, so PED will be high
If more urgent, consumers can't delay the purchase and will likely be willing to pay more for a replacement, so PED is low

The time period under consideration

The more time available, the greater the opportunity for demand to adjust
Consumers respond more strongly to a price rise in the long-run than in the short-run (i.e. need time to adjust)
Usually where some other factor (like a complement or a long-term contract) has tied consumers into buying the good for the time being

Relevance of PED to Firms

Key Point: Firms need to know what the PED of their product is for their market in order to reduce risk and uncertainty.

Sales forecasting
Life cycle of product
The effects of marketing
Pricing policy

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR).
For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.

Life cycle of product

PED will vary according to where the product is in its life cycle.
When new products are launched, there are often very few competitors and PED is relatively inelastic.
As other firms launch similar products, the wider choice increases PED.
Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common.

The effects of marketing

Firms may use persuasive marketing to win new customers and retain the loyalty of existing ones.
Marketers use a range of media including television, press, word of mouth, and social media.
Marketing increases demand and lowers PED

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price.

Revenue

The income a firm generates from selling its output. TR = P x Q

Changes in total revenue are influenced by PED

If PED is elastic i.e. >1 a rise in price will cause total revenue to fall and vice versa
If PED is inelastic i.e. <1 a rise in price will cause total revenue to rise and vice versa
Therefore, the total revenue depends on the PED of the good or service