Economics - Price Elasticity of Demand (PED) and Income Elasticity of Demand (YED)

Price Elasticity of Demand (PED)

Definition

Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a product to a change in its price.

Formula

The basic formula for PED is:

PED = \frac{\% \text{ Change in Quantity Demanded}}{\% \text{ Change in Price}}

Alternatively, PED can be calculated as:

PED = \frac{Q2 - Q1}{Q1} / \frac{P2 - P1}{P1}

Where:

  • Q1 = Initial quantity demanded

  • Q2 = New quantity demanded

  • P1 = Initial price

  • P2 = New price

Example:

Given:

  • P1 = 10 \text{ francs}

  • P2 = 5 \text{ francs}

  • Q1 = 20 \text{ chocolates}

  • Q2 = 30 \text{ chocolates}

PED = \frac{30 - 20}{20} / \frac{5 - 10}{5} = \frac{10/20}{-5/5} = -0.5

Sign of PED

Price and quantity demanded are inversely related, resulting in a negative PED value. However, it is common practice to ignore the negative sign and consider PED as a positive number for easier comparison.

Example:
A PED of 3 is considered larger than a PED of 2.

Perfectly Inelastic Demand

If PED = 0, demand is perfectly inelastic. This means that the quantity demanded does not change regardless of price changes. This often occurs in the short run.

Perfectly Elastic Demand

When PED is infinite (\infty), demand is perfectly elastic. In this case, any change in price will result in an infinite change in quantity demanded.

Elastic Demand

Demand is considered elastic when the value of PED is greater than one (1 < PED < \infty).

Determinants of PED

Several factors influence the price elasticity of demand:

  1. Substitutes: Number and Closeness

    • A greater number of substitutes leads to more elastic demand.

    • Closer substitutes result in more elastic demand.

    Example: Pasta is produced by many farmers and has many substitutes. Rice can be used as a substitute. Therefore, pasta has a high PED.

  2. Degree of Necessity

    • Luxury goods have a higher PED.

    • Necessity goods (e.g., bread, butter, water) have a lower PED.

  3. Product Definition

    • Broadly defined products are more inelastic.

    • Specifically defined products are more elastic.
      Example: Food is inelastic when defined broadly. When broken down into meat, vegetables, and cereals makes it more elastic. Further categorization into type of meat, brands and etc. will make it very elastic.

  4. Proportion of Income Spent

    • Products that constitute a small proportion of income have inelastic demand.

    Example: A small price increase in daily Starbucks coffee may not affect quantity demanded for a high earner.

  5. Time Period

    • In the short term, PED is generally lower (inelastic).

    • In the long term, PED is generally higher (elastic) because consumers have more time to adjust their consumption habits.

Income Elasticity of Demand (YED)

Definition

Income elasticity of demand (YED) measures the responsiveness of the quantity demanded of a product to a change in consumer income.

Formula

YED = \frac{\% \text{ change in quantity demand of the product}}{\% \text{ change in the income of the consumer}}

YED = \frac{Q2 - Q1}{Q1} / \frac{Y2 - Y1}{Y1}

Where:

  • Q1 = Initial quantity demanded

  • Q2 = New quantity demanded

  • Y1 = Initial Income

  • Y2 = New Income

Income Inelastic YED

YED is inelastic if its value is between 0 and 1. This is typical for necessity goods.

Negative YED

YED is negative if its value is below 0. This is typical for inferior goods.

Income Elastic YED

YED is elastic if its value is greater than 1. This is typical for luxury goods.