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Price Elasticity of Demand

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.
  • Law of Demand: As price increases, quantity demanded generally falls, but responsiveness varies.
    • Elasticity Variation:
    • Products with many substitutes (e.g., bananas, soft drinks) show higher elasticity (larger demand change).
    • Products with fewer substitutes (e.g., petrol, toothpaste) show lower elasticity (smaller demand change).

Types of Demand

  • Price Inelastic Demand:
    • Definition: Demand that is unresponsive to changes in price.
    • Example: Rice in Asia (low sensitivity to price changes).
  • Price Elastic Demand:
    • Definition: Demand that is highly responsive to price changes.
    • Example: Soft drinks (substitute availability leads to large demand changes).

Calculating PED

  • Formula:
    \text{PED} = \frac{% \Delta QD}{% \Delta P}
    where ( % \Delta QD ) is the percentage change in quantity demanded and ( % \Delta P ) is the percentage change in price.
  • Example Calculation:
    • Cinema Tickets Example:
    • Price increase from $10 to $11 (10% increase).
    • Demand falls from 3500 to 3325 tickets (5% decrease).

    • \text{PED} = \frac{-5}{10} = -0.5
    • Result shows price inelastic demand (less responsive).

Interpreting PED Values

  • PED < 1 (Ignoring minus sign): Demand is price inelastic.
  • PED > 1 (Ignoring minus sign): Demand is price elastic.
  • PED = 0: Perfectly price inelastic (demand unchanged with price change).
  • PED = ∞: Perfectly price elastic (demand falls to zero with small price increase).
  • PED = 1 (Unitary Elastic): Demand reacts proportionately to price change.

Determinants of PED

  1. Substitution Availability: More substitutes lead to higher elasticity.
  2. Income Proportion: Higher proportion of income spent on a product leads to more elastic demand.
  3. Necessity vs. Luxury: Essential products are often price inelastic; luxury items are more elastic.
  4. Habits/Addictions: Habit-forming products (like tobacco) tend to be inelastic.
  5. Advertising/Brand Loyalty: Strong brands create inelastic demand.
  6. Time Frame: Demand tends to become more elastic over time as consumers find substitutes.
  7. Durability: Non-perishable goods tend to have more elastic demand compared to perishable goods.
  8. Switching Costs: High costs to switch to substitute products can make demand inelastic.
  9. Broad Definition vs. Specific: General categories (e.g., food) have more inelastic demand than specific items (e.g., a specific type of fruit).

Relationship Between PED and Total Revenue

  • Sales Revenue Formula:
    \text{Sales Revenue} = \text{Price} \times \text{Quantity Demanded}
  • Implications for Pricing Strategy:
    • If demand is inelastic, increasing price raises total revenue.
    • If demand is elastic, decreasing price increases total revenue.
  • Example Application: If laptops' price decreases, and demand increases significantly, total revenue may increase due to high elasticity:
    1. Original revenue ($700 x 5000) = $3.5M.
    2. New price ($650 x 5500) = $3.575M (increase in revenue).

Significance of PED for Decision Makers

  • Producers: Determine pricing strategy based on how demand reacts to price changes.
  • Government: Policies on taxation can depend on the elasticity, targeting inelastic goods ensures revenue without severe demand drops.
  • Price Discrimination: Firms may charge different prices based on consumer elasticity.
    • Example: Theme parks charge different prices for adults versus children.

Exam-Style Questions

  1. Calculate PEM for various product scenarios based on given price and quantity changes.
  2. Discuss implications of PED knowledge for business strategies and government policies.