Price Elasticity of Demand

A-level Economics

What it is. How it is calculated. What affects it. How it affects Demand/Supply Diagrams.

Definition:

Price Elasticity of Demand [PED] – “measures how sensitive consumer demand is to a change in prices.”

It shows us how big a factor price is when people buy things.

Elastic Demand: This is when people are very sensitive to price changes. So, if the price of a good or service goes up by a small amount, then the demand will go down by a larger amount.

Example: The price of a laptop goes up by 20%. Let’s assume that the elasticity of demand for laptops is elastic. This will mean that the demand for laptops will fall by more than 20%

Inelastic Demand: This is when people are not very sensitive to price changes. So, if the price of a good or service goes up by a large amount, the demand will fall by a smaller amount.

Example: The price of petrol goes up by 20%. Let’s assume that the elasticity of demand for petrol is inelastic. This will mean that the demand for petrol will fall by less than 20%.

How do you calculate PED?

It is calculated using the following formula:

% change in Qty Demanded / % change in Price = PED

The figure you get from your calculation will tell you a story about the demand for the good or service.

PED = 1 (You have unit elasticity. Your good or service has perfectly proportional price and qty. If price goes up by 10%, then quantity demanded will fall by 10%)
PED larger than 1: [Your good or service is elastic. Consumers are sensitive to price changes. Quantity demand changes significantly when price is changed.]
PED between 0 and 1: [Your good or service is inelastic. Price is not such a big factor in the market for this good or service. Quantity demanded will not change significantly when price is changed.

What are the factors of PED? What makes something elastic or inelastic?

Necessity vs Luxury: Necessities will often be inelastic. Price is not such a big factor for a necessity because even if the price changes, you still need it. An example of this is fuel for your car. If you travel to work by car, then even if petrol rises in price you will not change your consumption by much because you still need to travel to work. In the case of a luxury item, such as perfume for example, this will not be the case. If the price goes up then quantity demanded will fall significantly [in general].
Brand Loyalty: In some cases, being loyal to a brand will make you less sensitive to price changes. Apple’s iPhone is generally more expensive than the competition, and when they raise their prices, their consumers still continue to buy iPhones.
Proportion of income: if a good has a low price in relation to your income [e.g. matchsticks], then a change in the price of this good will not affect quantity demanded by much. This is because it is already cheap in the first place. If matchsticks rise in price from 50p to 70p, this is a 40% price rise. This seems like a lot. But in reality it is only 20p. Most consumers will continue to buy matchsticks as they did before. There will certainly not be a fall in quantity demanded that exceeds 40%. If, for example, a house goes up by 5%, this could be £10,000 or more. This would have a significant effect on your demand for a house because £10,000 is a large chunk of your annual income.
Availability of Substitutes: If a good has no decent or viable alternatives, then if the price goes up, what do you do? You can’t go anywhere else for this good or service so you have to pay the price if you want it. An example of this is Royal Mail. Clearly, this company is a monopoly power. When Royal Mail increases their price of stamps, consumers have to pay it because nobody else offers the service.
Habitual consumption and addiction: A good example if alcohol or cigarettes. Demand is not significantly affected when there are price increases because people are creatures of habit. People have got used to going to pubs and bars and is a way they socialise with other people. So in general, people will continue to consume alcohol. Cigarettes are a similar story. A cigarette habit quickly turns into an addiction which makes them price inelastic. One criticism of the government is that they tax cigarettes heavily, claiming that they are trying to reduce consumption. But people continue to smoke because they are addicted. Therefore, some believe that government taxes on cigarettes is nothing more than a money making scheme.
Time period: The longer people have to notice and respond to prices, the more elastic their demand will be. In the short-term, you may not notice the price change of a good/service but over time you are more likely to notice and adapt your expectations of the price for that particular good. An example is taxi fares. Since the launch of Uber, people use an app for catching taxis which is usually significantly cheaper than calling a taxi company. As time goes by, people will become more used to Uber’s prices and will gradually become more price sensitive to traditional taxi fares.
Peak and Off Peak Demand: During peak periods [e.g. early morning trains], people are prepared to pay higher prices. Another example is holidays. Holidays are almost always more expensive after schools close because that’s the only time in the year when families can go together on holiday. So the companies take advantage of this and put prices up, knowing most people will continue to pay.

How does PED affect firms' revenues and their decision making?

PED is a powerful tool for companies to make use of. They can use this data to plan their future strategies in terms of pricing.

If PED is inelastic, then firms are more likely to increase prices. This is because they know that sales are not likely to fall by much. The price increase is more significant than the fall in demand. So this will lead to higher revenues.

[If the firm reduces their price and price is inelastic, then demand, again, will not increase by much. So it makes no sense for the firm to reduce their prices when they know price is inelastic.]

If PED is elastic, then firms are more likely to reduce prices. This is because they know that a small decrease in price will lead to a massive change in demand. The price decrease is outweighed by the larger change in demand. So this will lead to higher revenues.

[If the firm increases their price and price is inelastic, then demand will be massively affected in a negative way. They could end up losing a huge proportion of their customers and it will mean that revenues fall.

If PED is unit elastic, then the firm will have maximised its revenue. If it puts prices up or down, the firm will lose money.