The price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a good or service to a change in its price. It’s a key concept in economics that helps understand how changes in price affect consumer behavior and the overall demand for a product. The formula for calculating price elasticity of demand is:
\[ \text{Price Elasticity of Demand (PED)} = \frac{\%\, Change\, in\, Quantity\, Demanded}{\%\, Change\, in\, Price} \]
Determinants of Price Elasticity of Demand
Several factors influence the price elasticity of demand for a product:
1. **Substitutability**: Goods with close substitutes tend to have a more elastic demand because consumers can easily switch to another product if the price rises. For example, if the price of Coca-Cola increases, consumers might switch to Pepsi.
2. **Proportion of Income**: Products that represent a large proportion of a consumer’s income tend to have more elastic demand. For instance, demand for automobiles or houses is more sensitive to price changes than demand for low-cost items like toothpaste.
3. **Necessity vs. Luxury**: Necessities tend to have inelastic demand because consumers need to buy them regardless of price changes. In contrast, luxuries have elastic demand since consumers can postpone or avoid purchases if prices increase. For example, insulin has inelastic demand, whereas demand for high-end electronics is more elastic.
4. **Time Horizon**: Demand is generally more elastic over the long term than the short term. Consumers need time to adjust their behavior in response to price changes. For instance, if gasoline prices increase suddenly, demand may initially be inelastic since consumers can’t immediately change their commuting habits. Over time, as they find alternatives like carpooling or public transportation, demand becomes more elastic.
5. **Addictiveness**: Products that are addictive tend to have inelastic demand because consumers continue to buy them even if prices increase significantly. Tobacco products are a classic example.
– **Inelastic Demand (e < 1):** Demand changes less than proportionally to changes in price.
– **Unitary Elastic Demand (e = 1):** Demand changes exactly proportionally to changes in price.
– **Elastic Demand (e > 1):** Demand changes more than proportionally to changes in price.
– **Perfectly Inelastic Demand (e = 0):** Demand does not change regardless of changes in price.
– **Perfectly Elastic Demand (e = ∞):** Demand is infinitely sensitive to changes in price, represented by a horizontal line indicating that a small price change leads to an infinite change in the quantity demanded.
Examples of Price Elasticity of Demand
1. **Elastic Demand Example**: Suppose the price of a brand of ice cream decreases by 10%, and as a result, the quantity demanded increases by 20%. The price elasticity of demand would be:
\[ \text{PED} = \frac{20\%}{-10\%} = -2 \]
This negative value indicates that the demand for ice cream is elastic; a decrease in price leads to a proportionally larger increase in quantity demanded.
2. **Inelastic Demand Example**: Consider a situation where the price of salt increases by 5%, but the quantity demanded decreases by only 1%. The price elasticity of demand would be:
\[ \text{PED} = \frac{-1\%}{5\%} = -0.2 \]
Here, the demand for salt is inelastic, meaning a price increase does not significantly reduce quantity demanded.
3. **Unit Elastic Demand Example**: If the price of a certain type of coffee increases by 10% and the quantity demanded decreases by 10%, the price elasticity of demand is:
\[ \text{PED} = \frac{-10\%}{10\%} = -1 \]
This indicates that the demand for this coffee is unit elastic; the percentage change in quantity demanded is exactly the same as the percentage change in price.
Understanding price elasticity is crucial for businesses and policymakers. It helps businesses set prices to maximize revenue and profits and aids policymakers in assessing the impact of taxes, subsidies, and other economic policies on demand for goods and services.
Read next: Methods to calculate price elasticity of demand (PED)
