Price Elasticity of Demand: Explained with Diagrams

Definition

Price Elasticity of Demand (PED) is a measure of the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus. It is a key concept in economics that helps us understand how changes in price affect consumer behavior.

The formula for PED is:

Interpreting PED

The sign of PED is typically negative due to the Law of Demand, which states that if there is an increase in the price of a good, there will be a fall in quantity demanded of the good (inverse relationship between price and quantity demanded). Hence, we are more concerned with the magnitude of absolute PED, as it indicates whether the demand for a good is price elastic or inelastic. The larger the magnitude of PED, the more sensitive consumers are to changes in price of the good. We focus on the two main cases: price elastic demand (|PED|> 1) and price inelastic demand (|PED|< 1).

1. Price elastic demand (|PED| > 1):

• Consumers are highly responsive to price changes: A fall (rise) in the price of a good leads to a more than proportionate increase (decrease) in quantity demanded.

1. Price inelastic demand (|PED| < 1):

• Consumers are less responsive to price changes: A fall (rise) in the price of a good leads to a less than proportionate increase (decrease) in quantity demanded.

Factors Affecting PED

1. Availability of substitutes:

• Goods with many close substitutes tend to have price elastic demand because consumers can easily switch to another product if the price of the good rises.

• Availability of substitutes may be affected by how the market is defined. For example, the market for tea would have more price elastic demand than the market for beverages, since beverages is a wider market.

1. Habituality of consumption

• Goods that are consumed habitually tend to be price inelastic, since consumers continue to buy these goods regardless of price changes.

• The more addictive a good is, the more price inelastic its demand. 

1. Proportion of income:

• Goods that take up a large proportion of income tend to have price elastic demand, since a given percentage increase of the price will take up a significant amount of the consumer’s income.

• Vice versa, goods that take up a small proportion of income tend to have price inelastic demand.

1. Time period:

• In the short term, demand is often more price inelastic because consumers need time to adjust their behaviour.

• In the long term, demand becomes more price elastic as consumers are able to find alternatives and change their habits.

Examples of Price Elastic and Inelastic Goods

Price Elastic Goods

• Electronics (e.g. TV, laptop) : Many substitutes and takes up a large proportion of income

• Clothing: Many close substitutes

Price Inelastic Goods

• Prescription medication: Few substitutes available

• Staple food items (e.g. rice): Habitually consumed and takes up small proportion of income

Graphical Representation & Impact on Revenue

Price Elastic Demand Curve

A price elastic demand curve has a gentle slope, indicating that a small increase in price results in a more than proportionate decrease in quantity demanded. This reduces total revenue, since P0*Q0 > P1*Q1. Conversely, a decrease in price leads to a proportionally larger increase in quantity demanded, increasing total revenue.

Price Inelastic Demand Curve

An inelastic demand curve is relatively steeper, indicating that an increase in price results in a less than proportionate decrease in quantity demanded. This increases total revenue, since P0*Q0 < P1*Q1. Conversely, a decrease in price leads to a proportionally smaller increase in quantity demanded, reducing total revenue.

Government Policies and PED

Governments also consider PED when imposing taxes. For goods with price inelastic demand, higher taxes can generate significant revenue without substantially reducing consumption. For goods with elastic demand, higher taxes may lead to a significant drop in consumption, reducing tax revenue.

Conclusion

Price Elasticity of Demand (PED) is a fundamental concept that helps explain consumer responsiveness to price changes. By understanding whether demand for a good is price elastic or inelastic, businesses can make informed pricing decisions, and governments can design effective tax policies. Factors such as the availability of substitutes, habituality of consumption, proportion of income, and time period significantly influence the PED, making it a crucial element in economic analysis and decision-making.