Price elasticity of demand | Economics for Grade 12 PDF Download

The Definition & Calculation of PED

• The law of demand states that when there is an increase in price, there will be a fall in quantity demanded
  • Economists are interested by how much the quantity demanded will fall
• Price elasticity of demand reveals how responsive the change in quantity demanded is to a change in price
  • The responsiveness is different for different types of products

Calculation of PED

• PED can be calculated using the following formula
  
• To calculate a % change, use the following formula
  

Example: A firm raises the price of its products from £10 to £15. Its sales fall from 100 to 40 units per day. Calculate the PED of its products

Step 1:  Calculate the % change in QD

Step 2: Calculate the % change in P

Step 3: Insert the above values in the PED formula

PED = -60/50
PED = -1.2
The PED value will always be negative so economists ignore the sign and present the answer as 1.2

Interpreting PED Values

The Size of PED Varies From 0 To Infinity (∞) & Is Classified As Follows

The Determinants of PED

• Some products are more responsive to changes in prices than other products
• The factors that determine the responsiveness are called the determinants of PED & include:
  • Availability of substitutes: good availability of substitutes results in a higher value of PED (relatively elastic)
  • Addictiveness of the product: addictiveness turns products into necessities resulting in a low value of PED (relatively inelastic)
  • Price of product as a proportion of income: the lower the proportion of income the price represents, the lower the PED value will be. Consumers are less responsive to price changes on cheap products (relatively inelastic)
  • Time period: In the short term, consumers are less responsive to price increases resulting in a low value of PED (relatively inelastic). Over a longer time period consumers may feel the price increase more and will then look for substitutes resulting in a higher value of PED (relatively elastic)

PED & Total Revenue

• Revenue is the amount of money a firm receives from selling its goods/services
  • Total revenue = price x quantity
• The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are inelastic in demand & decrease prices on products that are elastic in demand 
• This can be illustrated using a demand curve
  

An illustration of price elastic demand where a small decrease in price from P₁→P₂ causes a large increase in quantity demanded from Q₁→ Q₂

Diagram Analysis

• The demand curve is very elastic in this market
• When a good/service is price elastic in demand, there is a greater than proportional increase in the quantity demanded to a decrease in price
• Total revenue is higher once the price has been decreased
  (P₂ X Q₂) > (P₁ X Q₁)
  

An illustration of price inelastic demand where a large increase in price from P₁→P₂ causes a small decrease in quantity demanded from Q₁→ Q₂

Diagram Analysis

• The demand curve is very inelastic in this market
• When a good/service is price inelastic in demand, there is a smaller than proportional decrease in the quantity demanded to an increase in price
• Total revenue is higher once the price has been increased
  (P₂ X Q₂) > (P₁ X Q₁)

Example: A firm raises the price of its products from £10 to £15. Its sales have fallen from 100 to 40 units per day. Explain if they made the correct decision

Step 1: Calculate the initial sales revenue

Sales Revenue = Price of product  X  Quantity sold
= £ 10 x  100
= £ 1,000

Step 2: Calculate the sales revenue after the price change

Sales Revenue = Price of product  X  Quantity sold
= £ 15 x  40
= £ 600

Step 3: Explain the decision
By raising the price, the total revenue has fallen by £400. This indicates that the product is price elastic in demand and the firm should have lowered their price in order to maximise revenue

The Implications of PED for Stakeholders

• Knowledge of PED is important to firms seeking to maximise their revenue
  • If their product is price inelastic in demand, they should raise their prices
  • If price elastic in demand, then they should lower their prices
  • Firms can choose to use price discrimination to maximise their revenue i.e. lower prices for certain segments & higher prices for others
• Knowledge of PED is important to Governments with regard to taxation and subsidies
  • If they tax price inelastic in demand products, they can raise tax revenue without harming firms too much
  • Consumers are less responsive to price changes so firms will pass on the tax to the consumer
  • If Governments subsidise price elastic in demand products, there can be a greater than proportional increase in demand