Price Elasticity

Elasticity

Price Elasticity of Demand Formula

PED =           % Change in Quantity Demanded                        % Δ in QD

                              % Change in Price                                         % Δ in P

Price elasticity of demand can be defined as the responsiveness of quantity demanded to a change in price.

If demand is elastic then a small change in price will result in a larger change in quantity demanded i.e. Responsive

If demand is inelastic then a large change in price will result in a smaller change in quantity demanded i.e. Unresponsive

For example

Holidays Abroad 25% rise in QD, 10% fall in P = -2.5 (Responsive, Elastic)

Cigarettes 10% fall in QD, 45% increase in P  = -0.22 (Unresponsive, inelastic)

In both cases, and indeed all situations of Price Elasticity of Demand, a negative figure is calculated. This is because of the inverse relationship between price and quantity demanded, i.e. as price falls the quantity demanded rises. (Economists ignore this sign)

For holidays abroad a value greater than one (2.5) is obtained, this suggests that the product is responsive or relatively elastic. For cigarettes a value of less than one (0.22) is obtained, this suggests that the product is relatively unresponsive or inelastic to price changes.

Where a product is bought in the same quantity irrespective of the price charged it is referred to as being perfectly inelastic.

0% fall in QD, 55% rise in P, PED  = 0 (Perfectly inelastic)

Therefore when PED is equal to 0, demand is perfectly inelastic.

However if price falls in figure 15 from P1 to P2, so that D becomes infinite, i.e. people will buy all that is available, then the product is deemed to be perfectly elastic, i.e. responsive to changes in price.

∞ % fall in QD, 25% rise in P    =  ∞    (Perfectly elastic)

Thus, if the PED is equal to ∞, then the good is perfectly elastic.

Unitary Elasticity

If the rise in price is matched by an equal fall in quantity demanded, then the PED is equal to  – 1. When PED is equal to –1 it is said to have a unitary elasticity over that price range.

Factors that influence Price Elasticity of Demand

There are 4 key factors that influence price elasticity of demand

1. The range and attractiveness of substitutes

The greater the number of substitutes, and the greater the closeness of these substitutes, the more responsive economists would expect consumers to be to a price change. In other words they will buy alternative products when the price rises.

Branding can reduce the closeness of substitutes, and thus the PED will be reduced.

2. Necessity or Habit Forming

The degree to which people consider the product to be a necessity, and whether the product has any addictive properties, i.e. whether it is habit forming. The greater these properties the more likely the product is to be price inelastic.

3. Proportion of Income taken by Product

A rise in price will reduce the purchasing power of an individual. The larger the proportion of someone’s income a product makes up, the more responsive an individual will be to a price change. On the other hand, a product representing a small proportion of income will not be responsive to a change in price.

For example a box of matches rise by 30 per cent in price, from 10p to 13p, demand would not fall by as much. Thus the product is relatively inelastic.

4. Time

In the short-term, for example weeks or months, people or firms might find it hard to react to a change in price, as they are trying to find new suppliers. However if the price goes up and remains high, then consumers will be more inclined to find alternatives suppliers.