Price Elasticity of Demand (PED)

Price elasticity of demand (PED) is a measure of how much the quantity demanded of a good changes in response to a change in its price. It is a crucial concept in economics as it helps firms understand how their sales will be affected by price changes and how consumers react to price fluctuations. Understanding PED is vital for making informed pricing decisions.

Calculating PED

PED is calculated using the following formula:

$$PED = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}$$

The percentage change in quantity demanded is calculated as: $$ \frac{\text{New Quantity} - \text{Old Quantity}}{\text{Old Quantity}} \times 100$$

Similarly, the percentage change in price is: $$ \frac{\text{New Price} - \text{Old Price}}{\text{Old Price}} \times 100$$

Types of Demand

Based on the PED value, demand can be classified into three main types:

• Elastic Demand: PED > 1. A significant change in quantity demanded occurs with a small change in price.
• Inelastic Demand: PED < 1. A small change in quantity demanded occurs with a large change in price.
• Unit Elastic Demand: PED = 1. The percentage change in quantity demanded is equal to the percentage change in price.

PED and Revenue

The relationship between PED and a firm's revenue is fundamental. The firm's revenue is calculated as Price x Quantity. The effect of a price change on revenue depends on whether the demand is elastic, inelastic, or unit elastic.

Demand Type	Price Change	Percentage Change in Quantity	Percentage Change in Price	Effect on Revenue
Elastic	Price Increase	Large Decrease	Small Increase	Revenue Decreases
Elastic	Price Decrease	Large Increase	Small Decrease	Revenue Increases
Inelastic	Price Increase	Small Decrease	Large Increase	Revenue Increases
Inelastic	Price Decrease	Small Increase	Large Decrease	Revenue Decreases
Unit Elastic	Price Change	Equal Percentage Change	Equal Percentage Change	Revenue Remains Unchanged (Ideally)

Examples

Example 1: Luxury Goods

The demand for luxury goods like designer clothing is often elastic. If the price of a designer handbag increases, consumers are likely to buy fewer handbags and switch to cheaper alternatives. Therefore, the firm's revenue will decrease.

Example 2: Necessities

The demand for necessities like food and medicine is often inelastic. Even if the price of these goods increases, consumers will continue to buy them. Therefore, the firm's revenue will increase.

Factors Affecting PED

Several factors can influence the PED of a good:

• Availability of Substitutes: More substitutes lead to more elastic demand.
• Necessity vs. Luxury: Necessities tend to have inelastic demand.
• Proportion of Income Spent: Goods that represent a large proportion of a consumer's income tend to have more elastic demand.
• Time Horizon: Demand tends to become more elastic over longer time horizons as consumers have more time to adjust their consumption habits.

Conclusion

Understanding PED is essential for firms to make informed pricing decisions. By analyzing the PED of their products, firms can predict how changes in price will affect their revenue and adjust their pricing strategies accordingly. A firm needs to consider the elasticity of demand when deciding whether to raise or lower prices.