Resources | Subject Notes | Economics
This section explores the relationship between price elasticity of demand (PED) and the total expenditure on a product. Understanding this relationship is crucial for businesses when making pricing decisions.
Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. It is calculated as:
$$PED = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}$$
The values of PED are typically categorized as follows:
Total expenditure is the total amount spent on a good or service. It is calculated as:
$$TE = \text{Price} \times \text{Quantity Demanded}$$
The relationship between PED and total expenditure is a key concept in economics. The following table summarizes the relationship for different types of demand:
| Demand Elasticity | Relationship between Price and Quantity | Effect on Total Expenditure |
|---|---|---|
| Elastic (PED > 1) | Quantity demanded is highly sensitive to price changes. | A decrease in price leads to a proportionally larger increase in quantity demanded, resulting in an increase in total expenditure. Conversely, an increase in price leads to a proportionally larger decrease in quantity demanded, resulting in a decrease in total expenditure. |
| Inelastic (PED < 1) | Quantity demanded is not very sensitive to price changes. | A decrease in price leads to a proportionally smaller increase in quantity demanded, resulting in a decrease in total expenditure. Conversely, an increase in price leads to a proportionally smaller decrease in quantity demanded, resulting in an increase in total expenditure. |
| Unit Elastic (PED = 1) | Quantity demanded changes proportionally to the change in price. | A decrease in price leads to an equal decrease in quantity demanded, leaving total expenditure unchanged. Conversely, an increase in price leads to an equal increase in quantity demanded, leaving total expenditure unchanged. |
Example: Consider a luxury good. If the price of a luxury good is high (and demand is inelastic), a small price decrease might not significantly increase the quantity demanded, leading to a small increase in total expenditure. However, if the price is low (and demand is elastic), a small price decrease could lead to a large increase in quantity demanded, resulting in a significant increase in total expenditure.
Businesses need to consider the PED of their products when setting prices. If a product has inelastic demand, a price increase may be a good strategy to increase total revenue. However, if a product has elastic demand, a price decrease may be a better strategy to increase total revenue.
It's important to note that PED is an approximation and can be affected by various factors, including the availability of substitutes, the proportion of income spent on the good, and the time horizon considered.