Price Elasticity of Demand (PED)

Main Influences on Whether Demand is Elastic or Inelastic

Price elasticity of demand (PED) measures how much the quantity demanded of a good changes in response to a change in its price. Understanding the factors influencing PED is crucial for businesses and policymakers.

PED is calculated as:

$$PED = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$$

The value of PED can be categorized as follows:

• Elastic Demand: $|PED| > 1$ (Quantity demanded changes by a larger percentage than the price change)
• Inelastic Demand: $|PED| < 1$ (Quantity demanded changes by a smaller percentage than the price change)
• Unit Elastic Demand: $|PED| = 1$ (Quantity demanded changes by the same percentage as the price change)

Factors Influencing PED

Several factors determine whether the demand for a good is elastic or inelastic. These factors can be broadly categorized into:

• Availability of Substitutes
• Necessity vs. Luxury
• Proportion of Income Spent on the Good
• Time Horizon

1. Availability of Substitutes

The availability of substitute goods is a primary determinant of PED.

• Many Close Substitutes: Goods with many close substitutes tend to have elastic demand. If the price of one good increases, consumers can easily switch to a substitute. Example: Different brands of coffee.
• Few or No Substitutes: Goods with few or no close substitutes tend to have inelastic demand. Consumers have limited options if the price increases. Example: Life-saving medication.

2. Necessity vs. Luxury

Whether a good is considered a necessity or a luxury significantly impacts PED.

• Necessities: Goods considered necessities (essential for survival or well-being) generally have inelastic demand. People will continue to buy them even if the price increases. Example: Food, water, basic clothing.
• Luxuries: Goods considered luxuries (not essential) generally have elastic demand. Consumers are more likely to reduce or forgo purchases if the price increases. Example: Expensive jewelry, luxury cars.

3. Proportion of Income Spent on the Good

The proportion of a consumer's income spent on a good influences PED.

• Large Proportion of Income: Goods that represent a large proportion of a consumer's income tend to have elastic demand. Price changes have a significant impact on consumer purchasing decisions. Example: Housing, fuel.
• Small Proportion of Income: Goods that represent a small proportion of a consumer's income tend to have inelastic demand. Price changes have a less significant impact. Example: Salt, pepper.

4. Time Horizon

PED can change over time.

• Short Run: In the short run, demand may be more inelastic as consumers have limited time to adjust their consumption habits or find substitutes.
• Long Run: In the long run, demand tends to be more elastic as consumers have more time to find substitutes or adjust their behavior. Example: If the price of petrol increases, in the short run people may still need to travel the same amount. However, in the long run, they might choose to buy more fuel-efficient cars, move closer to work, or use public transport.

Factor	Influence on PED	Example
Availability of Substitutes	Many substitutes increases PED; Few/no substitutes decreases PED	Coffee (many substitutes) vs. Life-saving medication (few substitutes)
Necessity vs. Luxury	Necessity decreases PED; Luxury increases PED	Food (necessity) vs. Luxury cars (luxury)
Proportion of Income	Large proportion increases PED; Small proportion decreases PED	Housing (large proportion) vs. Salt (small proportion)
Time Horizon	Short run tends to decrease PED; Long run tends to increase PED	Petrol price increase (short run - limited options) vs. Petrol price increase (long run - alternative transport)

Understanding these factors is essential for businesses when making pricing decisions and for policymakers when considering the impact of taxes and subsidies.