Resources | Subject Notes | Economics
Price elasticity of demand (PED) is a measure of how much the quantity demanded of a good or service changes in response to a change in its price. It is a crucial concept in economics as it helps businesses understand how their sales will be affected by price fluctuations and how consumers react to changes in price. Understanding PED is vital for firms when making pricing decisions and for governments when considering taxation policies.
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: $$ \frac{\text{New Quantity} - \text{Old Quantity}}{\text{Old Quantity}} \times 100$$
The percentage change in price is calculated as: $$ \frac{\text{New Price} - \text{Old Price}}{\text{Old Price}} \times 100$$
Based on the PED value, demand can be classified into three main types:
The relationship between PED and a firm's revenue is a key aspect of understanding its importance. The impact on revenue depends on whether demand is elastic, inelastic, or unit elastic.
When demand is elastic (PED > 1), a decrease in price will lead to a proportionally larger increase in quantity demanded. This means that total revenue will increase. Conversely, an increase in price will lead to a proportionally larger decrease in quantity demanded, resulting in a decrease in total revenue.
Price | Quantity Demanded | Total Revenue |
---|---|---|
$10 | 100 | $1000 |
$9 | 120 | $1080 |
$8 | 140 | $1120 |
In this example, as the price decreases, the quantity demanded increases by a larger percentage, leading to an increase in total revenue.
When demand is inelastic (PED < 1), a change in price will lead to a proportionally smaller change in quantity demanded. If the price increases, total revenue will increase. If the price decreases, total revenue will decrease.
Price | Quantity Demanded | Total Revenue |
---|---|---|
$10 | 100 | $1000 |
$11 | 90 | $990 |
$12 | 80 | $960 |
Here, even though the quantity demanded decreases, the decrease in price is smaller, resulting in an overall increase in total revenue.
When demand is unit elastic (PED = 1), the percentage change in quantity demanded is equal to the percentage change in price. A change in price will result in an equal and opposite change in total revenue. Total revenue remains constant.
Price | Quantity Demanded | Total Revenue |
---|---|---|
$10 | 100 | $1000 |
$11 | 110 | $1210 |
$10.50 | 105 | $1102.50 |
In this case, the increase in quantity demanded is directly proportional to the increase in price, keeping total revenue constant.
Several factors influence the price elasticity of demand:
Governments often consider PED when deciding on taxes. If demand is inelastic, a tax will likely result in increased government revenue. If demand is elastic, a tax may lead to a decrease in government revenue.
Understanding price elasticity of demand is essential for businesses and policymakers. By analyzing PED, firms can make informed pricing decisions to maximize revenue, and governments can design effective taxation policies. The relationship between PED and revenue is a fundamental concept in microeconomics.