Below is a very good video from the Wall Street Journal on price elasticity of demand (PED). PED is key to understanding how companies price their products. Consumer spending has held up relatively well so far despite inflation, but experts say we’re approaching an inflection point. The WSJ explains the role ‘elasticity’ plays in a company’s decision on whether to raise prices. After the video I’ve included some notes about calculating PED and a mindmap.
Price Elasticity of Demand (PED)
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:
% change in Quantity ÷ Demanded % change in Price
How is PED calculated?
Consider the following demand schedule for buses in a city centre.
Price (average fare) Quantity of passengers per week
100c 1000
60c 1300
30c 2275
Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?
The percentage change in QD is equal to:
• The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%
The percentage change in price is equal to:
• The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%
These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75
Let us now consider the PED when the average fare is cut from 60c to 30c
The percentage change in QD is equal to:
• The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%
The percentage change in price is equal to:
• The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%
These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5
Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as:
PED = (-) 0.2
What price elasticity of demand figures tell us.
Determinants of Elasticity of Demand
The elasticity of a product is influenced by:
• the number of substitutes available
• whether it could be described as a luxury or a basic commodity
• the proportion of the purchaser’s income it represents
• the durability of the product.
Usefulness of Price Elasticity of Demand
The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:
1. The effect of a change in price on the total revenue & expenditure on a product.
The relationship between elasticity and total revenue.
Elastic Inelastic Unitary
Price ↑ TR↓ TR↑ No Change
Price ↓ TR↑ TR↓ No Change
2. The likely price volatility in a market following unexpected changes in supply.
3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.
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