1.2.3 Price Elasticity of Demand (PED)

Question 1

Define Price Elasticity of Demand (PED)

Answer 1

Measures the sensitivity of the quantity demanded of a product to a change in its own price

Question 2

What is the formula of PED?

Answer 2

PED = % change of quantity demanded / % change in price

FACT:
PED will ALWAYS have a NEGATIVE value because price and quantity move in opposite directions (since the demand curve is downward sloping)

Question 3

What are the factors that influence Price Elasticity of Demand?

Answer 3

• Availability of substitutes: if substitutes are available there will be a strong incentive to shift consumption to them when the price of the product rises. The existence of substitutes will therefore tend to make demand for the product elastic
• Proportion of income spent on a product: if only a small percentage of income is spent on a product such as salt then demand will tend to be inelastic, whereas if a high percentage of income is spent on the product then demand will tend to be elastic, e.g. exotic holidays and works of art by famous artists
• Nature of the product: if the product is addictive, e.g. alcohol and tobacco, then demand will tend to be inelastic
• Durability of the product: if the product is long-lasting and hard-wearing, e.g. furniture and cars, then demand will be fairly elastic since it’s possible to postpone purchases. However, demand for non-durable goods, e.g. milk and petrol, will tend to be inelastic because these must be replaced regularly
• Length of time under consideration: it usually takes time for consumers to adjust their expenditure patterns following a price change. For example, it will take time for motorists to switch from fuel-greedy to more fuel-efficient cars. Consequently, demand is usually more price elastic in the long-run than in the short-run
• Breadth of definition of a product: if a product is broadly defined, e.g. fruit, demand is likely to be price inelastic. However, demand for particular types of fruit, e.g. apples, is likely to be more price elastic

Question 4

What is Total Revenue (TR)?

Answer 4

The value of goods sold by a firm

Price x Quantity Sold = Total Revenue

Question 5

What are the key relationships between PED and TR?

Answer 5

• When DEMAND IS INELASTIC, a price change causes Total Revenue to change in the SAME DIRECTION
• When DEMAND IS ELASTIC, a price change causes Total Revenue to change in the OPPOSITE DIRECTION
• When DEMAND IS UNIT ELASTIC, a price change causes Total Revenue to REMAIN UNCHANGED
• When DEMAND IS PERFECTLY INELASTIC, a price change causes Total Revenue to change in the SAME DIRECTION BY THE SAME PROPORTION
• When DEMAND IS PERFECTLY ELASTIC, a price rise causes Total Revenue to FALL TO ZERO