What is Price Elasticity of Demand?
The price elasticity of demand (PED) measures how much the quantity demanded of a product changes when its price changes. It helps businesses determine the optimal pricing strategy by understanding consumer behavior.
For example, if you run an electronics shop and sell 200 TV sets for $800 each, you might wonder: What happens if I lower the price to $700? Will I sell enough units to increase my revenue despite the price cut?
Key Concepts
- High elasticity - Luxury products (electronics, cars): Price decrease → Large demand increase → Higher revenue
- Low elasticity - Essential products (fuel, medicines): Price decrease → Small demand increase → Lower revenue
Midpoint Formula for Elasticity of Demand
This calculator uses the midpoint method, which provides a consistent measure regardless of whether price increases or decreases:
PED = [(Q₁ - Q₀) / ((Q₁ + Q₀) / 2)] / [(P₁ - P₀) / ((P₁ + P₀) / 2)]
Where:
- P₀ = Initial price of the product
- P₁ = Final price of the product
- Q₀ = Initial quantity demanded
- Q₁ = Quantity demanded after price change
- PED = Price elasticity of demand
Note: PED is almost always negative because price and demand have an inverse relationship - higher price means lower demand, and vice versa.
How to Calculate Price Elasticity of Demand
Example: Electronics Store TV Sales
- Initial price: $800 per TV set
- Initial quantity: 200 units sold per month
- Final price: $700 per TV set (price decrease)
- Final quantity: 250 units sold per month
- Calculate PED:
- Change in quantity: (250 - 200) / ((250 + 200) / 2) = 50 / 225 = 0.222
- Change in price: (700 - 800) / ((700 + 800) / 2) = -100 / 750 = -0.133
- PED = 0.222 / -0.133 = -1.67
- Revenue analysis:
- Initial revenue: $800 × 200 = $160,000
- Final revenue: $700 × 250 = $175,000
- Revenue increase: $15,000 (9.38%)
Understanding PED Values and Revenue Impact
Perfectly Inelastic (PED = 0)
Price changes don't affect demand. Essential survival goods. Price decrease → Revenue drops
Inelastic (-1 < PED < 0)
Price decrease causes slight demand increase. Price decrease → Revenue drops
Example: Gasoline, prescription medicines
Unitary Elastic (PED = -1)
Price decrease is proportional to demand increase. Price decrease → Revenue stays the same
Elastic (-∞ < PED < -1)
Price decrease causes large demand increase. Price decrease → Revenue increases
Example: Luxury goods, electronics, restaurant meals
Perfectly Elastic (PED = -∞)
Any price increase causes demand to drop to zero. Price increase → All revenue lost
Example: Fixed-value goods like currency
Revenue Formula
Revenue (R) = Price (P) × Quantity (Q)
Revenue Change:
ΔR = R₁ - R₀ = (P₁ × Q₁) - (P₀ × Q₀)
Practical Examples
Example 1: Elastic Demand (Restaurant)
- Initial: $25/meal, 1,000 meals/month → Revenue: $25,000
- Final: $20/meal, 1,500 meals/month → Revenue: $30,000
- PED: -2.5 (elastic)
- Result: Revenue increased by $5,000 (20%)
Example 2: Inelastic Demand (Gasoline)
- Initial: $3.00/gallon, 10,000 gallons/day → Revenue: $30,000
- Final: $2.50/gallon, 10,500 gallons/day → Revenue: $26,250
- PED: -0.33 (inelastic)
- Result: Revenue decreased by $3,750 (12.5%)
Example 3: Unitary Elastic
- Initial: $10/item, 5,000 items/month → Revenue: $50,000
- Final: $8/item, 6,250 items/month → Revenue: $50,000
- PED: -1.0 (unitary)
- Result: Revenue unchanged
Major Determinants of Price Elasticity
- Availability of substitutes: More substitutes → More elastic
- Necessity vs luxury: Luxuries are more elastic than necessities
- Price relative to income: Expensive items are more elastic
- Time frame: Demand becomes more elastic over longer periods
- Market definition: Narrower markets are more elastic
Frequently Asked Questions
What does the price elasticity of demand measure?
Price elasticity of demand measures how much the demand for a good changes with its price. If demand changes significantly with price, the demand is elastic (luxury goods). If demand doesn't change much, it's inelastic (necessary goods).
How does elasticity affect a company's pricing policy?
Businesses charge as much as possible without significantly affecting demand. If production costs rise, businesses will raise prices on inelastic goods (like medicine) because demand won't drop much. For elastic goods, price increases can severely hurt revenue.
What is cross price elasticity?
Cross price elasticity measures how demand for one good changes when the price of another related good changes. For competitive products (Coke vs Pepsi), if one price increases, demand for the other increases. For complementary products (cars and gasoline), if one price increases, demand for both decreases.
How is the price elasticity of demand measured?
Record the price and quantity sold at one point in time, then change the price and measure quantity sold again over the same time period. Use the midpoint formula to calculate PED from these four values.
How is total revenue related to the price elasticity of demand?
For inelastic products, price increases raise total revenue (people buy anyway). For elastic products, price increases lower total revenue (people stop buying). This relationship helps businesses optimize pricing strategies.
What is the difference between elastic and inelastic demand?
Elastic demand (|PED| > 1) means quantity changes more than price - consumers are sensitive to price changes. Inelastic demand (|PED| < 1) means quantity changes less than price - consumers are not very sensitive to price changes.