PRICE ELASTICITY OF DEMAND — MEANING, TYPES, IMPORTANCE AND DETERMINANTS

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In analyzing demand, our focus has been on understanding the general direction of change in price and its effect on the quantity demanded.

To add greater meaning to this explanation, It is necessary to look at the extent to which quantity demanded changes in response to price changes. 

This brings us to today's topic–price elasticity of demand.

Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. 

In simple words, price elasticity of demand is the degree of responsiveness of quantity demanded to change in price.

It shows how sensitive the quantity demanded is to a change in price. In the simplest form, the Price elasticity of demand is calculated as:

$PED=\frac{\%∆QD}{\%∆P}$ 

It is pertinent to mention here that the coefficient of price elasticity of demand is usually negative. 

The reason is not far-fetched. The law of demand states that there is an inverse relationship between price and quantity demanded. Hence, the coefficient of price elasticity of demand will be negative.

However, economist usually refers to the price elasticity of demand as an absolute term by ignoring the negative sign.

Five types of price elasticity of demand

Five cases of price elasticity of demand can be identified, which are:

1. Relatively elastic demand

2. Relatively inelastic demand

3. Unit elastic demand.

4. Perfect elastic demand

5. Perfect inelastic demand

Relatively elastic demand or more than unit demand

This occurs when a change in price leads to a significant change in quantity demanded. 

This means that the proportional change in quantity demanded is greater than the proportional change in price.

More appropriately, an elastic demand is one in which elasticity is greater than one. To illustrate, a 5% change in price leads to a 7% change in quantity demanded is a relatively elastic demand.

Relatively Inelastic demand or less than unit demand

If a change in price leads to an insignificant change in quantity demanded,  demand is relatively inelastic

Alternatively, relatively inelastic demand can also refer to a demand whose elasticity is lesser than 1.

A 10% change in price which leads to a 6% change in quantity demanded is an example of inelastic demand.

Unitary elastic demand

A unitary elastic demand is one in which the proportionate change in quantity demanded equals the proportionate change in price, indicating proportionate responsiveness of demand.

In simple words, a unitary elastic demand is one in which elasticity is equal to 1. The demand curve of unitary elastic demand is usually a rectangular hyperbola.

It is worth noting that a firm maximizes revenue when the elasticity of demand is unit elastic because the marginal revenue at unit elastic demand is zero.

Perfectly elastic or infinite elastic demand

The demand for a good is said to be perfectly elastic when a small change in price leads to an infinite change in quantity demanded.

Here, a price increase would lead to zero quantity demand as consumers will only buy at a particular price.

Hence, elasticity is equal to infinity. The demand curve of perfectly elastic demand is a horizontal straight line. 

This kind of demand curve is commonly associated with perfectly competitive firms

It is important to note that the e slope of the perfectly elastic demand curve is zero.

Perfectly inelastic or zero elastic demand

Goods are said to be perfectly inelastic if, and only if, the quantity demanded does not change in response to price changes. 

This means the quantity demanded is the same regardless of the price.

In such cases, the elasticity is zero. A $10\%$ change in price which leads to zero change in quantity demanded is a good example of perfectly inelastic demand. The demand curve of perfectly inelastic demand is a vertical straight line.

In addition to the price elasticity of demand, there is a special case of price elasticity called isoelastic demand.

An isoelastic demand is a demand with a constant price elasticity of demand along the same demand curve.

To put it in another way, an isoelastic demand has an unchanging price elasticity of demand regardless of the number of goods demanded

Having explained five cases of price elasticity of demand, our next task is to look at the ways of determining the price elasticity of demand.

Methods Of Calculating Price Elasticity Of Demand

1. Percentage method

2. Midpoint method

Simple percentage method

The price elasticity of demand can be solved using the simple percentage method. According to this method, the price elasticity of demand (PED) is derived by dividing the percentage change in quantity demand by the percentage in price.

$PED=\frac{\%∆QD}{\%∆P}$

Example

Find the price elasticity of demand if a 20% increase in the price of rice leads to a 10% reduction in the quantity demanded.

PED=$\frac{∆Qd}{∆P}$

PED=$\frac{-10}{20}$

PED=$-0.5$

PED=$-0.5$

The numerical value (0.5) is less than one, we, therefore, say that the demand is relatively inelastic.

Note: we usually ignore the negative sign of price elasticity of demand.

The midpoint method

This is another great way of solving the price elasticity of demand. In this method, the average of the old and new prices and quantities are taken. It is expressed as:

PED=$\frac{\frac{∆Q}{\frac{Q_1-Q_2}{2}}\times100}{\frac{∆P}{\frac{P_1-P_2}{2}}\times100}$

Where $Q_1$ is the original quantity demanded.

            $Q_2$ is the new quantity demanded

             $P_1$ is the original Price.

              $P_2$ is a new Price.

Relevance Of Price Elasticity Of Demand On Total Revenue

So far, we have looked at the different cases of price elasticity of demand. However, Did you know that price elasticity also influenced total revenue? 

To understand this, let's begin with some basic terms.

In economics, total revenue is price times quantity. For example, if a shop down the street sells 700 books this week for €4 each, its total revenue is €2800.

Knowing fully well that total revenue is price times quantity, you would have expected that total revenue will increase as price increases. That is, however, not exactly the case

Why?

There are different variations of price elasticity of demand, which means total revenue may increase, decrease, or remain constant if price changes.

Ok, let's see how the price elasticity of demand affects total revenue.

Relatively elastic demand and total revenue.

If demand is elastic, a small increase in price will lead to a significant decrease in the quantity demanded. 

This means gains made from the price increase will be lesser than losses arising from diminished quantity demanded. Hence, the total revenue diminishes.

Think of what would happen if there is a decrease in the price of a commodity with elastic demand. 

Here, the quantity demanded will rise by a greater amount than the price fall. This will lead to increased revenue.

Relatively inelastic demand and total revenue

In inelastic demand, the price change will be greater than the change in quantity demanded. 

An increase in price will be greater than the decrease in quantity demanded, hence, revenue will increases

Conversely, price falls will lead to an insignificant rise in quantity demanded thereby causing total revenue to fall.

Unitary elastic demand and total revenue

In unitary elastic demand, though in opposite direction, the quantity demanded, and price change by the same percentage. This means a 7% increase in price will also lead to a 7% decrease in quantity demand.

Hence, a price change would not exactly have an impact on revenue because price changes would be equalized by changes in quantity demanded.

From the foregoing discussion, we can conclude that:

1. There is an inverse relationship between total revenue and price when demand is elastic.

2. There is a direct relationship between total revenue and price and revenue when demand is inelastic

3. Price changes would have no changes in total revenue when demand is unitary elastic.

The price elasticity of demand is also very important for price-discriminating firms.

Remember that price discrimination can only be done after segregating customers into different groups based on their price elasticity of demand.

You will know more about that in this blog post, be sure to check it out here.

Determinants Of Price Elasticity Of Demand

The elasticity of demand differs from commodity to commodity. The various factors upon which elasticity depends are the following:

1. Substitute goods: The more substitute there are for a given commodity, the greater the elasticity.

This is because consumers can switch to other substitute goods even with a small price change. Conversely, if there are no substitutes, the demand for goods will likely be inelastic.

2. Percentage of income spent: The elasticity of goods is also affected by the percentage of income spent on a commodity.

If the percentage of income spent on a commodity is high, the demand for such commodities will be elastic.

For Instance, we spend a large percentage of our income on cars, hence, it has an elastic demand.

Conversely, goods with a low amount of total income spent on them will have an inelastic demand.

An example of such a good is a pen. Since we spend less amount on pens, we tend to buy pens even with increased prices.

3. The nature of goods: PED is also influenced by the nature of the goods concerned.

Necessity goods( like rice, and water) tend to have inelastic demand. This is because they are no substitute for them and people depend entirely on them for survival.

Luxurious goods, on the other, are elastic because people refrain from buying them even for a small price change.

4. Addictive nature of goods: An obvious factor that affects the price elasticity of demand is addictive goods. Goods that are addictive(or habitual) are likely to have inelastic demand because people would still buy them even with significant price changes.

This explains why cigarettes are highly demanded despite the negative publicity and externalities associated with them.

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5. Fashion: If a commodity is in fashion, its demand will be inelastic as fashion-minded individuals would buy them even if the price is high.

Conversely, a commodity that is out-of-fashion will have an elastic demand because only a few will buy if the price changes.

READ ALSO: 5 DETERMINANTS OF PRICE ELASTICITY OF DEMAND

There you have it. In the next post, You would find some exercises to test and solidify your knowledge of the price elasticity of demand, be sure to check it out here.

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