Price elasticity of Demand
The price elasticity of demand (PED) refers to the responsiveness of total quantity demanded of a product to a change in the price of that product. The PED can be mathematically calculated between any two points along a firm’s demand curve using the formula:
PED = % change in quantity demanded/% change in Price
With normal downward sloping demand curves, the value for the PED will be negative, but for simplicity, economists ignore the negative sign when reporting the size of PEDs. Accordingly:
The higher is the PED, the greater is the responsiveness of QD to a change in P. This will be represented by a demand curve that is relatively flat, highlighting that any reduction in the price of the product will result in a greater proportional increase in the QD. For example, if the price of butter falls by 10% and the demand for butter increases in response by 20%, then the PED is high.
The lower is the PED, the smaller is the responsiveness of QD to a change in P. This will be represented by a demand curve that is relatively steep, highlighting that any reduction in the price of the product will result in a less than proportional increase in the QD. For example, if the price of cigarettes falls by 10% and the demand for cigarettes increases in response by only 5%, then the PED is low.
A business would prefer to have a low PED (i.e. a steep demand curve). This would enable it to restrict supply, raise prices and maximise profits. Typically, businesses in highly concentrated markets (i.e. where there are few suppliers), such as a monopoly (one seller) or oligopoly (few sellers) are the ones experiencing low PEDs. By raising prices or restricting supply, these businesses can increase total revenue and profit because a much higher price only causes a relatively small reduction in quantity demanded. Conversely, those businesses in highly competitive markets, where there is a high PED, will find that raising prices only works to reduce total revenue and profit. Accordingly their strategies will centre on becoming more price competitive and attracting consumer loyalty and brand allegiance in order to reduce their PED over time.
Factors affecting price elasticity of demand
The degree of necessity
Necessities are those goods and services that are ‘needed’ by consumers, with the basic necessities being food, clothing and shelter. These types of products will usually have a low PED, whereas luxury products will have a relatively higher PED. If the price of bread increased, for example, the quantity demanded would decrease, but by a smaller percentage, as bread is a staple item for most households. Similarly, if a person is addicted to a product (such as a drug) they are unlikely to decrease their consumption of the drug if the price increases. Therefore, necessities will have a low PED while luxury items will tend to have a high PED.
Availability of substitutes
The greater the number of substitutes that are available for a product, the greater the PED. This occurs because consumers are likely to switch to a close substitute if the price rises. For example, upon the invention of new (and much needed) pharmaceutical product, the manufacturer will immediately experience a very low PED and it will be able to charge very high prices for the product. However, once competing manufacturers learn of the breakthrough they will immediately set about developing a substitute product. Once produced, the number and availability of these substitutes will work to increase the PED for the original product. [Note this is why the Australian government provides patents to companies that invest large amounts of money into research and development (R&D). The patent effectively provides the business with sole rights to produce the product for a specified period of time. This guarantees that the firm can take advantage of a low PED and make ‘monopoly’ profits for long enough to justify continued R&D investment.)
Proportion of income
The greater the percentage of income that is needed to purchase a good or service, the greater the PED. If the price of a box of matches increased by 100% for example, it would be surprising to see a decrease in sales by anything close to 100%. It is more likely to induce a drop in demand of less than 10%, meaning that the PED is very low (0.1). In contrast, a 5% increase in the price of a new house, could amount to thousands of dollars which could be the deciding factor excluding them from the market, resulting in a larger than 5% drop in the quantity demanded.
Consumers are less likely to notice price changes in the short term. Over time however, consumers may notice the price increase and experiment with alternative products. For example, if the price of petrol rises by 50%, then people may continue to purchase similar quantities in the short term. However, over time, they are likely to reduce their fuel consumption by using public transport more often or even selling their existing vehicle and purchasing a more fuel-efficient vehicle (e.g. hybrid car or motorcyle). This means that, for many products, price elasticity of demand is more elastic in the longer term.