Price Elasticity of Demand (PED)

Price Elasticity of Demand (Ep)

Price elasticity of demand (Ep) measures the responsiveness of demand after a change in price.Ep = % change in Q.D % change in PriceSuppose the percentage decrease in the price of the commodity is 25% and the percentage increase in the quantity demanded is 50%.Hence,ep = 50%/-25% = -2

Price Elasticity of DemandThe price elasticity of demand can be any value between zero and infinity.

The price elasticity of demand reflects the law of demand relation between price and quantity. An elastic demand means that the quantity demanded is relatively responsive to changes in price. An inelastic demand means that the quantity demanded is not very responsive to changes in price.Degrees of Price Elasticity of Demand

Degrees of Price Elasticity of Demand

Perfectly Elastic:Perfectly elastic given by E = . Shape of demand curve is horizontal. It means that at a particular price, buyers are ready to buy all commodities. If there is even a slight change in the price, the quantity demanded will be zero. (Perfect Competitive Market)Degrees of Price Elasticity of Demand

2. Perfectly Inelastic: Another type shown in this chart is perfectly inelastic, given by E = 0. Perfectly inelastic means that quantity demanded is unaffected by any change in price. The quantity is essentially fixed. It does not matter how much price changes, quantity does not Change. Looking at Medicine, for instance, it is possible that, following a 5% increase in its price, the demand for the product remains unchanged because the good is such a necessity.

Degrees of Price Elasticity of Demand

3. Unit Elastic: The third category is unit elastic, in which the coefficient of elasticity is E = 1. In this case, any change in price is matched by an equal relative change in quantity. The percentage change in quantity is equal to the percentage change in price. For example, a 10 percent change in price induces a equal 10 percent change in quantity demanded.

Degrees of Price Elasticity of DemandUnit Elastic is primarily a dividing line, a boundary, between elastic and inelastic. If the coefficient of elasticity is greater than one, then a good is elastic. If the coefficient of elasticity is less than one, then a good is inelastic. If the coefficient just happens to be exactly equal to one, then it is unit elastic.

For example, a theater may be able to sell 100 tickets at $20 each and only 80 tickets at $25 each, but at either price/demand combination the total revenue is $2000. In most cases, perfect unitary elasticity does not occur.

Degrees of Price Elasticity of Demand

4. Relatively Inelastic: The fourth category is relatively inelastic, in which the coefficient of elasticity falls in the range 0 < E < 1. With relatively inelastic demand, relatively large changes in price cause relatively small changes in quantity. The percentage change in quantity is less than the percentage change in price. In this case, a 10 percent change in price induces less than a 10 percent change in quantity demanded (perhaps only 5 percent). Shape of demand curve is quite steep. [Necessaries]Degrees of Price Elasticity of Demand

5. Relatively Elastic: The second category is relatively elastic, in which the coefficient of elasticity falls in the range 1 < E < . With relatively elastic demand, relatively small changes in price cause relatively large changes in quantity. Quantity is very responsive to price. The percentage change in quantity is greater than the percentage change in price. Here a 10 percent change in price leads to more than a 10 percent change in quantity demanded (maybe something 20 percent). The demand curve will be flatter. [Luxurious]Measurement of Price Elasticity of Demand1. Total Outlay Method

Total outlay or expenditure (P * Q) by consumers are the revenue earned by the sellers.

When price of a good changes, it brings about a change in the total revenue of the seller. The change in total revenue depends upon the price elasticity of demand. When price of a good changes, three situations can take place.1. Total Outlay MethodUnder this method, Alfred Marshall suggested three types of elasticity:

Elasticity of demand greater than one:

If the expenditure made by the consumer is increases due to the fall of price of commodity, then it is known as elasticity of demand greater than one. It is a case of elastic demand.

Normal Goods : Essential & Luxurious1. Total Outlay Method2. Elasticity of demand less than one

If the total expenditure made by consumer decreases due to fall in price is known as elasticity of demand less than one. It is a case of inelastic demand

Inferior Goods1. Total Outlay Method3. Elasticity of demand equal to one

If the total expenditure made by consumers remains constant due to any change in price of any commodity is called elasticity of demand equal to one.

It is difficult to give example in this situation1. Total Outlay Method

1. Total Outlay Method

1. Total Outlay Method

2. Percentage MethodPerfectly inelastic demand (ep = 0)Perfectly elastic demand (ep = ) Unitary elasticity (ep = 1) Relatively Elastic Demand (ep > 1) Relativley Inelastic (less elastic) demand (ep < 1)

3. Arc Elasticity of Demand Price elasticity of demand is the percentage change in quantity demanded for a unit change in price. Arc elasticity computes the percentage change between two points in relation to the average of the two prices and the average of the two quantities, rather than the change from one point to the next. This provides the average elasticity for the arc of the curve between the two points. Hence, the term "arc elasticity."3. Arc Elasticity of Demand Arc elasticity of demand is a measure of the average responsiveness to price change exhibited by a demand curve over some finite stretch of the curve.

Arc elasticity is the elasticity at the mid-point of an arc of a demand curve.

3. Arc Elasticity of Demand In the case of arc elasticity we have to measure the price elasticity over an arc of the demand curve such as between points A and B on the demand curve DD in the above figure. In the measurement of arc elasticity we use the averages of the two prices and two quantities (both original and subsequent). Thus the formula for measuring arc elasticity of demand is:

3. Arc Elasticity of Demand

3. Arc Elasticity of Demand

Importance of Price Elasticity of Demand1. International Trade: In order to fix price of the goods to be exported it is important to its knowledge about the elasticity of demand for such goods.

2. Formulation of government policy: The concept of price elasticity of demand is important for formulating govt. policy specially the taxation policy. A country may fix higher prices for the products with inelastic of demand or Govt. can impose higher taxes on goods in elastic of demand. Importance of Price Elasticity of Demand3. Factor Pricing: Price elastic of demand helps in determining price to be paid to the factors of production.

4. Decision Monopolist: A monopolist considers the nature of demand while fixing price of his product. If demand for the product is elastic then he will fix low price.

Income Elasticity of DemandIncome Elasticity measures the responsiveness of demand due to an increase or decrease in consumer income.

Ey = % change in quantity demanded % change in incomeTypes of Income ElasticityHigh income elasticity of demand (Ey >1): An increase in income is accompanied by a proportionally larger increase in quantity demanded. This is typical of a luxury or superior good.

Unitary income elasticity of demand (Ey =1): An increase in income is accompanied by a proportional increase in quantity demanded.

Low income elasticity of demand (Ey