Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded. Show
The following equation enables PED to be calculated. % change in quanti ty demanded% change in pri ce We can use this equation to calculate the effect of price changes on quantity demanded, and on therevenue received by firms before and after any price change. For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be: – 50+20=(-) 2.5 The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by this change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000). The range of responsesThe degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’. PED can also be:
PED along a linear demand curvePED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to right. PED = 1 at the midpoint of a linear demand curve. PED and revenueThere is a precise mathematical connection between PED and a firm’s revenue. Revenue is measured in threee ways:
Answer Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue – then answer the following:
ObservationsWhen TR is at a maximum, MR = zero, and PED = 1.
Why does a firm want to know PED?There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price. Sales forecastingThe firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800. Pricing policyKnowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price. Revenue_grid PED = 1PED < 1PED > 1PricedecreasePriceincreaseElasticity and revenue RevenuefallsRev enuefallsRevenuerisesRevenuerisesRevenueconstant Revenueconstant Non-pricing policyWhen PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity. Determinants of PEDThere are several reasons why consumers may respond elastically or inelastically to a price change, including: The number and ‘closeness’ of substitutesA unique and desirable product is likely to exhibit an inelastic demand with respect to price. The degree of necessity of the goodA necessity like bread will be demanded inelastically with respect to price. Whether the good is habit formingConsumers are also relatively insensitive to changes in the price of habitually demanded products. The proportion of consumer income which is spent on the goodThe PED for a daily newspaper is likely to be much lower than that for a new car! Whether consumers are loyal to the brandBrand loyalty reduces sensitivity to price changes and reduces PED. Life cycle of productPED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms Test your knowledge with a quizPress Next to launch the quizYou are allowed two attempts – feedback is provided after each question is attempted.The effects of advertisingFirms may use persuasive advertising by to win new customers and retain the loyalty of existing ones. Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic. There are three extreme cases of PED.
What refers to the situation when a decrease in selling price will cause a less than a proportionate increase in sale?*Inelastic demand occurs when a decrease in the selling price produces a less than proportionate increase in sales.
Is the quantity of certain commodity that is bought at a certain price at a given place and time?Quantity demanded is the quantity of a commodity that people are willing to buy at a particular price at a particular point of time.
Which accurately describes the difference between elastic and inelastic demand?Which accurately describes the difference between elastic and inelastic demand? Elastic demand refers to a change in demand by consumers when the price of a good or service changes, whereas inelastic demand refers to the lack of change in demand as prices change.
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