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Price Elasticity of Demand
DEFINITION: Measures the responsiveness of quantity demanded to changes in price.
Formula: 
Explanation of terms:
Q1 = Original quantity demanded
Q2 = New quantity demanded
DQ = Change in quantity demanded
P1 = Original price
P2 = New price
DP = Change in price
Example 1
Q1 = 1000 units, Q2 = 1500 units, P1 = £10, P2 = £8.Solution 1:
DQ = 500 units, DP = -£2
= -1.8 {Has a negative PED}Example 2
P1 = £10, P2 = £12, Q1 = 1000 units, Q2 = 1500 unitsSolution 2:
DQ = 500 units DP = £2
= 2.2 {Has a positive PED}The importance of the sign
Goods which obey law of demand have a negative PED (P ® Q ¯ and P ¯ ® Q ). Goods which do not obey the law of demand have a positive PED. (P ® Q and as P ¯ ® Q ¯ ).
The importance of the size of the number
Elastic Goods: If the answer is greater than one (e.g. 1.3, 2.5, -1.4, -2.1) The change in quantity is greater than the proportionate change in price.
Inelastic Goods: If the number is less than one (e.g 0.2, 0.04, -0.2, -0.01) The change in quantity is less than the proportionate change in price.
Unit Elasticity: If the number is equal to one (+1.0 or -1.0) The change in quantity is equal to the proportionate change in price.
Three cases are analysed to see how the PED value affects profits and revenues.
CASE 1: PED > -1.8
The good obeys the law of demand because it has a negative sign.The good is also elastic because the value is greater than one in absolute terms.
To increase revenue: If the price is lowered the quantity demanded rises by a higher proportion. Therefore the total revenue rises. (TR = P x Q).
To increase profits: If the price is lowered the revenue rises, but the average cost also rise because of the lower prices, therefore the effect on profits are unclear.
CASE 2: PED = -0.6
This good also obeys the law of demand because it has a negative sign.This good is inelastic because the value is less than one in absolute terms.
To increase revenue: Increase the price and the quantity demanded falls by a smaller proportion. Therefore revenue rises.
To increase profits: Increase the price and the average costs will fall because of the higher price per unit. The revenue has risen and the costs have fallen. Therefore profits will rise.
CASE 3: PED = -1.0
This good also obeys the law of demand and is unit elastic.To increase revenue: If price is increased then the quantity falls by the same proportion and vice versa. Therefore revenue cannot be increased.
To increase profits: Increase the price and the costs fall. Therefore profits will rise because revenue is the same but the costs have fallen. (Profits = TR - TC)
Factors affecting Price Elasticity of Demand
1. The existence of substitutes.
The more substitutes the greater the PED because people can buy other goods.
2. Durability
If the good is long lasting it will have a greater PED because people will hold onto the existing good if the price increases.
3. Brand loyalty
If people are loyal to a certain good, then an increase in price may not cause them to change to another good. If there is strong loyalty, then the PED will be inelastic.
4. Complementary goods
Example: Tennis racquets and tennis balls. The cheaper of the two goods is more likely to be inelastic because an increase in their price will have a smaller effect on the cost of the game.
5. The percentage of income spent on the goods
The greater the percentage of income spent on a good, the more elastic the PED will be.
