Price Elasticity of Demand
Price Elasticity of Demand is simply the measurement of the reaction of customers when the price changes.
It is calculated by this formula:
PEd= | % change in Quantity Demanded/% change in Price |
See the || brackets? They mean modulus, which means you only take the positive value of the answer. This means if you get -1.5 after the calculation, simply remove the negative sign. Tada!
Now compare your values against this:
<1 = Inelastic
>1 = Elastic
0 = Perfectly Inelastic
Infinity = Perfectly Elastic
1 = Unit Elastic
REMEMBER THIS!
So what does each mean?
Inelastic:
This means a change in price does not affect demand much.
A drop in demand will not cause a change in demand, and vice versa.
Most inelastic goods are usually necessities.
One such example is a bag or rice.
Since people need to eat, there will still be a relatively same amount of people buying rice if the price rices, and same if the price drops (maybe a slight change but relatively the same). This is linked very much to revenue, which is price of good*quantity sold.
An inelastic good will garner more revenue by raising its price since the demand will not change. By decreasing price, it will only decrease revenue (see the formula for more).
Elastic:
A change in price will drastically affect demand.
If the price drops, demand will increase,
If price rises, demand will decrease.
Elastic goods are usually those with lots of substitutes (similar products that can replace each other, for example Coca Cola and Pepsi) and are necessities, for example luxury goods.
One must realise this is more or less common sense. If there are two bags of chips of equal quality, and one is cheaper, which would you buy? The cheaper one of course! Thus, the cheaper an elastic good is, the more demad it will garner. This is basically it. Therefore, an elastic good will earn more revenue by lowering its prices.
What about unit and perfectly elastic/inelastic?
You do not really need to know these as these ar mainly hypothetical. However, it is good to have a basic understanding.
Unit Elastic: Demand rises or drops in proportion to price rise or fall. Note that this is a negative correlation, which means if price falls by one unit, demand rises by one unit.
Perfectly Inelastic: Change of price has no effect whatsoever on demand.
Perfectly Elastic: There is an infinite demand for every price. Don't worry if you don't get this!
Comments