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Price elasticity of demand
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Price elasticity of demand (PED) measures how much quantity demanded responds to a change in price. It helps firms decide whether to raise or cut prices.
The formula
PED = % change in quantity demanded ÷ % change in price
PED is usually negative, because price and quantity demanded move in opposite directions.
Example: price rises 10%, quantity demanded falls 20%. PED = −20 ÷ 10 = −2.
PED is usually negative, because price and quantity demanded move in opposite directions.
Example: price rises 10%, quantity demanded falls 20%. PED = −20 ÷ 10 = −2.
Interpreting PED
Factors and total revenue
Demand is more elastic when there are many substitutes, the good is a luxury not a necessity, it takes a large share of income, and over a longer time.
Total revenue = price × quantity.
If demand is inelastic, a price rise increases revenue. If demand is elastic, a price rise reduces revenue, and a price cut increases it.
Total revenue = price × quantity.
If demand is inelastic, a price rise increases revenue. If demand is elastic, a price rise reduces revenue, and a price cut increases it.
The price of a bus fare rises by 20% and passenger numbers fall by 5%. Find the PED and say whether demand is elastic or inelastic.
- PED = −5 ÷ 20
- = −0.25
- 0.25 is less than 1
Answer: −0.25, inelastic
PED = %ΔQd ÷ %ΔP (usually negative). Less than 1 (ignoring sign): inelastic; more than 1: elastic. Many substitutes, luxuries, big share of income and long time periods make demand elastic. Raise prices if inelastic to increase revenue.
The interactive lesson includes the diagrams for this topic.
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