Price Elasticity of Demand

Definition

The Price Elasticity of Demand is an economic measure that evaluates how much the quantity demanded of a good reacts to a change in its price. It is calculated by dividing the percentage change in quantity demanded by the percentage change in price. A higher elasticity implies that consumers will have a significant response to a change in price, whereas a lower elasticity suggests a less significant response.

Phonetic

Prahyss Ee-las-ti-si-tee uhv Di-mand

Key Takeaways

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1. Measures Responsiveness: The Price Elasticity of Demand (PED) is a measure that determines how responsive demand for a good is to a change in price. In other words, it shows how much the quantity demanded will alter in response to a price change.
2. Degree of Elasticity: Depending on the coefficient calculated for PED, demand may be identified as perfectly elastic, perfectly inelastic, relatively elastic, relatively inelastic or unitary. This means that the demand varies from no response to price change to a very high sensitivity to price changes.
3. Affects Revenue: Companies use PED to help make decisions about pricing and supply. If a product’s demand is elastic, a price decrease can increase total revenue, while if the demand is inelastic, a price increase could potentially lead to higher revenue.

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Importance

Price Elasticity of Demand is a crucial concept in the field of business and finance as it allows companies to understand how sensitive consumers are to changes in price. This parameter gauges the percentage change in the quantity demanded of a product or service following a one percent change in its price. It helps businesses devise their pricing strategies, optimize profit margins, and predict how changes in price can affect the overall demand and revenue. By understanding the elasticity of demand, businesses can make more informed decisions about pricing commodities, factoring in how changes could impact sales volumes, customer behavior, and market share.

Explanation

The Price Elasticity of Demand is a significant concept in the field of economics and business as it helps gauge the potential impact that changes in price will have on the demand for a particular product or service. It essentially measures the responsiveness or sensitivity of consumers to changes in the price of a product. This measurement, in turn, aids businesses to ascertain a price strategy, providing valuable information on how to price items to maximize profitability.For instance, if a product has high price elasticity, it means the demand for that product significantly changes with even a small change in price. Thus, businesses with such products may choose to lower prices to drive higher sales volume, resulting in increased total revenue. Conversely, if a product showcases low price elasticity, it implies that price changes do not markedly influence demand; it might be due to a lack of substitute products or that the product is essential. Hence, businesses could potentially increase prices to boost total revenue without the fear of a substantial drop in sales volume. Therefore, the Price Elasticity of Demand acts as a compass for manufacturers, distributors, retailers, and marketers, affording strategic price setting, marketing planning, and revenue forecasting.

Examples

Price Elasticity of Demand is a measure of the change in quantity demanded of a product in response to a change in its price. Here are three real-world examples:1. Luxury Cars: Luxury cars, like those produced by Rolls-Royce and Bentley, are an example of a good with price inelastic demand. This means that the quantity demanded doesn’t change significantly when the price changes. People who buy these cars are typically not sensitive to price changes because they are willing and able to pay for the exclusivity and status symbol these cars represent.2. Gasoline: Gasoline is another product with relatively inelastic demand. Despite price fluctuations, consumers need to fill up their vehicles to commute to work, run errands, etc. If the price of gasoline increases, customers may gripe, but their consumption doesn’t drastically decrease because they need this product to maintain their current lifestyle.3. Airline Tickets: Airline tickets are an example of a product with price elastic demand. This means that the quantity demanded changes significantly when the price changes. If an airline raises its ticket prices, customers may choose to fly with another airline, use another mode of transportation, or not travel at all. Conversely, when airlines drop their prices, sales can significantly increase as customers take advantage of the discounted fares.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Consumer Demand
• Supply and Demand
• Substitute Goods
• Income Elasticity of Demand
• Price Elasticity of Supply

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Khan Academy
• Economics Online