Price Elasticity of Demand (PED)

Definition

Price Elasticity of Demand (PED) measures the responsiveness of the quantity demanded of a good or service to a change in its price.

$PED = \frac{\% \Delta Q_d}{\% \Delta P}$

• Elastic Demand: PED > 1 (Quantity demanded is highly responsive to price changes)
• Inelastic Demand: PED < 1 (Quantity demanded is not very responsive to price changes)
• Unit Elastic Demand: PED = 1 (Percentage change in quantity demanded equals the percentage change in price)
• Perfectly Elastic Demand: PED = ∞ (Demand is infinitely responsive to price changes. Horizontal demand curve)
• Perfectly Inelastic Demand: PED = 0 (Quantity demanded does not change regardless of price. Vertical demand curve)

Factors Affecting Price Elasticity of Demand (Determinants of PED)

1. Degree of Necessity

• Necessities: Goods and services considered essential for survival or basic living have relatively inelastic demand. Even if the price increases, consumers will likely continue to purchase them.
  • Examples: Bread, medicine (insulin for diabetics), electricity.
• Luxuries: Goods and services that are not essential have relatively elastic demand. If the price increases significantly, consumers may choose to forgo the purchase or find alternatives.
  • Examples: Designer clothing, expensive holidays, luxury cars.

KEY TAKEAWAY: The more necessary a good or service is, the more inelastic its demand tends to be.

2. Availability of Substitutes

• Many Substitutes: If there are many close substitutes available, demand will be more elastic. Consumers can easily switch to a different product if the price of one good rises.
  • Examples: Different brands of coffee, butter vs. margarine.
• Few Substitutes: If there are few or no close substitutes, demand will be more inelastic. Consumers have limited alternatives if the price of the good increases.
  • Examples: Petrol (for car owners), prescribed medications, unique products.

EXAM TIP: When discussing substitutes, clearly identify what the substitute is and why it makes demand more elastic.

3. Proportion of Income

• Large Proportion: If a good or service represents a significant portion of a consumer’s income, demand will be more elastic. Consumers are more sensitive to price changes for expensive items.
  • Examples: Cars, houses, university education.
• Small Proportion: If a good or service represents a small portion of a consumer’s income, demand will be more inelastic. Consumers are less sensitive to price changes for inexpensive items.
  • Examples: Chewing gum, salt, stationery.

COMMON MISTAKE: Students often forget to consider the proportion of income. It’s not just about the price, but how much of their budget it consumes.

4. Time

• Short Run: In the short run, demand tends to be more inelastic. Consumers may not have enough time to find alternatives or change their consumption habits.
  • Example: Petrol prices spike; people still need to drive to work.
• Long Run: In the long run, demand tends to be more elastic. Consumers have more time to find substitutes, adjust their behavior, or invest in alternatives.
  • Example: Petrol prices remain high; people buy more fuel-efficient cars or use public transport.

STUDY HINT: Think of time as the opportunity for consumers to adjust their behavior and find alternatives.

Summary Table

VCAA FOCUS: VCAA often asks about how multiple factors interact to influence PED in real-world scenarios. For example, how might the availability of electric vehicles affect the PED for petrol in the long run?