Price Elasticity of Demand (PED)
What it is:
Price elasticity of demand (PED) measures the change in the quantity demanded relative to a change in price for a good or service.
How it works (Example):
The formula for price elasticity is:
Price Elasticity = (% Change in Quantity) / (% Change in Price)
Let's look at an example. Assume that when gas prices increase by 50%, gas purchases fall by 25%. Using the formula above, we can calculate that the price elasticity of gasoline is:
Price Elasticity = (-25%) / (50%) = -0.50
Thus, we can say that for every percentage point that gas prices increase, the quantity of gas purchased decreases by half a percentage point.
Price elasticity is usually negative, as shown in the above example. That means that it follows the law of demand; as price increases quantity demanded decreases. As gas price goes up, the quantity of gas demanded will go down.
Price elasticity that is positive is uncommon. An example of a good with positive price elasticity is caviar. The buyers of caviar are generally wealthy individuals who believe that the more expensive the caviar, the better it must be. Thus, as the price of caviar goes up, the quantity of caviar demanded by wealthy people goes up as well.
Why it Matters:
It is important to understand concept of price elasticity of demand to know how the relationship between the price of a good influences its demand.
If the quantity demanded changes a lot when prices change a little, a product is said to be elastic. This often is the case for products or services for which there are many alternatives, or for which consumers are relatively price sensitive. For example, if the price of Cola A doubles, the quantity demanded for Cola A will fall when consumers switch to less-expensive Cola B.
When there is a small change in demand when prices change a lot, the product is said to beinelastic. The most famous example of relatively inelastic demand is that for gasoline. As the price of gasoline increases, the quantity demanded doesn't decrease all that much. This is because there are very few good substitutes for gasoline and consumers are still willing to buy it even at relatively high prices.