1.2.4 - Price Elasticity of Demand
Price elasticity of demand helps a business predict how strongly customers will react when price changes. That matters because a pricing decision can change sales volume and total revenue, so this lesson focuses on how to calculate PED, interpret it, explain what influences it, and use it in pricing decisions.
Calculating PED
PED is about responsiveness, not just direction. The law of demand tells us that a price rise usually reduces quantity demanded, but PED tells us whether demand falls a little or a lot.
Price elasticity of demand (PED)
Measures the responsiveness of quantity demanded to a change in price. It is always negative due to the law of demand.
To calculate PED, compare the percentage change in quantity demanded with the percentage change in price.
Price elasticity of demand
An exam-safe method is:
- calculate the percentage change in price
- calculate the percentage change in quantity demanded
- divide the quantity change by the price change
- keep the negative sign, then classify the size of the answer
If price rises by 10% and quantity demanded falls by 20%, PED is -20% / +10% = -2. The negative sign shows the opposite movement between price and demand. The size of the answer matters because it shows customers are reacting twice as strongly as the price change itself.
Interpreting PED values
A PED figure becomes useful only when it is interpreted correctly. In business discussion, the full value is negative, but classification usually focuses on its size.
Price elastic
Quantity demanded is responsive to a change in price.
Price inelastic
Quantity demanded for the product is less responsive proportionately to a change in price.
If |PED| > 1, demand is price elastic, so quantity demanded changes by a bigger percentage than price. If |PED| < 1, demand is price inelastic, so quantity demanded changes by a smaller percentage than price. If |PED| = 1, demand is unitary, meaning quantity demanded changes by exactly the same percentage as price.
The closer PED is to 0, the less price-sensitive customers are. The further PED moves beyond 1 in size, the more sensitive customers are. That distinction matters because two products may both lose sales after a price rise, but one may lose only a few customers while the other loses a large share of the market.
When Microsoft cut the US price of the Xbox One from $500 to $400, sales volumes reportedly doubled soon afterwards. A 20% price cut and a 100% rise in demand suggests a PED of -5, which is highly elastic, so customers were reacting very strongly to price at that point.
Factors affecting PED
PED depends on how easy it is for customers to switch, delay purchase, or absorb a higher price. In other words, demand becomes more elastic when buyers have realistic alternatives and more inelastic when they feel they must keep buying.
Pearson treats a necessity as a basic good consumers need to buy, while a luxury is a good consumers like to buy if they can afford it. That helps explain why demand for luxuries is often more elastic than demand for necessities.
The main factors can be summarised clearly:
| Factor | PED tends to be more elastic when... | Why this matters |
|---|---|---|
| Availability of substitutes | there are many close alternatives | customers can switch quickly if price rises |
| Product differentiation and brand loyalty | the product is not seen as distinctive | weak attachment means rivals look acceptable |
| Proportion of income spent | the item takes a large share of income | even a small price rise feels important to the buyer |
| Nature of the product | it is a luxury rather than a necessity | customers can delay or avoid the purchase more easily |
| Time period | consumers have longer to react | over time they can compare, switch, or change habits |
The key pattern is straightforward: the easier it is to walk away, the more elastic demand tends to be. The harder it is to replace the product, the more inelastic demand tends to be. This is why a supermarket shopper may switch from Sprite to 7 Up after a price rise, while a loyal Coca-Cola customer may be less willing to change brand.
PED, pricing and total revenue
Businesses care about PED because price changes affect total revenue, not just units sold. A price rise can still be worthwhile if the drop in quantity demanded is proportionately smaller, because the higher price per unit more than offsets the lost sales volume.
Total revenue
This gives a high-yield rule for pricing decisions:
| Demand condition | If price rises | If price falls | Likely pricing implication |
|---|---|---|---|
| Price elastic | Total revenue falls | Total revenue rises | cutting price may increase revenue |
| Price inelastic | Total revenue rises | Total revenue falls | raising price may increase revenue |
Unitary (PED = -1) | Total revenue is unchanged | Total revenue is unchanged | price changes do not change revenue |
The logic is cause and effect. If demand is elastic, customers react strongly, so a higher price causes a bigger percentage fall in quantity demanded and revenue drops. If demand is inelastic, customers react weakly, so the higher price outweighs the smaller percentage fall in sales and revenue rises.
When the Telegraph increased its cover price from £1 to £1.20, sales volume fell by only 4%. Because the percentage rise in price was much larger than the percentage fall in quantity demanded, daily revenue increased, which is the classic outcome when demand is relatively inelastic.
PED also helps with pricing forecasts. If a business expects PED to be -0.75 and plans a 20% price rise, it can estimate a 15% fall in quantity demanded. That matters because the firm can judge in advance whether the price change is likely to support or damage its revenue objective.
Judgement Bank
If demand is price inelastic, a price rise can be a powerful way to increase total revenue because quantity demanded falls by a smaller percentage than price rises. That makes PED highly useful for businesses selling necessities or strong brands where customers are less willing to switch.
However, a business should not treat PED as fixed forever because customer responsiveness can change if rivals enter, substitutes improve, or brand loyalty weakens. A price rise based on old PED data could therefore damage revenue if demand has become more elastic.
The best pricing decision depends on the business objective and the market context. If the aim is to maximise revenue in the short run, a firm may prefer higher prices on inelastic products, but if the aim is to build market share or fill spare capacity, cutting price on an elastic product may be the better choice.