What is the Price Elasticity of Demand?
Within the microeconomics material of TC Finance, Price Elasticity of Demand (aka PED) is discussed. The formula is in the module material, but students often ask: what exactly does PED represent? And why is it normally negative? Are there any circumstances where it could be positive?
Peter Reid, one of our Finance lecturers, gives us the lowdown. Here are his key points:
To understand Price Elasticity of Demand, the best place to start is by restating the Law of Demand. We know that as price increases, the quantity demanded of a product will decrease. This leads to the downward slope of the demand curve.
This Law, however, doesn’t tell us anything about the degree of change. Imagine the downward sloping demand curve. Some demand curves may be a steep slope, and others relatively flat. The severity of the slope – the gradient, if you prefer – is what is measured by PED.
- If PED is a high numerical value (>1), this means the gradient – the slope – is quite severe. So a minor change in pricing will lead to a fairly substantial change in the quantity demanded. (This would be described as an elastic (read: sensitive) product.)
- If PED is a low numerical value (<1), this means the slope is slight. So a change in pricing won’t impact on demand all that much. (This would be described as an inelastic (read: insensitive) product.)
So PED, then, is a measure of the sensitivity. If price changes by a certain amount, will demand be very sensitive to this, or barely care.
The fact that PED is always negative can be explained by considering that the demand curve is always downward sloping. The gradient of a demand curve always relates to a downhill slope, which is why we just assume that PED is always negative, whether expressly stated or not.
Until anyone can think of a product for which demand would increase as the selling price rises, we will take PED as a consistently negative figure. There are no circumstances where we would consider PED as being actually positive.