As price falls, ceteris paribus, quantity demanded rises. So demand responds to price changes. If quantity demanded rises a lot when price changes then demand is responsive to price changes. An economist would say demand is therefore elastic. An elastic band can be stretched, if it is very elastic then it is responsive/stretchy, if it is inelastic then it is not responsive/stretchy. Demand is elastic if it is responsive to price changes and inelastic if it is not responsive to price changes. To measure this elasticity economists use price elasticity of demand.
Price elasticity of demand (PED) measures the responsiveness of demand to a change in price.
Demand is price elastic if demand is highly responsive to a change in price. A percentage change in price causes a larger percentage change in quantity demanded, ceteris paribus. An elastic demand curve is relatively flat. Anything that is a luxury likely has an elastic demand for example, top-brand jewellery and restaurants. Anything with substitutes likely has an elastic demand for example, Nike trainers, Samsung TVs and iPhones.
Demand is perfectly elastic (or infinitely elastic) if any change in price causes quantity demanded to fall to zero, ceteris paribus. At the market price P* consumers are willing and able to buy an infinite amount of the good. The demand curve is horizontal.
Demand is unit elastic if a percentage change in price causes the same percentage change in quantity demanded, ceteris paribus.
Demand is price inelastic if demand is very unresponsive to a change in price. A percentage change in price causes a smaller percentage change in quantity demanded, ceteris paribus. Anything that is a necessity or has a few substitutes likely has an inelastic demand for example, water, oil, electricity, rent, tube travel and medication.
Demand is perfectly inelastic if a change in price causes no change in quantity demanded, ceteris paribus. The consumer will pay any price for the good. The demand curve is vertical. A possible example is heroine to a drug addict.
Many factors determine PED:
1) Availability of Substitutes.
As the number and/or quality of substitutes for good X increases, consumers become more sensitive to price changes so X’s PED becomes more elastic.
2) Market Width.
As a market is defined more widely, there are less substitutes so PED becomes more inelastic. For example, the PED for Nike trainers may be elastic because there are many substitutes like Adidas and Puma, but the PED for all footwear should be inelastic because there are no substitutes for footwear.
As the time period increases, consumers can act upon price changes so PED becomes more elastic. Buyers may be locked into paying for a good in the short-run, but they may be able to substitute away from it in the long-run. For example, if the price of tube tickets rise so high that it is cheaper to buy a car, tube users will continue to use the tube in the short-run because of the time it takes to obtain a driving license, find and buy the car and pay for insurance etc. In the long-run, the tube users will substitute away from tube travel and buy a car.
Addictions and habits make consumers become attached to a good and become less sensitive to price changes so PED becomes more inelastic. As consumers become more addicted to a good, they care less about its price.
5) Luxuries and Necessities.
Luxuries (necessities) have a more elastic (inelastic) PED. A luxury is not necessary to survive, an increase in its price causes a large fall in quantity demanded. A necessity is necessary to survive, an increase in its price causes only a small fall in quantity demanded.
Let’s say you want to buy a Milky Way chocolate bar. At a very high price you buy none, as price falls a lot to a reasonable amount you buy one, as price keeps falling you buy more and more. Demand is highly responsive to price changes so PED is elastic. But then you become bored of Milky Ways and as price falls further you only buy a little bit more. Demand is very unresponsive to price changes so PED is inelastic.
Revenue/Expenditure and PED Revenue or expenditure is price times quantity. A fall in price causes an increase in quantity demanded but revenue could rise, fall or stay the same depending on PED.
If PED is inelastic, a rise (fall) in price causes a proportionally smaller fall (rise) in quantity demanded so revenue rises (falls) because the rectangle below gets larger (smaller). The original total revenue is the red and green areas. After price rises, total revenue falls by the green area because less units are sold but total revenue rises by the blue area because units are now sold at a higher price. The blue area is larger than the green area so total revenue rises.
If PED is elastic, a rise (fall) in price causes a proportionally larger fall (rise) in quantity demanded so revenue falls (rises) because the rectangle below gets smaller (larger). The original total revenue is the red and green areas. After price rises, total revenue falls by the green area because less units are sold but total revenue rises by the blue area because are now sold at a higher price. The blue area is smaller than the green area so total revenue falls.