PRICE ELASTICITY OF DEMAND & INCOME ELASTICITY OF DEMAND (PED & YED) REVISION NOTES

1. PRICE ELASTICITY OF DEMAND - REVISION NOTES
Some important points from which you can realize the important of price elasticity of
demand!
Price elasticity of demand is a very important concept. Its importance can be realized from
the following points:
1. International trade:
In order to fix prices of the goods to be exported, it is important to have knowledge about the
elasticity’s of demand for such goods.
A country may fix higher prices for the products with inelastic demand. However, if demand
for such goods in the importing country is elastic, then the exporting country will have to fix
lower prices.
2. Formulation of Government Policies:
The concept of price elasticity of demand is important for formulating government policies,
especially the taxation policy. Government can impose higher taxes on goods with inelastic
demand, whereas, low rates of taxes are imposed on commodities with elastic demand.
3. Factor Pricing:
Price elasticity of demand helps in determining price to be paid to the factors of production.
Share of each factor in the national product is determined in proportion to its demand in the
productive activity. If demand for a particular factor is inelastic as compared to the other
factors, then it will attract more rewards.

2. 4. Decisions of Monopolist:
A monopolist considers the nature of demand while fixing price of his product. If demand for
the product is elastic, then he will fix low price. However, if demand is inelastic, then he is in
a position to fix a high price.
5. Paradox of poverty amidst plenty:
A bumper crop, instead of bringing prosperity to farmers, brings poverty. This is called the
paradox of poverty amidst plenty. It happens due to inelastic demand for most of the
agricultural products. When supply of crops increases as a result of rich harvest, their prices
drastically fall due to inelastic demand. As a result, their total income goes down.
Price Elasticity of Demand (PED): Definition, Calculation and Effects of
Change in PED
Price elasticity of demand (PED) measures the extent to which the quantity demanded
changes when the price of the product changes.
The formula used to calculate it is:
PED = Percentage change in quantity demanded/Percentage change in price
This is often abbreviated to:
PED = %ΔQD/%ΔP
Calculating PED:
To work out elasticity of demand, it is necessary to first calculate the percentage change in
quantity demanded and a percentage change in price. To do this, the change in demand is
divided by the original demand and multiplied by 100.
The same process is used to work out the percentage change in price. For instance, demand
may rise from 200 to 240 as a result of price falling from $10 to $9. In this case, the
percentage change in quantity demanded is:
Change in demand / Original quantity demanded X 100 i.e. 40/200 x 100 = 20%
The percentage change in price is:
Change in price / Original price X 100 i.e. -$1/$10 X 100 = -10%
When these changes have been calculated, the percentage change in quantity demanded is
divided by the percentage in price to give the PED. In this case, this is 20%/-10%. Remember
that a division involving different signs gives a minus figure. Hence the PED is – 2.

3. Interpretation of PED:
The PED figure provides two pieces of information. One is given by the sign. In the vast
majority of cases, it is a minus. This tells us that there is an inverse relationship between
demand and price – a rise in price will cause a contraction in demand and a fall in price will
cause an extension in demand.
The other piece of information is provided by the size of the figure. This indicates the extent
by which demand will extend or contract when price changes. A figure of – 2, for instance,
indicates that a 1% change in price will cause a 2% change in quantity demanded.
Changes in PED:
PED becomes more elastic as the price of a product rises. Consumers become more sensitive
to price changes, the higher the price of the product. This is because, for instance, a 10% rise
in price when price was initially $10,000 would involve consumers having to spend
considerably more (i.e. $1,000) to buy the product. If a supplier was foolish enough to keep
raising the price, a point would come when the product would be priced out of the market. At
this point, demand would be perfectly elastic.
As the price falls, demand becomes more inelastic. For e.g. a 10% fall in price when the price
was initially $1 is not very significant and is unlikely to result in much extra demand. If price
falls to zero, there will be a limit to the amount people want to consume. At this point,
demand is perfectly inelastic. Fig. 3 shows how PED varies over a straight line demand
curve. At the mid-point there is unit PED, with the percentage change in quantity demanded
matching the percentage change in price.
PED also changes when there is a shift in the demand curve. The more consumers want and
are able to buy a product, the less sensitive they are to price changes. So a shift in the demand
curve to the right reduces PED at any given price. In Fig. 4, PED is initially -5 (50%/ -10%)
when price falls from $10 to $9. Then when demand increases to D1D1, PED falls to -2.5
(25%/-10%).

4. When demand decreases, consumers become more sensitive to price changes and demand
becomes more elastic. Fig. 5 shows PED rising from -5 to -10 (100%/ -10%).
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5. Income Elasticity of Demand YED
This measures the responsiveness of demand to a change in income.
e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then
the YED = 20/ 5 = 4.
YED = % change in Q.D
% change in Income
Definition of INFERIOR GOOD
This occurs when an increase in income leads to a fall in demand. Therefore YED<0.
E.g. clothes from charity shops, cheap bread
When your income increase you buy better quality goods
Defintion of NORMAL GOOD
This occurs when an increase in income leads
To an increase in demand for the good, Therefore YED>0
Definition of LUXURY GOOD
This occurs when an increase in demand causes a bigger
% increase in demand, therefore YED > 1.
 Luxury goods will also be normal goods and we can say
They will be income Elastic
 Income inelastic This means an increase in income leads to a smaller % increase
in demand. Therefore 0> YED <1
 Firms will make use of YED by producing more luxury goods during periods of
economic growth, similarly there will be less demand for inferior goods.