To measure the rate of the response of quantity demands as a result of price changes you need to use price elasticity of demand (simply known as price elasticity). The formula for this is known as the price Elasticity of Demand (or PED for short), this formula is as follows:
PED = (percentage change in quantity demand) / (percentage change in price)
How to Calculate the Price Elasticity Demand
An example question that may be put fourth to you is to calculate the price elasticity of demand based on a given set of data. For example if the price changes from $9 to $10, you will need to use the chart at the bottom of this page. For this example, I will walk you through calculating the correct answer, if you wish to find the arc price elasticity of demand, please see that specific article.
Firstly we need to gather the required data. The original price is $9 and the updated price is $10, this gives us Old(price) = $9 and New(price) = $10. The attached chart also states that the demanded quantity at the old price is $9 and 110 at the new price. This now gives us Old(demand) of 150 and New(demand) of 110, by demand we are of course referring to the quantity which is demanded. To summarise, we now know these variables:
Old(price) = $9
New(price) = $10
Old(demand) = 150
New(demand) = 110
We can now use these variables to calculate the price elasticity, but to do that we firstly need to calculate the percentage change in both demand quantity and price. It is standard practice to calculate these percentages one at a time to avoid the possibility of mistake.
Calculating the Percentage Change in Demand Quantity
We use the following formula to calculate the percentage change that occurs for the quanity demanded:
[ New(demand) – Old(demand) ] / Old(demand)
For our example the calculation with the data is:
[110 - 150] / 150 = -0.2667
This gives us the result of a -0.2667 as the percentage change in the demand quanity. As an actual percentage this would be – 27% however for further calculations we keep this in the decimal format.
Calculating the Percentage Change in Price
Just like the previous example with the percentage change in demand, we use the same formula.
[ New(price) – Old(price) ] / Old(price)
Again by putting out data into the equation we get the following, note that we also keep this in the decimal format:
[10 - 9] / 9 = 0.1111
Now that we have calculated the percentage changes in price and demand we can continue on to calculate the price elasticity of demand.
Calculating the Price Elasticity of Demand
Now we get to use the formula mentioned at the start of this article, you may notice we are using the percentages worked out in the previous two steps:
PED = (percentage change in quantity demand) / (percentage change in price)
Using the data calculated earlier we can plug our data into the formula to calculate the variable, this result is again in decimal format.
PED = ( -0.2667 ) / ( 0.1111 ) = -2.4005
In terms of analyzing price elasticity, we are actually taking note of the absolute value (that is to say that we remove the negative for the number). In the example above (with the price increase up for $9 to $10) we calculate a price elasticity of demand to be 2.4005 (notice the negative sign is gone).
Interpretation of the Price Elasticity of Demand
Being good at economics is not just about calculating the numbers, although it does help greatly. It is taking that number and analyzing it to work out what it actually means, in this case we use price elasticity of demand to see how a price change can influence the demand of the product (or service). If you get a high elasticity in your calculation, then the consumers are very sensitive to the price change. If you get a high price elasticity would then indicate that the increase in price has caused customer to purchase much less of the product, if you then decide to lower the price customer demand should be expected to increase. A low price elasticity indicates that the change in price has had little or no effect on the demand.
We can actually assign the following rules to the results of price elasticity of demand. Keep in mind they are generalisations however.
If PED is greater than one then the demand is sensitive to the change in price (price elastic).
If PED is one then the demand is what we call unit elastic.
If PED is less than one then the demand is not affected by price change (called price inelastic).
As you may remember we always remove (or ignore) the negative when dealing with price elasticity, this means that PED will always become a positive number. In the example worked through in this article we got a result of 2.4005, this indicates that the demand is affected to the change of price.