Relationship between PED and the amount spent by consumers and revenue raised by firms

The Allocation of Resources – Price Elasticity of Demand (PED)

What is Price Elasticity of Demand?

Price Elasticity of Demand measures how much the quantity demanded of a good changes when its price changes. It tells us whether consumers are elastic (very responsive) or inelastic (not very responsive) to price changes.

Formula (written in LaTeX): \$PED = \frac{\% \Delta Q_d}{\% \Delta P}\$

How to Interpret PED Values

  • Elastic demand (|PED| > 1) – Quantity changes more than price. Example: 🍕 pizza, a small price drop leads to a big jump in orders.

  • Unit‑elastic demand (|PED| = 1) – Quantity changes proportionally with price.

  • Inelastic demand (|PED| < 1) – Quantity changes less than price. Example: 🚗 fuel – people still need it even if the price rises.

Analogy: The Rubber‑Band Test

Imagine a rubber band. If you pull it (increase price) and it stretches a lot (quantity falls a lot), the demand is elastic. If it barely stretches, demand is inelastic.

Example Calculation

Pizza price rises from \$8 to \$9 (a 12.5% increase). Quantity sold falls from 100 to 90 (a 10% decrease).

PED = \$\frac{-10\%}{12.5\%} = -0.8\$ → inelastic demand (|PED| < 1).

Impact on Consumer Spending

Total amount spent by consumers = price × quantity.

ScenarioPrice ($)Quantity (units)Total Spending ($)
Before price rise8100800
After price rise990810

Even though fewer pizzas were sold, total spending increased because the price increase outweighed the drop in quantity – a typical result when demand is inelastic.

Impact on Firm Revenue

Firm revenue (TR) = price × quantity. The effect of a price change on revenue depends on PED.

Elasticity TypeEffect of Lowering PriceEffect of Raising Price
Elastic (|PED| > 1)Revenue increases (quantity rises more than price falls).Revenue decreases (quantity falls more than price rises).
Unit‑elastic (|PED| = 1)Revenue stays unchanged.Revenue stays unchanged.
Inelastic (|PED| < 1)Revenue decreases (quantity rises less than price falls).Revenue increases (quantity falls less than price rises).

Quick Check: What Would Happen?

  1. Price of a popular video game drops by 20%. The quantity sold increases by 50%. Is the demand elastic or inelastic?

  2. Fuel prices rise by 10%, but quantity demanded falls by only 5%. What does this say about consumer spending on fuel?

Answers: 1️⃣ Elastic (|PED| = 2.5). 2️⃣ Inelastic – consumers still buy almost the same amount, so total spending on fuel goes up.

Key Takeaways

  • Elasticity tells us how sensitive demand is to price changes.

  • Consumer spending (total amount spent) = price × quantity.

  • Firm revenue changes with price depending on whether demand is elastic, unit‑elastic, or inelastic.

  • Use the PED formula to predict whether a price change will raise or lower revenue.