It is defined as the responsiveness of demand to a change in price.
Here is the formula for calculating P.E.D:
(% Change in quantity demanded) / (% Change in Price)
The figures are usually negative but a rule of thumb is to omit the negative sign.
P.E.D is important in many situations and is particularly significant when considering a change in price. How will demand change when I increase or decrease the price? Is it worthwhile to manipulate the price?
The answer to these questions are determined by whether the product in question is demand elastic or inelastic...
Elastic
Elastic products are those where demand is extremely sensitive to changes in price. If the price went up by a few pence, we would expect a significant change in demand. The idea here is that people decide not to purchase your product. Products in competitive markets where there are many substitutes will probably be elastic. For example if the chocolate bar you buy increases in price from 50p to 70p you will probably look to buy a cheaper alternative if you budget around 50p per day. The only exception will be extreme brand loyalty when you refuse to buy any other substitute chocolate bar other than your favourite.
If we calculate P.E.D of a product using the above formula and p.e.d >1 then you've got yourself an elastic demand. Groovy.
We can illustrate elastic demand graphically too:
Remembering that demand curves slope downwards most of the time we can see that a small decrease in price from p1 to p2 results in a large increase in quantity demanded (q1 to q2) as a reduced price results in more consumers rushing to buy the product now that it's cheaper. To spot these diagrams look for a D Curve near to the horizontal!
Inelastic
Products that are demand inelastic respond little to a change in price. Therefore if prices increased or decreased significantly demand would stay similar or even the same. This occurs in the commodity markets - a commodity being something that has no direct substitute and if for example Mr Cadbury requires cocoa to make his chocolate he is forced to buy cocoa on the world market whatever the price as there is no alternative. Demand therefore stays similar. In addition other essentials such as petrol for your car is still bought even though prices are going up and up and up...
Even addictive products such as drugs and alcohol have inelastic demand. People are determined to consume these whatever the price and so as you'll see later, putting taxes on these goods is less effective than putting it on an elastic product.
If we calculate P.E.D of a product using the above formula and p.e.d < 1, then the product in question is demand inelastic.
Perhaps you prefer diagrams?
This is characterised by a D Curve near to the vertical. We can see that as price moves from p1 to p2, the change in the quantity demanded between q1 and q2 is small and so represents the fact that with inelastic goods a change in price results in a much smaller movement along the Q axis.
Extremes of P.E.D.
Perfectly Elastic
With a Perfectly Elastic (horizontal) Demand Curve demand is infinite and so there can't be a change in price.
Perfectly Inelastic
With a perfectly inelastic Demand Curve (Vertical) demand stays exactly the same despite changes in price. P.E.D = 0.
