Price Elasticity of Demand (PED)

PED is not only a firm's tool. It shapes the decisions of four groups: consumers, workers, producers and the government.

Consumers

PED describes consumers' own responsiveness, so it decides which price rises a household absorbs and which it reacts to. For a necessity with no close substitute, demand is inelastic: the household keeps buying much the same quantity, its total expenditure on that good rises, and less of the budget is left for everything else. For an elastic good, the consumer has real choices: switch to a rival brand, postpone the purchase until prices fall, or go without. Knowing which of your purchases are elastic tells you where cutting back actually protects your budget.

Workers

Demand for labour is derived from demand for the product, so the PED of what a worker helps produce affects that worker's job. Where the product has price-inelastic demand, a price rise barely dents sales, so output and revenue are stable, employment is more secure, and workers are in a stronger position when bargaining for higher pay because the firm can pass the extra cost on to customers. Where the product is price-elastic, sales and output swing sharply with price, so hiring and hours are volatile and pay demands are more likely to be resisted or met with job losses, since the firm cannot raise its price without losing customers.

Producers and firms

Beyond setting the price (the rule above), PED tells a firm how much risk any price change carries. If demand is inelastic the firm can pass a cost increase or a new tax on to its customers with little loss of sales; if demand is elastic it has to absorb most of that cost itself. A firm whose products all have elastic demand also faces far less predictable revenue, so it will be more cautious about committing to extra capacity.

Government

The government uses PED when deciding what to tax and what to subsidise.

• Taxes on inelastic goods raise large tax revenue with a small fall in quantity sold. This is why "sin taxes" on cigarettes, alcohol and fuel are so common: these goods are inelastic, so the tax raises revenue without wiping out the market.
• Taxes on elastic goods raise less revenue and shrink the market a lot. A high tax on a luxury good would push consumers to substitutes, and tax revenue would fall.
• Subsidies on elastic goods produce a large rise in quantity demanded for each pound of subsidy spent. This is why subsidies for renewable-energy products like solar panels are designed to be substantial: demand responds strongly.

A common slip: saying that an inelastic good's demand does not fall at all when its price rises. It does fall, just by a smaller percentage than the price rise. When cigarette duty rises, smoking really does fall a little, but by less than the price has risen.