Price Elasticity: Types, Measurement & Real-World Impact

TAKEAWAYS:

• Price elasticity shows how much demand changes when price rises or falls.
• The midpoint formula (arc elasticity) is the most accurate way to calculate elasticity.
• Goods can be elastic (demand changes a lot), inelastic (demand barely changes), or unitary elastic (demand changes proportionally).
• Elasticity affects tax burden (who really pays more: buyers or sellers?).
• Real-world examples include Nepal’s fuel price hikes and smartphone demand.
• NEB exams test calculations, graphs, and real-world applications—practice all three!

---

What is Price Elasticity of Demand?

Price elasticity of demand (PED) measures how much the quantity demanded of a good changes when its price changes. It helps businesses and governments predict how consumers will react to price changes.

Key Idea:

• If price rises, quantity demanded falls (law of demand).
• But how much it falls depends on the good’s elasticity.

Formula:

$$\text{Price Elasticity of Demand (PED)}=\frac{\%\text{ Change in Quantity Demanded}}{\%\text{ Change in Price}}$$

But why use percentages? Because elasticity is unitless—it tells us the proportionate change, not absolute numbers.

---

Why Use the Midpoint (Arc Elasticity) Formula?

The simple percentage formula can give different answers depending on which point you start from. The midpoint formula avoids this problem.

Midpoint Formula:

$$\text{PED}=\frac{\%\Delta Q}{\%\Delta P}=\frac{\frac{Q_2-Q_1}{(Q_1+Q_2)/2}}{\frac{P_2-P_1}{(P_1+P_2)/2}}=\frac{(Q_2-Q_1)}{(Q_1+Q_2)/2}\times \frac{(P_1+P_2)/2}{(P_2-P_1)}$$

Simplified: $$\text{PED}=\frac{\Delta Q}{\Delta P}\times \frac{(P_1+P_2)}{(Q_1+Q_2)}$$

Why is this better?

• Gives the same answer no matter which direction price changes.
• More accurate for real-world calculations.

---

Types of Price Elasticity

Elasticity can be classified into five main types, each with different implications for businesses and policymakers.

1. Perfectly Elastic Demand (PED = ∞)

• Definition: A tiny price increase causes demand to drop to zero.
• Graph: Horizontal line (parallel to X-axis).
• Example:
  • Identical products (e.g., wheat from different farmers).
  • If one farmer raises price, buyers switch to another farmer instantly.

Real-World Example (Nepal):

• If one petrol pump in Kathmandu raises price, customers go to another pump immediately.

2. Perfectly Inelastic Demand (PED = 0)

• Definition: Price changes have no effect on quantity demanded.
• Graph: Vertical line (parallel to Y-axis).
• Example:
  • Life-saving drugs (e.g., insulin for diabetics).
  • Salt (people buy almost the same amount even if price doubles).

Real-World Example (Nepal):

• Electricity for hospitals (even if price rises, they must buy it).

3. Relatively Elastic Demand (PED > 1)

• Definition: Quantity demanded changes more than proportionally to price changes.
• Example:
  • Luxury goods (e.g., iPhones, designer clothes).
  • If price rises by 10%, demand falls by 20%.

4. Relatively Inelastic Demand (PED < 1)

• Definition: Quantity demanded changes less than proportionally to price changes.
• Example:
  • Necessities (e.g., rice, medicine, public transport).
  • If price rises by 10%, demand falls by only 5%.

5. Unitary Elastic Demand (PED = 1)

• Definition: Quantity demanded changes exactly proportionally to price changes.
• Example:
  • Some agricultural products (e.g., potatoes in Nepal).
  • If price rises by 10%, demand falls by 10%.

---

Determinants of Price Elasticity

What makes a good elastic or inelastic? Five key factors:

Example (Nepal):

• Rice (inelastic) vs. Smartphones (elastic).
• Fuel (short-term inelastic, but long-term elastic as people switch to electric vehicles).

---

Price Elasticity of Supply (PES)

While PED focuses on demand, Price Elasticity of Supply (PES) measures how much quantity supplied changes when price changes.

Formula:

$$\text{PES}=\frac{\%\text{ Change in Quantity Supplied}}{\%\text{ Change in Price}}$$

Types of PES:

---

Applications of Price Elasticity

1. Business Pricing Strategies

• Elastic Goods: Businesses lower prices to increase sales (e.g., airlines, hotels).
• Inelastic Goods: Businesses raise prices to increase revenue (e.g., medicine, electricity).

Example:

• Nepal’s Fuel Prices:
  • If demand for fuel is inelastic, a price hike increases total revenue for the government.
  • But if demand is elastic, people switch to public transport, reducing revenue.

2. Taxation and Government Revenue

Governments use elasticity to decide who bears the tax burden.

Why?

• If demand is elastic, buyers switch to substitutes → sellers pay more tax.
• If demand is inelastic, buyers have no choice → consumers pay more tax.

Example (Nepal):

• Sin Taxes (tobacco, alcohol): Inelastic demand → consumers pay more.
• Tax on Luxury Imports: Elastic demand → importers (sellers) pay more.

3. Agricultural Price Support

• Governments set minimum prices for farmers (e.g., rice, wheat in Nepal).
• If demand is inelastic, farmers can sell more even at higher prices.

---

Solved Examples (NEB Style)

Example 1: Calculating PED (Midpoint Formula)

Given:

• Initial Price (P₁) = Rs. 50, Initial Quantity (Q₁) = 100 units
• New Price (P₂) = Rs. 60, New Quantity (Q₂) = 80 units

Find: PED

Solution: $$\text{PED}=\frac{(80-100)}{(100+80)/2}\times \frac{(50+60)}{(60-50)}=\frac{-20}{90}\times \frac{110}{10}=-2.44$$ Interpretation:

• PED = -2.44 (ignoring the negative sign, demand is elastic).
• A 1% price increase leads to a 2.44% drop in demand.

Example 2: Identifying Elasticity Type

Scenario:

• When the price of Nepal’s public transport fare increased by 20%, the number of passengers dropped by 5%.

Find: Is demand elastic or inelastic?

Solution: $$\text{PED}=\frac{5\%}{20\%}=0.25(\text{Inelastic})$$ Conclusion:

• Demand is inelastic (PED < 1).
• Government can increase fares to raise revenue.

---

Common Mistakes to Avoid

1. Ignoring the Negative Sign:

   • PED is always negative (law of demand).
   • But we ignore the sign when classifying elasticity.

2. Using Simple Percentage Formula:

   • Always use the midpoint formula for accuracy.

3. Confusing PED and PES:

   • PED = Demand response to price.
   • PES = Supply response to price.

4. Assuming All Goods Are Elastic/Inelastic:

   • Check substitutes, necessity, time period, etc.

---

NEB Board-Style Questions (Practice)

Short Answer (5 Marks)

1. Define price elasticity of demand. Explain any two determinants of price elasticity.
2. Calculate the price elasticity of demand if the price of a good rises from Rs. 20 to Rs. 25 and quantity demanded falls from 100 to 80 units.
3. Why do governments impose higher taxes on demerit goods like tobacco? Explain with the concept of price elasticity.

Long Answer (10 Marks)

4. Explain the concept of price elasticity of supply with a diagram. How does it differ from price elasticity of demand? Give examples from Nepal’s economy.
5. A farmer in Nepal sells 50 kg of potatoes at Rs. 10 per kg. When the price rises to Rs. 12 per kg, he sells 40 kg. Calculate the price elasticity of demand. What does this tell you about the demand for potatoes in Nepal?

---

Exam Tip: How to Score Full Marks

1. Always Use the Midpoint Formula:

   • NEB expects accuracy—simple percentage formula may deduct marks.

2. Draw Diagrams for Elasticity Types:

   • Perfectly elastic = horizontal line.
   • Perfectly inelastic = vertical line.
   • Elastic/inelastic = sloped lines (steeper = inelastic, flatter = elastic).

3. Relate to Nepal’s Economy:

   • Use real examples (fuel, rice, smartphones, public transport).
   • NEB loves contextual answers.

4. Explain Both Theory and Application:

   • Don’t just calculate—interpret what the number means (elastic/inelastic?).
   • Link to business decisions, taxation, or government policies.

5. Memorize Key Values:

   • PED > 1 = Elastic
   • PED < 1 = Inelastic
   • PED = 1 = Unitary Elastic
   • PED = 0 = Perfectly Inelastic
   • PED = ∞ = Perfectly Elastic

---