Explain the concept of price elasticity of demand? How does one calculate it? What is the relationship between price elasticity of demand and firms’ total revenue?
Price elasticity of demand (PED) is a measure of the responsiveness of demand for a product after a change in that product’s price. It is calculated with the following formula: PED = %change in quantity demanded of good x/%change in price of good x. A good is said to have price inelastic demand when a change in price results in a less than proportional change in quantity. A good is said to have price elastic demand when a change in price results in a more than proportional change in quantity.
The relationship between price elasticity of demand and firms’ total revenue stems from this idea: for a price inelastic good, when a firm increases the good’s price, demand decreases but at a slower rate than the price increase so a firm can increase revenue through a price increase of the good. However, for a price elastic good when a firm increases the good’s price, demand decreases at a faster rate than the price increase so a firm decreases its revenue through a price increase of the good.
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