Measurement of Price elasticity of Demand
The Outlay Method
The Total Outlay Method is a way of measuring the Price Elasticity of Demand (PED) by examining the effect of a change in price on the total revenue earned by the seller. Total revenue is the amount of money earned by the seller from the sale of a product and is calculated by multiplying the price per unit by the quantity sold.
If the PED for a good is elastic (greater than 1), a decrease in price will lead to an increase in the quantity demanded that is proportionately greater than the decrease in price, resulting in an increase in total revenue. Conversely, an increase in price will lead to a decrease in the quantity demanded that is proportionately greater than the increase in price, resulting in a decrease in total revenue.
If the PED for a good is inelastic (less than 1), a decrease in price will lead to an increase in the quantity demanded that is proportionately less than the decrease in price, resulting in a decrease in total revenue. Conversely, an increase in price will lead to a decrease in the quantity demanded that is proportionately less than the increase in price, resulting in an increase in total revenue.
If the PED for a good is unitary elastic (equal to 1), a change in price will result in an equal percentage change in the quantity demanded and total revenue will remain unchanged.
Using the Total Outlay Method, businesses and policymakers can use the change in total revenue resulting from a change in price to determine the PED of a good or service and make informed decisions about pricing strategies and taxation policies.
The Total Point Method
The Total Point Method involves calculating the PED by comparing the initial price and quantity demanded with a new price and quantity demanded at a different point along the demand curve.
Here are the steps to calculate PED using the Total Point Method:
- Choose two points on the demand curve: Choose two points on the demand curve to compare the price and quantity demanded. The two points should be different enough to show a noticeable change in quantity demanded as the price changes.
- Calculate the percentage change in quantity demanded: Subtract the initial quantity demanded from the new quantity demanded, divide by the average of the two quantities, and multiply by 100% to get the percentage change in quantity demanded.
- Calculate the percentage change in price: Subtract the initial price from the new price, divide by the average of the two prices, and multiply by 100% to get the percentage change in price.
- Calculate the PED: Divide the percentage change in quantity demanded by the percentage change in price to get the PED.
For example, suppose the initial price of a good is $10, and the quantity demanded is 100 units. At a new price of $12, the quantity demanded falls to 80 units. Using the Total Point Method, we can calculate the PED as follows:
Percentage change in Quantity Demanded = ((80-100)/((80+100)/2)) * 100% = -20%
Percentage change in Price = ((12-10)/((12+10)/2)) * 100% = 16.67%
PED = (-20% / 16.67%) = -1.2
Since the absolute value of the PED is greater than 1, we can conclude that the demand for this good is elastic. This means that a 1% increase in price will lead to more than a 1% decrease in quantity demanded. Conversely, a 1% decrease in price will lead to more than a 1% increase in quantity demanded.
