How do I calculate and interpret price elasticity of demand? When is demand elastic vs inelastic?

Price elasticity of demand (PED) is one of those concepts that seems simple but has nuances the CFA exam loves to test. Let me break it down completely. **The Formula:** PED = % Change in Quantity Demanded / % Change in Price PED is almost always **negative** (price up, quantity down), but we typically discuss it in absolute value terms. **Interpreting the Result:** | |PED| Value | Classification | Revenue Effect of Price Increase | |-------------|----------------|----------------------------------| | > 1 | **Elastic** | Revenue **decreases** (quantity drops more than price rises) | | = 1 | **Unit elastic** | Revenue **unchanged** | | < 1 | **Inelastic** | Revenue **increases** (quantity drops less than price rises) | **Worked Example:** Crestview Beverages sells premium sparkling water at $3.50 per bottle and sells 40,000 bottles per month. They raise the price to $4.00 and sales drop to 32,000 bottles. **Step 1 — Calculate percentage changes:** - % Change in price = ($4.00 - $3.50) / $3.50 = 14.29% - % Change in quantity = (32,000 - 40,000) / 40,000 = -20.00% **Step 2 — Calculate PED:** - PED = -20.00% / 14.29% = **-1.40** - |PED| = 1.40 **Step 3 — Interpret:** Since |PED| > 1, demand is **elastic**. A 1% increase in price causes a 1.4% decrease in quantity demanded. Consumers are quite sensitive to price changes. **Step 4 — Revenue impact:** - Before: $3.50 x 40,000 = **$140,000** - After: $4.00 x 32,000 = **$128,000** - Revenue **fell by $12,000** — consistent with elastic demand **Factors That Make Demand More Elastic:** - Many close substitutes available (generic bottled water) - The good represents a large share of the consumer's budget - Longer time horizon (consumers find alternatives) - The good is a luxury, not a necessity **Factors That Make Demand More Inelastic:** - Few or no substitutes (insulin for diabetics) - Small share of budget (table salt) - Short time horizon - The good is a necessity **Exam Trap:** The CFA exam sometimes uses the **midpoint (arc) method** for calculating percentage changes, which uses the average of the two quantities and prices as the base. Always read the question carefully to see if they specify which method to use. For more economics practice problems with detailed solutions, explore our CFA Level I question bank on AcadiFi.