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Price elasticity of demand is a concept that is tested on the Business Environment and Concepts (BEC) exam and it's one that can be rather tricky. The price elasticity of demand is the measure of how sensitive demand is to a change in price. Like many of the concepts on the BEC CPA exam, it is important to know the formula and how to interpret the results. Let's go ahead and look at the two formulas that you may use to calculate price elasticity of demand.

The first formula:

Price Elasticity of Demand (ED) formula

ED=  Percentage change in quantity demanded ÷  Percentage change in price

The second formula is known as the ARC formula (most commonly used formula):

Price Elasticity of Demand (ED) ARC formula:

ED=( Change in quantity demanded ÷ Average quantity) ÷ ( Change in Price ÷  Average Price)

Now that we’ve taken a look at the two formulas you may use, let's look at an example. Because the ARC formula is the most common and complex, we will do an example using the ARC formula.

 Price elasticity of demand example: XYZ Co. sells product X for \$10. The usual demand is 100 units per day. In order to increase sales, XYZ Co. lowers the price of the product to \$8. The sales increase to 500 sales per day. Step 1: Calculate the change in quantity demanded: (500 - 100) = 400 Step 2: Calculate the change in price: (\$10 - \$8) = \$2 Step 3: Calculate the average quantity: [(500 + 100) ÷ 2] = 300 Step 4: Calculate the average price: [(\$8 + \$10) ÷ 2] = \$9 Step 5: Plug the pieces into the ARC formula

ED= (400 ÷ 300) ÷ (\$2 ÷ \$9)

ED = (1.33 ÷ .22)

ED = 6.0

Alright, here's the deal. So we know the product that XYZ sells has a price elasticity of demand that is equal to 6. But what does that mean? Here are the basic rules to interpreting price elasticity of demand.

If the elasticity is greater than 1, then the price is considered to be  elastic. The product in the above example is elastic since the elasticity is 6. This means that the product is sensitive to price change. So, if the price of the product increases, then total revenue will decrease. If the price of the product decreases, then the total revenue will increase (as with the above example).

If the elasticity is less than 1, then it is considered  inelastic. This means that the product is not sensitive to price change. If the price of the product increases, then the total revenue increases. If the price of the product decreases, then the total revenue decreases.

If the elasticity is equal to 1, then the product is  unitary. This means that the product is neither sensitive nor insensitive to price change. If there is a price change then total revenue stays the same.

By using the elasticity coefficient of a product, it is possible to predict how a change in price will affect demand. Using the product from the example, which had an ED of 6, if the price were to decrease by 5%, then the demand would increase by 30% (5% x 6).

Price elasticity of demand is a tough concept. However, like many of the concepts on BEC with a little practice and the right CPA review course you can be confident that you will know how to answer even the toughest questions on the CPA exam. For more tips, visit our  free resources page or take a look at one of our  sample chapters from our  BEC review course.

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