Price Elasticity of Demand – Definition
Price elasticity of demand (PED) measures how sensitive the quantity demanded of a good or service is to changes in its price. It measures how much demand for a good or service changes based on the change in the price of that same good or service.
In simpler terms, it tells us how much the demand for a product changes when its price changes.
A good is considered to have elastic demand if the percentage change in price leads to a larger percentage change in quantity demanded. Conversely, a good is considered inelastic if the percentage change in price leads to a smaller percentage change in quantity demanded.
Price elasticity of demand tells us how much the demand for a product changes when its price changes.
Price Elasticity of Demand – Formula?
The formula for price elasticity of demand (PED) is:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
Where:
% Change in Quantity Demanded is the percentage change in the amount of goods or services that consumers are willing to purchase.
It’s calculated as [New Quantity/Old Quantity – 1]*100.
% Change in Price is the percentage change in the price of a good or service.
It’s calculated as [New Price/Old Price – 1]*100.
It is important to note that the price elasticity of demand will always be negative since price and quantity move in opposite directions on the demand curve.
However, when we discuss elasticities, we always discuss them as positive numbers. Therefore, mathematically, we need to take the absolute value of the calculation.
Price Elasticity of Demand – Interpreting
The price elasticity of demand can be described as elastic, inelastic, or unitary elastic.
Elastic
The price elasticity of demand is elastic when the ratio of the percentage change in quantity demanded to the percentage change in price is greater than one. In other words, the percentage change in price leads to a greater percentage change in quantity demanded.
A good (or service) is said to be elastic if the value of the price elasticity is greater than 1. That means consumers are relatively sensitive to changes in price.
Real-life example:
Lays chips
If the price of Lays chips changes, consumers may switch to a different brand, which decreases demand for Lays. This is because there are many close substitutes for Lays chips.
Fancy cut of steak
If the price of a Fancy cut steak increases, many customers may choose hamburgers instead.
Consumer durables
Items like washing machines and automobiles are purchased infrequently and can be postponed if prices increase.
Inelastic
The price elasticity of demand is inelastic when the ratio of the percentage change in quantity demanded to the percentage change in price is less than one. In other words, the percentage change in price leads to a lesser percentage change in quantity demanded.
A good is considered inelastic if the elasticity formula results in a value less than 1. That means consumers are relatively insensitive to price changes.
Real-life example:
Gasoline
The demand for gasoline generally is fairly inelastic, especially in the short run. Car travel requires gasoline. The substitutes for car travel offer less convenience and control.
Much car travel is necessary for people to move between activities and can’t be reduced to save money.
However, in the long run, more options are available, such as purchasing a more fuel-efficient car or choosing a job that is closer to where you work.
Unitary
The price elasticity of demand is said to be unitary when the ratio of the percentage change in quantity demanded to the percentage change in price equals one. In other words, the percentage change in the quantity demanded of a product is equal to the percentage change in the price of the product.
A good is said to be unitary (or unit) elastic if the percentage change in its price leads to an equal percentage change in demand. However, unitary demand is fairly rare.
Real-life example:
Digital cameras
If the price of digital cameras increases by 10%, the quantity of digital cameras demanded decreases by 10%.
How to Calculate Price Elasticity
Let’s look at some examples of calculating PED.
Ex.1: Assume that gasoline prices increase from $3.50 per gallon to $4.50 per gallon. This represents an approximate 29% increase in price. Further, assume that demand decreases by 10%. This results in a price elasticity of 0.3 (10%/29%). Since the result of this calculation is less than 1, the good is considered inelastic.
Ex. 2: Now let’s assume that the price of a luxury sports car decreases by 5%. In turn, the demanded quantity increases by 15%. This results in an elasticity of 3 (15%/5%), which is considered highly elastic.
Please note that these examples are hypothetical and not necessarily representative of actual elasticities for these goods.
Factors that Impact Elasticities
The elasticity of demand for products will vary depending on a number of factors, including the availability of substitutes, the necessity of the product, the proportion of income spent on the product, and the time period.
Number of substitutes
The greater the number of substitutes, the more elastic the demand will be. This is because consumers can easily switch to a different but similar product if the price of the original product increases. If there are not many substitutes, then the demand will be relatively inelastic.
Necessity of the product
The necessity of the product also impacts the elasticity. Necessary goods and services will have inelastic demand since they are required for everyday use. If goods are not necessary, then they will exhibit relative elasticity.
Disposable income
The proportion of income spent on the product impacts elasticity as well. Basically, if someone spends a lot of income on a specific good, the demand for that product is generally more elastic.
Conversely, if a product represents a small fraction of a person’s income, the demand tends to be less sensitive to price changes, making it more inelastic.
An example of an elastic product in this case would be the cost of housing. Since the cost of housing normally represents a significant portion of a person’s income, a change in the price of housing can lead to substantial changes in behavior.
An inelastic product with this factor would be toothpaste, which is relatively inexpensive and would continue to be used even if the price increased quite a bit.
Time
Time also affects elasticity. For example, gasoline has an inelastic demand over the near term as consumers will have to pay the price in order to travel. However, over a longer time, consumers may be able to switch to a hybrid vehicle, so any increase in gasoline price might be offset by the more fuel-efficient hybrid.
Limitations of Elasticity of Demand
The price elasticity of demand, like any analytical tool, has some limitations and is impacted by various factors, including:
Ceteris Paribus assumption
Elasticity calculations usually rely on the assumption that all other factors remain constant (known as ceteris paribus). In reality, this is rarely the case since multiple variables can and do change simultaneously.
Availability of Data
Reliable data on quantities sold and actual prices is necessary for calculating elasticity accurately. However, in many cases, it’s quite difficult to find this data.
Time Horizon
As mentioned previously, elasticity can vary between the short-term and long-term. Short-term elasticity estimates may not be applicable to long-term scenarios (or vice versa).
How is the Price Elasticity of Demand Related to the Law of Supply and Demand?
Elastic demand ties directly to the demand curve, which graphically represents the relationship between the price of a good and the quantity.
The steeper the demand curve, the more inelastic the demand. In contrast, a flatter demand curve indicates more elastic demand.
The price elasticity of demand also impacts the supply side of the market. Suppliers need to understand the demand elasticity for their products in order to set the optimal price. Suppliers might be able to raise prices for inelastic goods, whereas a price increase for elastic goods would potentially reduce sales.
The Importance of Understanding Elasticity for Businesses and Policymakers
Understanding the price elasticity of demand is necessary for both businesses and policymakers because it impacts decision-making and formulating public policy. Below are some examples of how price elasticity is important for both groups.
Pricing strategy
Elasticity helps businesses determine the optimal pricing of their products and services. As an example, businesses that face elastic demand might avoid high price increases, since elasticity implies that consumers would likely significantly reduce their consumption.
Conversely, for goods with inelastic demand, businesses might be able to increase prices without losing much demand, potentially increasing total revenue.
Resource allocation
Understanding which products have elastic or inelastic demand can help management properly allocate resources to product development. For example, companies might invest more in marketing and improving products that are inelastic in order to generate more stable sales.
Market entry
Elasticity analysis can help companies decide whether to enter new markets by evaluating the demand elasticity of potential customers in different regions or socioeconomic segments.
Tax policy
Elasticity can be used by policymakers to determine the potential effects of taxing particular goods or services. Taxes on an inelastic good like gasoline are likely to generate higher revenue with less decline in consumption. In contrast, taxes on elastic goods might lead to a significant reduction in consumption, resulting in lower tax revenue.
Regulatory decisions
Regulators need to understand how price regulations might impact the market and consumers. Elasticity can be used to predict whether regulatory decisions will lead to changes in consumption.
Economic planning
Elasticity projections can help policymakers with fiscal and monetary policy. For example, understanding how fuel price changes affect consumer behavior and transportation costs can help in formulating policies that can promote economic stability and growth.
Other Types of Elasticities
Income Elasticity of Demand
Income elasticity of demand measures the relationship between the consumer’s income and the demand for a particular good. It may be positive or negative, or even non-responsive for a particular product.
The consumer’s income and a product’s demand are directly linked to each other, dissimilar to the price-demand equation.
Positive income elasticity is typically associated with normal goods, where demand increases as income increases. An example of this would be electronics, where the demand increases when a consumer’s income increases.
Negative income elasticity is associated with inferior goods, where demand decreases as income increases.
An example of an inferior good is generic brand groceries. These groceries are staples that are typically offered at a lower price compared to similar brand-name products. When people’s income increases, they may opt for the more expensive brands.
Cross-Price Elasticity of Demand
Cross-price elasticity measures how the demand for one good changes in response to a change in the price of another good.
A positive cross-price of elasticity indicates the presence of substitutes since the increase in the price of one good increases the demand for a different good.
An example of this would be airline tickets. If one airline decides to raise the price of a round-trip ticket, consumers will likely notice the difference and purchase tickets from a cheaper, different airline.
A negative cross-price of elasticity indicates the presence of complementary goods. An example of a complementary product is an eBook reader. If the price of an eBook reader drops, the consumption of eBooks and audiobooks will increase because more consumers can afford the reader.
Price Elasticity of Supply (PES)
A similar concept to PED is the price elasticity of supply (PES). In this case, PES measures how much of a good or service is supplied relative to a change in the price. The key difference is that the price elasticity of supply is focused on the supply side instead of the demand side.
The formula for price elasticity of supply is essentially the same as the PED formula, but the numerator is the percentage change in quantity supplied instead of demanded.
Price Elasticity of Supply = % Change in Quantity Supplied / % Change in Price
Like demand, the elasticity of supply can be described as elastic or inelastic. A good is elastic if the PES formula is greater than one and inelastic if the result is less than one.
A supply-elastic good is typical where production can be increased or decreased relatively easily in response to changes in price.
Inelastic supply often happens with goods that require a long time to produce or where there are resource limitations.
