What Is Price Elasticity of Demand?
Price elasticity of demand is a measurement of the change in the consumption of a product in relation to a change in its price. Expressed mathematically, it is:
Price Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Price
Economists use price elasticity to understand how supply and demand for a product change when its price changes. Besides demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity of supply refers to the relationship between change in supply and change in price. It's calculated by dividing the percentage change in quantity supplied by the percentage change in price. Together, the two elasticities combine to determine what goods are produced at what prices.
- Price elasticity of demand is a measurement of the change in consumption of a product in relation to a change in its price.
- A good is perfectly elastic if the price elasticity is infinite (if demand changes substantially even with minimal price change).
- If price elasticity is greater than 1, the good is elastic; if less than 1, it is inelastic.
- If a good's price elasticity is 0 (no amount of price change produces a change in demand), it is perfectly inelastic.
- If price elasticity is exactly 1 (price change leads to an equal percentage change in demand), it is known as unitary elasticity.
- The availability of a substitute for a product affects its elasticity. If there are no good substitutes and the product is necessary, demand won’t change when the price goes up, making it inelastic.
What Is Elasticity?
Understanding Price Elasticity of Demand
Economists have found that the prices of some goods are very inelastic. That is, a reduction in price does not increase demand much, and an increase in price does not hurt demand either. For example, gasoline has little price elasticity of demand. Drivers will continue to buy as much as they have to, as will airlines, the trucking industry, and nearly every other buyer.
Other goods are much more elastic, so price changes for these goods cause substantial changes in their demand or their supply.
Not surprisingly, this concept is of great interest to marketing professionals. It could even be said that their purpose is to create inelastic demand for the products they market. They achieve that by identifying a meaningful difference in their products from any others that are available.
If the quantity demanded of a product changes greatly in response to changes in its price, it is elastic. That is, the demand point for the product is stretched far from its prior point. If the quantity purchased shows a small change after a change in its price, it is inelastic. The quantity didn’t stretch much from its prior point.
Factors That Affect Price Elasticity of Demand
Availability of Substitutes
The more easily a shopper can substitute one product for another, the more the price will fall. For example, in a world in which people like coffee and tea equally, if the price of coffee goes up, people will have no problem switching to tea, and the demand for coffee will fall. This is because coffee and tea are considered good substitutes for each other.
The more discretionary a purchase is, the more its quantity of demand will fall in response to price increases. That is, the product demand has greater elasticity.
Say you are considering buying a new washing machine, but the current one still works; it's just old and outdated. If the price of a new washing machine goes up, you’re likely to forgo that immediate purchase and wait until prices go down or the current machine breaks down.
The less discretionary a product is, the less its quantity demanded will fall. Inelastic examples include luxury items that people buy for their brand names. Addictive products are quite inelastic, as are required add-on products, such as ink-jet printer cartridges.
One thing all of these products have in common is that they lack good substitutes. If you really want an Apple iPad, a Kindle Fire won’t do. Addicts are not dissuaded by higher prices, and only HP ink will work in HP printers (unless you disable HP cartridge protection).
Duration of Price Change
The length of time that the price change lasts also matters. Demand response to price fluctuations is different for a one-day sale than for a price change that lasts for a season or a year.
Clarity of time sensitivity is vital to understanding the price elasticity of demand and for comparing it with different products. Consumers may accept a seasonal price fluctuation rather than change their habits.
Types of Price Elasticity of Demand
Price elasticity of demand can be categorized according to the number calculated by dividing the percentage change in quantity demanded by the percentage change in price. These categories include the following:
|Types of Price Elasticity of Demand|
|If the percentage change in quantity demanded divided by the percentage change in price equals:||It is known as:||Which means:|
|Infinity||Perfectly elastic||Changes in price result in demand declining to zero|
|Greater than 1||Elastic||Changes in price yield a significant change in demand|
|1||Unitary||Changes in price yield equivalent (percentage) changes in demand|
|Less than 1||Inelastic||Changes in price yield an insignificant change in demand|
|0||Perfectly inelastic||Changes in price yield no change in demand|
Data: Khan Academy
Example of Price Elasticity of Demand
As a rule of thumb, if the quantity of a product demanded or purchased changes more than the price changes, the product is considered to be elastic. (For example, the price goes up by 5%, but the demand falls by 10%.)
If the change in quantity purchased is the same as the price change (say, 10%/10% = 1), the product is said to have unit (or unitary) price elasticity.
Finally, if the quantity purchased changes less than the price (say, -5% demanded for a +10% change in price), then the product is deemed inelastic.
To calculate the elasticity of demand, consider this example: Suppose that the price of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers increase their apple purchases by 20%. The elasticity of apples is thus: 0.20/0.06 = 3.33. The demand for apples is quite elastic.
What Is Price Elasticity of Demand?
Price elasticity of demand is the ratio of the percentage change in quantity demanded of a product to the percentage change in price. Economists employ it to understand how supply and demand change when a product’s price changes.
What Makes a Product Elastic?
If a price change for a product causes a substantial change in either its supply or demand, it is considered elastic. Generally, it means that there are acceptable substitutes for the product. Examples would be cookies, luxury automobiles, and coffee.
What Makes a Product Inelastic?
If a price change for a product doesn’t lead to much if any change in its supply or demand, it is considered inelastic. Generally, it means that the product is considered to be a necessity or a luxury item with addictive constituents. Examples would be gasoline, milk, and iPhones.
What is the importance of price elasticity of demand?
Knowing the price elasticity of demand of a good allows someone selling that good to make informed decisions about pricing strategies. This metric provides sellers with information about consumer pricing sensitivity. It is also key for makers of goods to determine manufacturing plans as well as for governments assessing how to impose taxes on goods.
Harvard Business Review. "A Refresher on Price Elasticity."
St. Louis Fed. "Elasticity of Demand - The Economic Lowdown Podcast Series."
CFA Institute. "Demand and Supply Analysis: Introduction."
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