Price Elasticity of DemandDefined along with Formula & How to Calculate
Price elasticity of demand is a measurement of how much the quantity demanded of a good or service will change in response to a change in price.
This measurement indicates how responsive the quantity demanded of a good is in response to a change in price.
This can be calculated by dividing the percentage in quantity demanded by the percentage change in the price of the good or service.
This is a critical measurement that shows how much a business can alter its prices before it has a negative impact on sales.
This works alongside the measurement of price elasticity of supply which represents the relationship between changes in supply and price.
When used in conjunction with each other, these two price elasticity measurements can be used to determine the sensitivity of demand and supply for a good or service to changes in price.
Price Elasticity of Demand Explained
Price elasticity of demand plays a central role in applying the law of demand in real marketplaces.
This measurement shows how responsive demand for a good or service will be to a change in price.
In other words, this measurement shows how consumers will react to a change in price.
This is a crucial measurement for businesses that would like to know how much they can charge before demand for their product drops.
For some products, demand is highly inelastic, which means that a change in demand will have little impact on the quantity demanded, and for others, the demand is highly elastic, which means that a change in price will have a significant effect on the quantity demanded.
Most companies would like their products to be inelastic, and in many cases, it is the job of marketing to help differentiate products from competitors and create an inelastic demand.
A common example of an inelastic good is the gasoline which drivers will continue to demand regardless of most changes in price. However, in contrast, most luxury goods, such as sports cars, have a high price elasticity meaning that a change in price will have a significant impact on consumers’ demand.
Price Elasticity of Demand and Total Revenue
One of the biggest concerns that a company has when it comes to price elasticity of demand is how a change in price will impact its total revenue.
Total revenue is based on the price per unit times the quantity demanded, so a company’s revenue is determined both by the price of its products and the amount consumers demand.
Because a change in price will almost always have an inverse impact on demand, i.e., an increase in price will reduce demand, and a decrease in price will increase demand, it can be difficult to predict how a change in pricing will affect total revenue.
The key to determining how a change in price for a product will affect total revenue is to determine how much change will occur in quantity demanded compared to the change in price, in other words, its price elasticity.
Price Elasticity and Total Revenue Example One
Consider a producer of carbonated water.
At $0.50 per can, the consumers demand 10,000 cans every day, which means total daily revenue of $5,000 ($0.50 * 10,000).
However, when the producer chose to increase the price to $0.60 per can, demand dropped to only 6,000 cans daily.
This means a total daily revenue of only $3.600 ($0.60 * 6,000), meaning that the increase in price led to a drop in total revenue.
In this example, the price changed from $0.50 to $0.60, and the quantity demanded changed from 10,000 cans a day to 6,000 cans a day. We will use the formula:
Price Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Price
Which can be expanded to:
Price Elasticity of Demand = [(New Quantity Demanded – Old Quantity Demanded) / Old Quantity Demanded] / [(New Price – Old Price)]
Computing the Percentage Change in Quantity Demanded
To compute the percentage change in quantity demanded, we will subtract the old quantity demanded from the new quantity demanded and divide the result by the old quantity demanded.
This will give us the percentage change in quantity demanded. The calculation is shown below.
Percentage Change in Quantity Demanded = [(10,000 – 6,000) / 6,000] = 0.667
Percentage Change in Quantity Demanded = 66.7%
Computing the Percentage Change in Price
Now that we have the percentage change in quantity demanded, we need to determine the percentage change in price.
To calculate this, we subtract the old price from the new price and divide this number by the old price.
This will give us the percentage change in price, as shown below.
Percentage Change in Price = [($0.60 – $0.50) / $0.50] = 0.20
Percentage Change in Price = 20%
Calculating the Price Elasticity of Demand
Next, we use the percentage change in quantity and price demanded to compute the price elasticity of demand.
We will divide the percentage change in quantity demanded by the percentage change in price demanded to obtain the price elasticity of demand.
Price elasticity of Demand = 0.667 / 0.20
Price elasticity of Demand = 3.34
This indicates that the price elasticity of demand for carbonated water is elastic. In this example, an increase in price led to a large drop in demand, which the increased price did not make up for. Therefore, there was a drop in total revenue.
Price Elasticity and Total Revenue Example Two
Now consider a gas station. Suppose that at $3.50 per gallon, consumers demand 2,100 gallons of gasoline per day.
This would result in total daily revenue of $7,350 ($3.50 * 2,100).
The gas station decided to raise the price to $4.25 per gallon, and the quantity demanded dropped to 2,000 gallons per day, resulting in total daily revenue of 8,500.
Though the quantity demanded dropped, the gas station’s total revenue still increased.
In this example, the price of gas increased from $3.50 to 4.25.
The quantity demanded at a price of $3.50 per gallon was 2,100 gallons per day.
When the price increased to $4.25 per gallon, the quantity demanded dropped to 2,000 gallons per day.
We will calculate the percentage change in quantity and price demanded using the same method used in example one.
Then, we will calculate the price elasticity of demand.
Computing the Percentage Change in Quantity Demanded
Percentage Change in Quantity Demanded = [(2,100 – 2,000) / 2,000] = 0.05
Percentage Change in Quantity Demanded = 5%
Computing the Percentage Change in Price
Percentage Change in Price = [($4.25 – $3.50) / $3.50)] = 0.214
Percentage Change in Price = 21.4%
Calculating the Price Elasticity of Demand
We will now calculate the price elasticity of demand for gasoline.
Price Elasticity of Demand = 0.05 / 0.214 = 0.25
Price Elasticity of Demand = 0.25
The price elasticity of demand for gasoline is .25, which is inelastic.
The increase in the price of gasoline only caused a small decrease in demand, and the increase in price more than made up for this decrease.
Therefore, the total revenue for the gas station increased.
In order for these businesses to use this information to determine how a price change will affect their total income, they can determine how elastic the demand for their product is.
When the price of a good changes, the quantity demanded will move in the opposite direction. Total revenue will move in the direction of the quantity that changes by the largest percentage.
For an elastic product, a change in price will result in a larger change in quantity demanded, which means that total revenue will move in the direction of the quantity change.
For an inelastic good, a change in price will result in a smaller quantity change, which means total revenue will follow the change in price if the change in price and quantity are the same as in the case of unitary elastic products.
Factors Impacting Price Elasticity of Demand
There are several factors that have a significant impact on how elastic the demand for a product is. These are some of the factors that have the largest impact.
Availability of Alternatives
If a consumer can easily acquire a substitute for a given product, then it is likely that if the price for such a product increases, then consumers will choose to purchase a substitute if prices rise.
This means that the product is more likely to have high elasticity.
The degree to which a product is a necessity will have a major impact on how demand is impacted by a change in price.
For example, if a drug is necessary to treat a certain medical condition, then it is likely that demand will not be highly impacted by a change in price.
However, if a purchase is highly discretionary, such as purchasing an expensive candy, then a change in price is likely to have a large impact on demand.
If a given product has significantly differentiated itself from competitors, then it is likely that it will have a lower degree of price elasticity.
For example, consumers may have a specific brand of cell phone that they will choose regardless of most changes in price.
Another brand may not suffice even if it can perform the same function meaning demand may be relatively inelastic.
Duration of Price Changes
The length of time that a price change lasts may have a significant impact on price elasticity.
For example, a sudden change in price, such as for a weekend sale, could have a much different impact on demand than a seasonal change in price.
It is important to consider the length of any changes in judging the elasticity of demand.
In addition, it is important to remember that over an extended period, goods become increasingly elastic.
For example, in the short term, a consumer may be willing to accept a large increase in gas prices.
However, if the price remains high for an extended period, they may choose to purchase an electric vehicle.
Categories of Elasticity
In order to better understand the elasticity of a particular good, economists have devised several categories of elasticity in which a particular good or service can be placed according to its particular elasticity. These Include:
If, when calculated, the price elasticity demand is infinite, then it is known as perfectly elastic.
Perfectly elastic demand indicates that even a small change in price will have an extreme effect.
Even a slight increase in price could result in demand declining to zero, and a slight decrease could result in an increase in demand to infinity.
An elastic demand results when the value of the price elasticity is greater than one.
With elastic demand, changes in price will result in a significant effect on demand.
An increase in price will generally result in a decrease in demand and vice versa.
If the resulting value is precisely one, then the demand is unitary elastic.
A change in price will result in a proportional change in demand, meaning that if a seller raises their prices by 10%, consumer demand will, in turn, decline by 10%.
If the resulting value is less than one, a change in price will result in very little effect on demand.
In this case, an increase in price would not result in a significant decrease in demand or vice versa.
If the value of the elasticity is zero, then the demand is perfectly inelastic.
In this case, a change in price will result in no change in demand.
A common example of this is life-saving medication such as insulin which has a nearly perfectly inelastic demand.
This is because regardless of a change in price, a consumer who needs insulin will have to purchase a certain amount of it to avoid death.
Example of Price Elasticity of Demand
As an example of price elasticity of demand, consider the XYZ Company.
This company wants to determine the price elasticity of demand for two of the products it sells in order to optimize pricing.
To do so, it raises the price of product A by 4%, which results in a decline in quantity demanded by 2%.
As a result, the XYZ Company can conclude that demand for product A is at least somewhat inelastic because raising the price of the product resulted in a less than proportional drop in sales.
As a result, the company can raise the price of product A and achieve greater revenue.
XYZ Company also tested the price elasticity of product B by raising its price by 3%.
This led to a decline in the quantity demanded for product B by 7%.
The XYZ Company can conclude from this that the demand for product B is highly elastic as the decrease in demand for this product was more than twice as great as the change in price.
For product B, the company cannot achieve greater revenue by raising its price.
What is the price elasticity of demand?
Price elasticity of demand is a measurement that indicates the degree to which a change in the price of a product will affect the quantity demanded of the product. This measurement is used by economists to understand how a change in a product’s price affects the supply and demand of the product.
What makes the demand for a good elastic?
When a change in price results in a significant change in demand or supply for a good or service, it is considered to be elastic. This often occurs when a good has readily available substitutes. A common example of an elastic good is coffee. If the price of coffee rises, many consumers are willing to choose a cheaper alternative, such as tea or energy drinks.
What makes the demand for a good inelastic?
When a change in price does not result in a significant change in the quantity demanded, a good is considered to be inelastic. Commonly this is the case when a good is a necessity, such as medicine or a food staple. Common examples of this include insulin and gasoline.
Why is the price elasticity of demand important?
An understanding of the price elasticity of demand for a good or service is crucial for making pricing decisions. By understanding how elastic the demand for a good is, a seller can adjust their pricing appropriately to achieve the highest total revenue. When used in combination with the elasticity of supply, this can provide a thorough understanding of the optimum level of pricing and supply for a given good or service.
Price elasticity of demand is one of the most important economic concepts any business leader needs to understand.
Price elasticity plays a crucial role in optimizing pricing strategies by determining how responsive consumers are to a change in price.
By understanding how elastic demand is, businesses can make educated decisions concerning pricing and grow sales revenue.
- Price elasticity of demand measures the responsiveness of demand to a change in price.
- Price elasticity of demand is almost always negative because the quantity demanded of a good will ordinarily fall when prices rise, as described by the law of demand.
- Demand for a product is considered elastic if the absolute value of its price elasticity is greater than one and inelastic if it is less than one.
- A product is considered to be perfectly inelastic if it has a price elasticity of zero, and in contrast, it is perfectly elastic if the price elasticity is infinite.
- The elasticity of demand for a given product is heavily reliant on the availability of substitutes. If a product is necessary and no suitable substitute is available, then consumers will have to continue purchasing it regardless of an increase in price. This means that demand for the product is inelastic.
FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.