Price Elasticity of Demand

What Is Price Elasticity of Demand?

Price elasticity of demand is a measurement of the change in consumption of a product in relation to a change in its price. Expressed mathematically, it is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Economists use price elasticity to understand how supply and demand for a product changes when its price changes.

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 termed "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 termed "inelastic." The quantity didn't stretch much from its prior point. 

Availability of Substitutes Is a Factor

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.

Urgency Is a Factor

The more discretionary a purchase is, the more its quantity of demand will fall in response to price rises. 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 It's just old and outdated.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.

But 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 like 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, another tablet brand won't do. Addicts are not dissuaded by higher prices. And only HP ink will work in HP printers.

Sales Skew the Numbers

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 in time sensitivity is vital to understanding the price elasticity of demand and for comparing it across different products. Consumers may accept a seasonal price fluctuation rather than change their habits.

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 termed elastic. (For example, the price changes 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 termed 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 therefore is: 0.20/0.06 = 3.33, The demand for apples is quite elastic.