Corporate Finance & Accounting

price elasticity of demand

What is price elasticity of demand?

Price elasticity of demand is a measure of the change in the consumption of a product as the price changes. 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 change when the price of a product changes.

key takeaways

  • Price elasticity of demand is a measure of how changes in consumption of a product relate to changes in its price.
  • A commodity is elastic if a change in price causes a significant change in demand or supply.
  • A good is inelastic if changes in price do not result in large changes in demand or supply.
  • The availability of product substitutes affects its resilience. If there are no good substitutes and the product is necessary, demand will not change when prices rise, making it inelastic.

Understanding the Price Elasticity of Demand

Economists have found that the prices of some commodities are very inelastic. That is, falling prices will not greatly increase demand, and rising prices will not hurt demand. For example, the price elasticity of demand for gasoline is small. Drivers will continue to buy as much as they can, as will airlines, the cargo industry and pretty much every other buyer.

Other commodities are much more elastic, so changes in the price of these commodities can cause significant changes in their demand or supply.

Not surprisingly, the concept has attracted a lot of interest from marketing professionals. One could even say that their purpose is to create inelastic demand for the products they sell. They do this by identifying meaningful differences between their product and any other available product.

A product is elastic if the quantity demanded varies greatly with its price. That is to say, the demand point of the product is far beyond the previous point. If the quantity purchased shows a small change after the price changes, it is inelastic. The amount hasn’t changed much from the previous point.

special attention items

Availability of alternatives is a factor

The easier it is for shoppers to substitute one product for another, the more prices drop. For example, in a world where people love coffee and tea, if the price of coffee rises and people have no problem switching to tea, the demand for coffee will drop. This is because coffee and tea are considered good substitutes.

Urgency is a factor

The freer you are to buy, the less it will be demanded as the price rises. That is, product demand is more elastic.

Let’s say you’re considering buying a new washing machine, but your current one still works; it’s just old and outdated. If the price of a new washing machine goes up, you might give up on buying it now and wait until the price drops or the current machine fails.

The less discretionary a product is, the less its demand falls. Examples of inflexibility include luxury goods that people buy for their own brands. Addictive products are very inflexible, like necessary add-ons like inkjet printer cartridges.

One thing all of these products have in common is their lack of good alternatives. If you really want an Apple iPad, the Kindle Fire won’t do it. Addicts won’t be dissuaded by higher prices, only HP inks can be used in HP printers (unless you disable HP ink cartridge protection).

Sales skewed the numbers

The length of time the price change lasts is also important. A one-day sale has a different demand response to price fluctuations than a price change that lasts for a season or a year.

Time-sensitive clarity is critical to understanding the price elasticity of demand and comparing it with different products. Consumers may accept seasonal price fluctuations rather than change their habits.

An example of price elasticity of demand

As a rule of thumb, a product is considered elastic if the change in demand or the quantity of the product purchased is greater than the change in price. (For example, price increases by 5%, but demand decreases by 10%.)

If the change in quantity purchased is the same as the change in price (for example, 10%/10% = 1), the product is said to be unit (or unitary) price elastic.

Finally, if the change in quantity purchased is less than the price (for example, a +10% change in price is -5% in quantity demanded), the product is considered inelastic.

To calculate the elasticity of demand, consider this example: Suppose the price of apples falls 6% from $1.99 per bushel to $1.87 per bushel. In response, grocery shoppers increased their apple purchases by 20%. Therefore, Apple’s elasticity is: 0.20/0.06 = 3.33. Apple’s demand is very elastic.

What is price elasticity of demand?

Price elasticity of demand is the ratio of the percentage change in the quantity demanded of a product to the percentage change in price. Economists use it to understand how supply and demand change when the price of a product changes.

What makes a product resilient?

A product is considered elastic if its price changes cause its supply and demand to change significantly. Generally, this means that there are acceptable substitutes for the product. Such as cookies, luxury cars and coffee.

What makes a product inelastic?

If a change in the price of a product does not cause any change in its supply or demand, then it is considered inelastic. Usually, this means that the product is considered a necessity or luxury with addictive ingredients. Such as gasoline, milk and iPhone.

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