Price elasticity of demand refers to how much the demand for a product changes when the price of that product changes. In other words, it describes how buyers react to raising or lowering costs by altering how much they buy at any given price point.
In economics, price elasticity of demand (PED) measures the sensitivity of the quantity of goods demanded (or services) to changes in their price.
The measurement can vary between -1 and 1, where 1 indicates that every 1% change in price results in a proportional change in quantity demanded, and -1 indicates that every 1% change in price results in an inverse proportional change in quantity demanded.
Price elasticity of demand is necessary because it tells business owners how much their customers will react to changes in pricing and helps businesses set prices strategically to maximize sales and revenue based on their research into demand.
What is Price Elasticity of Demand?
Price elasticity of demand is defined as the responsiveness of demand for a particular product to changes in its price. It is the rate at which the quantity demanded changes as its price changes.
Price elasticity of demand is the degree of how complex the demand for a service or product is to changes in its price. Price elasticity is calculated by dividing the (%) change in the quantity demanded by the (%) change in price.
The higher the value, the more sensitive consumers are to changes in price.
When analyzing demand elasticity, there are three commonly discussed types: fairly or perfect elasticity, fairly inelastic or inelasticity, and unitary elasticity.
- Perfect elasticity is when the quantity demanded is infinitely sensitive to changes in price – meaning that a slight decrease in price results in an infinite increase in demand.
- Unitary elasticity occurs when a one percent decrease in price causes a one percent increase in demand.
- Inelasticity is when a one percent decrease in price results in less than a one percent increase in demand.
In other words, when Ed is less than 1, demand is said to be inelastic. On the other hand, demand is said to be perfectly elastic when Ed is greater than one. When the elasticity of demand is equal to one (i.e., Ed = 1), demand can be described as unitary elastic.
Understanding price elasticity is important for businesses, as it can help them determine pricing strategies and adjust their products accordingly. By understanding the price elasticity of demand, companies can develop an effective pricing strategy that will lead to greater sales and profit margins.
For example, if a product is highly elastic, businesses may benefit from lowering prices to increase sales volume. On the other hand, if the product is relatively inelastic, companies may increase their prices to maximize profits.
The formula for Price Elasticity of Demand
We can use the this formula to calculate the price elasticity of demand:
Ed = % Change in quantity demanded / % Change in price
Change in the quantity demanded/Original quantity demanded = Change in price/Original price
New quantity – Original quantity / Original quantity = New price – Original price/Original price
Where Ed stands for the elasticity of demand.
From the above calculation method, it can be seen that price elasticity of demand is the comparison between the rate of change in demand with the rate of change in the price that causes the change in demand.
How to Calculate Price Elasticity of Demand
Price elasticity of demand is an essential concept in economics that measures the responsiveness of consumers to changes in the price of a service or good.
You can calculate price elasticity of demand by dividing the %change in the quantity demanded of goods by the %change in its price. This calculation indicates how price-sensitive consumers are, and it can be used to inform pricing decisions and other business strategies.
In other to find the price elasticity of demand, you need to know the initial and final prices and quantities. From this, you can calculate the percentage change in price and the percentage change in quantity.
For example, let’s say the price of a product is initially $10, and after a decrease, it is now $8. The quantity demanded initially is 1,000 units; after the decrease, it is 1,400 units. If you want to calculate the price elasticity of demand, you need to calculate the percentage changes for both the price and quantity.
The price would be (8-10)/10 = -0.2 or -20%. For the quantity, it would be (1,400-1,000)/1,000 = 0.4 or 40%. So now you can divide the percentage change in quantity (40%) by the percentage change in price (-20%) to get a price elasticity of demand of 2.
This tells us that for every 1% decrease in price, there was a 2% increase in the quantity demanded. In this case, consumers are more responsive to changes in price than not, indicating that the demand for this product is price elastic.
- Understanding and calculating the price elasticity of demand can help businesses set their prices effectively and maximize profits.
- It can also predict how price changes will affect sales and revenue.
- By understanding how sensitive consumers are to price changes, businesses can make informed decisions about their pricing strategies.
Types of Elasticity of Demand
We have five (5) types of elasticity of demand:
- Zero elasticity of demand
- Elastic demand
- Inelastic demand
- Unitary elasticity of demand
- Infinitely elastic demand
1. Zero elasticity of demand:
When the quantity demanded remains the same, regardless of the change in price, the demand is said to be completely inelastic. Therefore, the elasticity of demand equals zero.
That occurs when prices stay the same, and the quantity stays unchanged no matter what happens with demand. As you may have guessed already, there’s no such thing as negative elasticity–it doesn’t make sense mathematically. However, the shape of a curve that shows how quantity varies with price reveals whether it has positive or negative elasticity.
2. Unitary Elasticity of Demand:
When the elasticity of demand equals 1, a fall or rise in price will lead to the same percentage rise or fall in quantity demanded. The demand is said to be unitary.
Unitary elasticity means that every time the price changes by a certain percentage, the quantity demanded changes by exactly that same percentage. So, for example, if we find out that at $1 per bottle of water, 100 bottles are sold per day, but at $2 per bottle of water, only 50 bottles are sold per day, then we know that the unitary elasticity is -50%.
3. Inelastic demand:
When the elasticity of demand has a value between 0 and 1, that is, a small change in price leads to a smaller percentage of change in the quantity purchased, the demand is inelastic.
In contrast to the cases above, when there is inelastic demand, large changes in the price will result in only small changes in the quantity demanded; therefore, as prices rise or fall, small amounts of adjustments happen.
4. Elastic Demand:
If the elasticity of demand is greater than one (1) but less than infinity, a small percentage change in price gives rise to a significant percentage change in the quantity supplied or demanded. The demand is said to be elastic.
When there is elastic demand, small changes in the price will result in significant changes in the quantity demanded. If people have many options for products and can easily switch between them, this will cause more of their purchases to be based on price.
On the other hand, if people have limited options and are not able to switch quickly from one product to another because they would lose some benefit from switching (e.g., customer loyalty), then this will cause less of their purchases to be based on price
5. Infinitely elastic demand (theoretical model)
The demand curve is horizontal, indicating that all quantities are sold at the same price. Purchasers are prepared to buy all the goods available at some price, P, and none at all at a slightly higher price. Such a situation is known as perfectly or infinitely elastic demand.
When there is infinitely elastic demand, the result of any small change in the price is a large proportionate change in the quantity demanded. An example of this could be ice cream sales during the summer months. It takes very few hot days to generate increased sales, even though each sale might not be all that expensive
Factors that affect Price Elasticity of Demand
Several factors affect the price elasticity of demand. They include;
1. Availability of Substitutes
The availability of substitutes can significantly affect the price elasticity of demand. For example, if there are many close substitutes for a product, customers can switch to other products if prices increase, resulting in a more elastic demand.
Conversely, if few close substitutes are available, customers may be less willing to switch, and the demand will be relatively inelastic.
2. Necessity of the Product
The necessity of a product also affects its price elasticity. Necessities, such as food and medical supplies, tend to have an inelastic demand because customers may be less likely to reduce consumption when prices rise.
On the other hand, luxury goods have more elastic demand because customers may be more willing to switch to alternatives when prices rise.
3. Time Frame for Measurement
The time frame for measuring the price elasticity of demand can also have an impact. Short-term elasticity is usually higher than long-term elasticity because customers may adjust their consumption patterns more quickly in response to short-term price changes.
As customers become accustomed to new prices over time, the long-term price elasticity becomes more important.
Understanding how these factors affect price elasticity of demand is essential for businesses to accurately forecast how price changes will affect revenue. By being aware of how these factors influence demand, companies can make better decisions about how to price their goods and services and optimize their profits.
Cross Elasticity of Demand
What is Cross Elasticity of Demand?
Cross elasticity of demand measure the responsiveness of the quantity demanded a good to changes in price for another good. It can be used to calculate how much total revenue would change if we changed the price or quantity sold.
Cross-elasticity estimates how responsive consumers will be to a given change in price and helps companies decide what prices they should charge. When used with revenue, it can help estimate potential profits from pricing changes.
In other words, it measures how much more (or less) consumers will buy when the price goes up (or down).
We use cross-elasticity as an indicator for our company’s next move on pricing because it tells us how well our product competes against similar products on price points near to ours and how responsive buyers are when prices go up or down.
Cross Price Elasticity of Demand
Firms want to maximize their revenues by adjusting their prices. To do this, they must consider the cross-price elasticity of demand – which is the change in total revenue generated by a certain percentage increase in price for one product divided by the same percentage increase in price for another product.
The higher this ratio is, the more likely firms are to increase the prices of their goods.
Companies may have different optimal pricing strategies based on whether customers tend to substitute goods when there’s an increase in one’s relative price or if customers purchase goods regardless of fluctuations in relative prices.
In conclusion, price elasticity of demand is a key economic concept that helps businesses understand how changes in price can affect their sales.
It’s important to remember that the price elasticity of demand varies depending on the good or service being offered and the circumstances under which it is being sold. By understanding price elasticity of demand, businesses can make more informed decisions about pricing strategies and maximize their profits.