Price elasticity of demand is all about how demand for a product changes when its price goes up or down.
Understanding this can be a game-changer for businesses, helping them forecast better, set smarter prices, and ultimately thrive in the market.
So, if you’re in sales or running your own business, getting cozy with price elasticity is like having a secret weapon in your arsenal—it’s the key to unlocking success in the ever-changing world of pricing.
Definition, formula, and diagram
Do you know how people react to price changes?
That’s where price elasticity of demand (PED) comes in. It’s like a gauge for how responsive demand is to price shifts.
You calculate PED by dividing the percentage change in quantity demanded by the percentage change in price.
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
For example, if demand jumps 15% in response to a 10% price drop, the PED would be 1.5. It’s a handy tool for understanding customer behavior and fine-tuning pricing strategies.
Typically, when prices go up, demand goes down, giving the price elasticity coefficient a negative value.
But economists, in their unique way, often express it as positive.
However, a drop in demand doesn’t always mean lower revenue. Increased profit margins can offset slight decreases in sales.
If the price elasticity is less than 1, it’s termed inelastic, meaning a price increase leads to a smaller drop in demand. Conversely, if the coefficient is over 1, it’s elastic, indicating a larger decrease in demand with a price hike. Maximum revenue occurs when elasticity equals 1, known as unit elastic demand.
Price Elasticity of Demand Vs Price Elasticity of Supply
| Aspect | Price Elasticity of Demand (PED) | Price Elasticity of Supply (PES) |
| Definition | Measures responsiveness of quantity demanded | Measures responsiveness of quantity supplied |
| to changes in price | to changes in price | |
| Formula | PED = % Change in Quantity Demanded / % Change in Price | PES = % Change in Quantity Supplied / % Change in Price |
| Interpretation | If PED > 1, demand is elastic | If PES > 1, supply is elastic |
| If PED < 1, demand is inelastic | If PES < 1, supply is inelastic | |
| If PED = 1, demand is unit elastic | If PES = 1, supply is unit elastic | |
| Focus | Focuses on the demand side of the market | Focuses on the supply side of the market |
Types of price elasticity of demand
This section will elaborate on various types of price elasticity of demand. Now we shall see each of these in detail.
Elastic demand
It refers to a scenario in economics where the demand for a product or service changes significantly in response to a change in its price.
Put simply, small fluctuations in price lead to substantial shifts in the quantity demanded. This concept is crucial for understanding how consumers react to price alterations in the market.
In elastic demand situations, a slight price increase results in a considerable decrease in the quantity demanded, while a minor price reduction prompts a significant increase in demand.
This responsiveness to price changes is often observed in products or services with numerous substitutes or those considered non-essential.
For instance, if the price of a specific brand of ice cream rises, consumers may readily switch to another brand or opt not to purchase ice cream at all, illustrating elastic demand for that brand.
Elastic demand is measured quantitatively using the price elasticity of demand (PED) formula, which calculates the percentage change in quantity demanded divided by the percentage change in price.
If the absolute value of this calculation exceeds 1, the demand is deemed elastic. This indicates that consumers are highly reactive to price shifts, demonstrating a significant sensitivity to pricing adjustments in their buying choices.
Unit elastic demand
Unit elastic demand occurs when the percentage change in quantity demanded of a product or service exactly matches the percentage change in its price.
In essence, any alteration in price results in an equivalent proportional adjustment in the quantity demanded. In economic terms, unit elastic demand describes a situation where consumers’ responsiveness to price fluctuations is precisely proportional.
For instance, if the price of a product rises by 10%, leading to a 10% decrease in demand for that product, it indicates unit elastic demand.
Similarly, if the price decreases by a certain percentage and the demand increases by the same percentage, it also signifies unit elastic demand.
The relationship between price and quantity demanded is measured using the price elasticity of demand (PED) formula, which calculates the percentage change in quantity demanded divided by the percentage change in price.
A PED value of precisely 1 denotes unit elastic demand. This value signifies that the product occupies a balance point between elastic and inelastic demand, displaying a direct one-to-one response to price shifts.
Unit elastic demand is relatively uncommon compared to elastic and inelastic demand as it necessitates a precise equilibrium in consumer behavior.
Products exhibiting unit elastic demand hold a distinctive position because alterations in their prices have a neutral impact on total revenue; any proportional increase in price is exactly counterbalanced by a proportional decrease in quantity demanded, and vice versa.
Relatively elastic demand
Elastic demand characterizes a scenario where the demand for a product or service exhibits heightened sensitivity to changes in its price.
Here, even a slight percentage change in price prompts a notably larger percentage adjustment in the quantity demanded.
This responsiveness implies that consumers are highly reactive to price fluctuations, with minor price tweaks potentially resulting in substantial increases or decreases in product consumption.
For instance, envision a circumstance where the price of a specific luxury coffee variant declines by 5%, leading to a subsequent 15% increase in demand for that coffee.
Such a scenario exemplifies relatively elastic demand, as the percentage change in quantity demanded (15%) surpasses the percentage change in price (5%).
The price elasticity of demand (PED) quantifies this correlation, calculated as the percentage change in quantity demanded divided by the percentage change in price.
When the absolute value of PED exceeds 1, it signifies relatively elastic demand, indicating heightened responsiveness to price variations.
Relatively elastic demand often manifests in markets offering numerous substitutes or for non-essential luxury items that consumers can easily forgo if prices rise.
This underscores the significance of pricing strategies for businesses, as minor price alterations can trigger substantial shifts in product sales, influencing overall revenue and market positioning.
For businesses, recognizing relatively elastic demand for their product necessitates careful consideration of the repercussions of price adjustments on demand and revenue.
It underscores the pivotal role of competitive pricing and marketing strategies in shaping consumer purchasing behaviors within these markets.
Unitary elastic demand
Unitary demand, also referred to as unit elastic demand, arises when the percentage change in quantity demanded precisely matches the percentage change in price, resulting in a price elasticity of demand (PED) of precisely 1.
This indicates that any alteration in the price of a product or service triggers an equivalent and proportional adjustment in the quantity demanded. Essentially, if the price of a product increases by a certain percentage, the demand for that product decreases by the same percentage, and vice versa.
While it’s challenging to find pure examples of unitary demand in real-world scenarios due to various influencing factors beyond price, such as income fluctuations, consumer preferences, and substitute availability, consider a hypothetical situation.
Suppose a streaming service raises its monthly subscription fee by 10%, leading to a subsequent 10% decrease in subscribers. This scenario would exemplify unitary demand for the subscription service.
Unitary demand holds significance for both businesses and economists as it represents a pivotal point where total revenue remains constant irrespective of price adjustments.
When a company raises prices, the reduction in quantity sold precisely offsets the increase in price, maintaining total revenue. Conversely, lowering prices results in a proportional increase in quantity sold, again preserving total revenue.
Deviation from this equilibrium point can either enhance elasticity, rendering demand more responsive to price variations, or diminish elasticity, reducing the sensitivity of demand to price fluctuations.
Inelastic demand
lastic demand characterizes a scenario where the demand for a product or service remains relatively unchanged despite fluctuations in its price.
This indicates that alterations in price have minimal impact on the quantity of the product purchased by consumers. Inelastic demand is commonly observed in goods or services deemed essential or possessing limited substitutes.
Consider essential medications for chronic illnesses as an example. Even if the price of these medications rises, individuals reliant on them will likely continue purchasing them due to the lack of viable alternatives and the essential nature of the product for their well-being.
Similarly, basic utilities such as water and electricity exhibit inelastic demand because they are indispensable, and consumers have few alternatives.
Quantitatively, inelastic demand is assessed using the price elasticity of demand (PED), which compares the percentage change in quantity demanded to the percentage change in price.
If the absolute value of PED is less than 1, the demand is categorized as inelastic. This indicates that consumers exhibit minimal responsiveness to price fluctuations when making purchasing decisions.
Inelastic demand underscores consumers’ reliance on a product, suggesting that businesses and policymakers can adjust prices without significantly impacting overall demand.
However, it also implies that reducing prices is unlikely to substantially boost demand, necessitating careful consideration in pricing strategies and policy formulations.
Perfectly inelastic demand
Perfectly inelastic demand characterizes a scenario wherein the demand for a product or service remains constant irrespective of variations in its price.
This implies that regardless of price fluctuations, the quantity demanded remains unchanged. Graphically, perfectly inelastic demand is depicted by a vertical line in a demand versus price graph, indicating no alteration in demand as prices shift.
Consider a life-saving medication for individuals with a critical condition as an illustration of perfectly inelastic demand.
For these individuals, the quantity of medication purchased remains constant regardless of the price, as it is indispensable for their survival.
The price elasticity of demand (PED) for a product exhibiting perfectly inelastic demand is 0, indicating that changes in price do not affect the quantity demanded.
Although perfectly inelastic demand is a theoretical concept and seldom encountered in real-world markets, it serves as a valuable tool for comprehending consumer responses to price variations.
It underscores scenarios wherein consumers lack alternatives or where the product is deemed an absolute necessity, rendering their purchasing decisions impervious to price changes.
Relatively inelastic demand
Relatively inelastic demand refers to a scenario in which the demand for a product or service exhibits only minimal changes in response to alterations in its price.
Here, a notable percentage shift in price results in a much smaller percentage adjustment in the quantity demanded. This indicates that consumers display limited responsiveness to price fluctuations, maintaining relatively consistent purchasing patterns even amidst price variations.
For example, consider the demand for gasoline. If the price of gasoline rises by 20%, the quantity demanded might only decrease by 5%. This scenario demonstrates relatively inelastic demand because the percentage change in quantity demanded (5%) is considerably smaller than the percentage change in price (20%).
The price elasticity of demand (PED) serves as a measure of this relationship, calculated by dividing the percentage change in quantity demanded by the percentage change in price.
When the absolute value of PED is less than 1, it signifies relatively inelastic demand, indicating that consumers are not highly responsive to price adjustments.
Relatively inelastic demand is typically associated with essential goods and services such as basic food items, utilities, and certain medications, where substitutes are limited, or the product is deemed a necessity regardless of price fluctuations.
Recognizing a product with relatively inelastic demand implies understanding that alterations in price are unlikely to significantly impact the quantity sold.
This insight can inform various strategies, including pricing strategies, tax policies, and subsidy decisions, particularly for essential commodities where demand is expected to remain stable despite price changes.
Types of price elasticity of demand.
| % Change in quantity demanded/ % Change in price | Type |
| 0 | Perfectly Inelastic |
| < 1 | Inelastic |
| = 1 | Unitary |
| > 1 | Elastic |
| Infinity | Perfectly Elastic |
Calculation of price elasticity of demand
Let’s illustrate the calculation of the price elasticity of demand (PED) using a straightforward example:
Suppose a coffee shop decides to reduce the price of its signature coffee from $5.00 to $4.50. Consequently, the quantity of coffee sold per day rises from 100 cups to 120 cups.
Step 1: Determine the percentage change in quantity demanded.
First, ascertain the change in quantity demanded: 120 cups – 100 cups = 20 cups.
Then, divide the change in quantity by the original quantity: 20 / 100 = 0.2.
Finally, convert it to a percentage: 0.2 * 100 = 20%.
Step 2: Calculate the percentage change in price.
Initially, determine the change in price: $4.50 – $5.00 = -$0.50.
Next, divide the change in price by the original price: -$0.50 / $5.00 = -0.1.
Lastly, convert it to a percentage: -0.1 * 100 = -10%.
Step 3: Compute the price elasticity of demand (PED).
PED equals the percentage change in quantity demanded divided by the percentage change in price.
Therefore, PED = 20% / -10% = -2.
In this example, the PED is -2, indicating elastic demand for coffee. This implies that for every 1% reduction in the coffee price, the quantity demanded increases by 2%. The negative sign is customary in PED calculations, reflecting the inverse relationship between price and quantity demanded as per the law of demand.
How Price Elasticity of Demand is Measured?
The Price Elasticity of Demand (PED) is determined by dividing the percentage change in the quantity demanded of a product or service by the percentage change in its price.
This calculation provides insight into the responsiveness of product demand to price fluctuations. When a minor price adjustment results in a significant demand shift, the product is deemed highly elastic.
What Price Elasticity of Demand Measures?
The Price Elasticity of Demand (PED) gauges the degree to which the quantity demanded of a good or service reacts to alterations in its price. It indicates the extent to which demand for a product will increase or decrease in response to price fluctuations.
This metric plays a crucial role in enabling businesses and economists to grasp consumer behavior and anticipate potential shifts resulting from various pricing strategies.
What influences the price elasticity of demand?
The researchers at the Ehrenberg-Bass Institute really dug deep into what makes people tick when it comes to pricing. They didn’t just scratch the surface; they uncovered some real gems about what drives prices up or down.
Let’s break down their findings in plain language:
- They found that whether a product’s price matches or exceeds that of the top dog in its category really affects how elastic its demand is. It’s not just about the number on the price tag; it’s about how it stacks up against the competition and common benchmarks like a nice, round $10 bill. So, if you’re trying to keep your product flying off the shelves, you’ve got to keep an eye on what your rivals are doing. If you’re playing catch-up in pricing, you better crunch some numbers to figure out the sweet spot relative to the big players.
- Size doesn’t always matter when it comes to brands and elasticity. Sometimes, it’s more about what stage the product is in and whether it’s seen as pretty much the same as everyone else’s. Take something like PVC pipes – they’re all pretty similar, right? In cases like that, people tend to care more about how much they’re shelling out or how well it’s being advertised rather than the brand name.
3. Nobody likes it when prices shoot up out of the blue. That’s why they found that sticking to moderate increases, like single-digit percentages, keeps customers happier. Once you cross that 10% mark, though, people start tightening their purse strings big time.
4. The regular folks out there – the mass market – are the most sensitive to price changes. Even small shifts in price can make a big difference in how much they’re buying. But when it comes to cheaper or fancier stuff, people tend to stick to their favorites, so elasticity isn’t as big of a deal.
5. Ever notice how a big, flashy discount sign grabs your attention more than a little sticker tucked away in the corner? Turns out, those attention-grabbing discounts work like a charm. Slap a bright red label on something, and suddenly, it seems like a steal.
6. Newbies to a brand or folks who really pinch pennies are the most likely to change their buying habits based on price. They’re less concerned about brand loyalty and more about snagging a deal. But even they have a limit – there’s a price they just won’t go below.
And hey, there’s a whole bunch of other stuff that plays into how people react to prices, but thankfully, there are some nifty pricing tools out there to help businesses navigate it all. So, if you’re curious to dive deeper into the world of pricing strategies, check out our handy guide.
Can Price Elasticity of Demand be Negative?
Absolutely, price elasticity of demand often takes on a negative value. This tendency stems from the fundamental law of demand, which dictates an inverse correlation between price and quantity demanded.
In simpler terms, when prices rise, typically demand falls, and conversely, when prices drop, demand tends to increase.
When Price Elasticity of Demand is Negative?
When the price rises and demand decreases, the price elasticity of demand (PED) takes a negative value. This pattern is quite common since, in general, consumers tend to purchase fewer goods or services as prices climb.
The negative sign simply indicates that the change in quantity demanded moves in the opposite direction compared to the change in price.
Why Price Elasticity of Demand is Negative?
PED exhibits a negative value due to a fundamental economic principle: typically, when the price of a product rises, consumers tend to demand less of it, and conversely, when the price falls, demand increases.
This inverse relationship between price and quantity demanded is precisely reflected by the negative sign associated with PED.
When Price Elasticity of Demand is Less than 1?
When PED is below 1, it signifies that the product’s demand is inelastic. In practical terms, this implies that the percentage change in demand is smaller than the percentage change in price.
Essentially, consumers show limited sensitivity to price fluctuations, and their purchasing patterns remain relatively stable even amid price adjustments.
Who uses Price Elasticity of Demand?
Price Elasticity of Demand (PED) is utilized by various stakeholders, including:
Businesses and Marketers: They employ it to determine optimal pricing strategies for their offerings, with the goal of maximizing profitability through insights into how alterations in prices may influence sales volumes.
Economists: They leverage PED to assess the macroeconomic landscape, forecasting how price fluctuations could impact consumer expenditure and overall economic expansion.
Policy Makers: PED aids policymakers in comprehending the potential ramifications of taxes, subsidies, and other regulatory measures on the demand for goods and services, informing decisions aimed at shaping economic outcomes.
How do companies use it?
Price elasticity serves as a valuable metric for gauging performance. It guides businesses towards crafting products and services that offer distinctive and enduring value to customers compared to alternative options.
Moreover, price elasticity is influenced by various factors such as the nature of the product, the income level of target consumers, economic conditions, and competitive dynamics.
It’s crucial to consider these contextual elements rather than examining price elasticity in isolation.
Understanding the underlying reasons behind consumer behavior in response to price changes is essential for predicting future responses and shaping effective marketing strategies.
However, it’s important to acknowledge that calculating price elasticity can be imprecise due to the impossibility of predicting consumer actions across all price points and market scenarios.
Additionally, while knowing the price elasticity of demand for a product is valuable, it doesn’t inherently provide guidance on how to manage that product effectively.
Examples of price elasticity of demand
Let’s simplify things with some real-life examples of price elasticity of demand. Generally, price and demand move in opposite directions, but the extent of this movement varies depending on the product, especially its necessity.
Let’s take the example of gasoline for your car. Will a $0.50 increase per gallon deter you from filling up your tank? Typically, aside from being annoying, the answer is no.
Many people depend on gasoline for their daily commute, so they’ll continue to purchase it even with a slight price hike.
In this case, gasoline is considered inelastic because it would take a significant price increase to significantly reduce demand. Check out the graph below for a visual representation of this price elasticity example:
On the flip side, imagine if the cost of your daily lunchtime pizza slice increased by $0.50. Would this impact your decision to buy it? Unless you had a strong preference for that particular pizza joint and lacked alternative options (more on that later), chances are you’d consider switching to another lunch spot.
Food items like pizza typically exhibit elasticity, meaning even minor price hikes can prompt shifts in demand.
How to determine the price elasticity of demand for your product?
Most businesses strive to maximize their revenue potential. Achieving this goal entails making your product as inelastic as possible, thereby boosting demand irrespective of price increases.
Ideally, you want your customers to perceive your business as indispensable, whether due to unique features, exceptional service, or top-notch marketing efforts. While the specific factors driving this perception may vary across customer segments, the overarching strategy remains consistent.
So, how can you assess your product’s elasticity within each segment and leverage this understanding to your benefit?
Here are some key considerations to ponder:
Is the product a necessity or a luxury?
Essentials like gasoline, electricity, and water tend to be inelastic goods, meaning demand remains relatively stable even with price fluctuations. Conversely, luxury items such as chocolate, dining out, and entertainment are more elastic—consumers are more likely to cut back on these expenses during tough times.
For instance, you might not hesitate to buy light bulbs even with a slight price increase, but you might reconsider booking that dream cruise if the cost rises.
Google’s AdWords platform serves as a prime example of driving demand effectively, as many businesses rely on its advertising to sustain their operations.
While competitors are emerging, the combination of effective marketing and a compelling product has established Google’s offering as a necessity for many.
To ensure your product remains indispensable to customers, consider the scenario where their revenue dwindles (for B2B) or their disposable income decreases (for B2C).
What aspects of your offering make it essential, even in challenging times? This concept is known as income elasticity of demand and can vary greatly, ranging from highly elastic to inelastic.
Close substitute availability
I’m a big fan of beef.
If the price of Wendy’s went up, I’d easily switch to another brand.
With so many options available, unless Wendy’s Head could somehow convince me that their quality justified the price hike, I’d likely opt for substitute goods. When your product faces stiff competition from similar alternatives, raising prices could drive customers away.
Let’s give a quick nod to product differentiation here.
In SaaS and software, this is often more achievable compared to selling vacuum cleaners. Therefore, focus on developing unique features that are indispensable to customers and set you apart from competitors.
Alternatively, aim to become an integral part of your customer’s story, where the hassle of switching from your product would outweigh any potential benefits.
For instance, switching CRM systems can be cumbersome both tactically and procedurally. However, it’s worth noting that competitors aware of this could develop user-friendly solutions to entice customers away from you and boost their own sales.
Actual cost of your product
Even if you specialize in selling some of the most budget-friendly cars on the market, the price of a car, even a cheap one, still represents a significant investment compared to many other products.
Generally, the higher the price, the more elastic the demand due to the psychological impact of pricing.
For instance, you probably don’t pay much attention to the exact cost of a pack of Paper Mate pens, so a small price increase of 10% (just a few cents) is unlikely to register with you.
However, if the price drops by 10% on that new car you’ve been eyeing (amounting to hundreds or even thousands of dollars), you’re bound to take notice.
You can leverage the actual price points of your products by offering options at various levels. While you wouldn’t sell a car for $50 (unless it’s a true beater), you might introduce a car rental program to cater to a lower price point.
Companies like Zipcar excel at this strategy with their hourly and daily rental rates.
Final words
Price elasticity of demand (PED) measures how sensitive consumers are to changes in the price of a product or service. It’s calculated by dividing the percentage change in quantity demanded by the percentage change in price.
A PED of greater than 1 indicates elastic demand, meaning consumers are highly responsive to price changes, while a PED of less than 1 suggests inelastic demand, indicating that changes in price have less impact on quantity demanded.
Factors influencing PED include the availability of substitutes, necessity of the product, and proportion of income spent on the product.
Understanding PED is crucial for businesses, economists, and policymakers. It helps businesses set prices to maximize profits, economists analyze market dynamics, and policymakers formulate effective economic policies.
FAQs
What are the types of price elasticity?
Price elasticity of demand encompasses two main categories: elastic demand and inelastic demand. Elastic demand occurs when the quantity demanded of a good is highly responsive to changes in price. In contrast, inelastic demand describes a situation where the demand for goods remains relatively unaffected by price variations. Generally, goods considered non-essential tend to exhibit elastic demand, while essential or necessity goods often display inelastic demand.
What is an example of elastic demand?
Elastic demand refers to a situation where a small change in price triggers a significant shift in demand. For instance, if the price of Lays chips undergoes a substantial increase, consumers are more inclined to switch to alternative brands, thereby reducing demand. Conversely, if the price decreases, demand tends to rise. This illustrates that chips exhibit elastic demand because there are readily available substitutes.
What is an example of inelastic demand?
Inelastic demand characterizes a situation where changes in price have little effect on the demand for a product. For instance, gasoline is essential for operating vehicles, and there are no viable substitutes for it. Consequently, regardless of how high the prices may rise, individuals with cars still need to purchase gasoline, resulting in inelastic demand.
Why is price elasticity of demand important?
Understanding price elasticity provides valuable insight into how a market will respond to adjustments in prices. This knowledge is crucial for businesses when making pricing decisions because increasing or decreasing prices directly affects sales volume. Taking price elasticity into account is an essential step for companies to establish appropriate pricing strategies tailored to their specific market segments.
What is Cross Price Elasticity?
This concept gauges the demand for a product in response to changes in the price of another product. For instance, when the price of Coca-Cola increases, consumers may switch to Pepsi, leading to a rise in demand for Pepsi. This price sensitivity phenomenon can also work in reverse. For example, if the price of burgers were to increase, the demand for burger buns would likely decrease.
