Price Elasticity of Demand: How Much Does Price Change What We Buy?
What is Price Elasticity of Demand?
Price Elasticity of Demand (PED) is a number that shows the relationship between a change in price and the resulting change in the quantity demanded. It answers the question: "If I change the price by 1%, by what percentage will the quantity people want to buy change?"
$PED = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Price}$
We use percentage changes to compare different products fairly. For example, a $1 change in the price of a candy bar is huge, but a $1 change in the price of a car is tiny. Percentages make these changes comparable.
The result of this calculation gives us one of five main categories, which are summarized in the table below.
| Elasticity Value (PED) | Term | What It Means | Simple Example |
|---|---|---|---|
| $PED > 1$ | Elastic Demand | Quantity demanded changes by a larger percentage than the price change. Consumers are very responsive. | A 10% price increase for a specific brand of cookies causes a 20% drop in sales, as people switch to other brands. |
| $PED < 1$ | Inelastic Demand | Quantity demanded changes by a smaller percentage than the price change. Consumers are not very responsive. | A 10% price increase for insulin[1] causes only a 2% drop in quantity demanded, as patients need it to survive. |
| $PED = 1$ | Unit Elastic Demand | Quantity demanded changes by the exact same percentage as the price change. | A 10% price cut leads to a 10% increase in quantity sold. Total money spent remains the same. |
| $PED = 0$ | Perfectly Inelastic Demand | Quantity demanded does not change at all when the price changes. The demand curve[2] is vertical. | A life-saving medicine with absolutely no substitutes. People will buy the same amount regardless of price. |
| $PED = \infty$ | Perfectly Elastic Demand | Consumers will buy an infinite quantity at a specific price, but nothing at a price even slightly higher. The demand curve is horizontal. | A farmer selling identical wheat in a huge market. If they raise their price even a cent above the market price, buyers will go elsewhere. |
What Makes Demand Elastic or Inelastic?
Several factors determine whether the demand for a product is elastic or inelastic. Think of these as the "rules of responsiveness."
1. Availability of Substitutes: This is the most important factor. If a product has many close substitutes, demand is usually elastic. If the price of Coke goes up, people can easily switch to Pepsi. If a product has few or no substitutes, demand is inelastic. There is no substitute for a specific prescription drug for a patient who needs it.
2. Necessity vs. Luxury: Necessities tend to have inelastic demand. People need to buy bread, milk, and electricity even if prices rise. Luxuries, like designer handbags or vacation packages, have elastic demand. If their prices go up, people can easily postpone or cancel buying them.
3. Proportion of Income Spent: Products that take up a large portion of your budget (like a car or rent) tend to have more elastic demand. A 5% price increase on a car makes you think twice. Products that cost very little (like salt or pencils) have inelastic demand. You won't change your salt buying habit much if its price doubles from $1 to $2.
4. Time Horizon: Demand is usually more inelastic in the short run and more elastic in the long run. When gas prices spike suddenly, you still need to drive to work or school (inelastic short-run demand). Over months or years, you might buy a more fuel-efficient car, use public transportation, or move closer to work, making your demand for gas more elastic.
Calculating Elasticity: A Step-by-Step Example
Let's make the formula come alive with a simple calculation. Suppose a movie theater sells 100 popcorn buckets per day at $5 each. They decide to lower the price to $4.50. After the price cut, they sell 120 buckets per day. What is the Price Elasticity of Demand for their popcorn?
Old Quantity = 100, New Quantity = 120.
Change in Quantity = 120 - 100 = 20.
We use the midpoint method for a more accurate percentage: $\frac{New - Old}{(New + Old)/2}$.
Average Quantity = $(100 + 120) / 2 = 110$.
% Change in Quantity = $(20 / 110) \times 100 \approx 18.18\%$.
Old Price = $5.00, New Price = $4.50.
Change in Price = $4.50 - $5.00 = -$0.50 (negative for a decrease).
Average Price = $(5.00 + 4.50) / 2 = $4.75$.
% Change in Price = $(-0.50 / 4.75) \times 100 \approx -10.53\%$.
$PED = \frac{18.18\%}{-10.53\%} \approx -1.73$
Step 4: Interpret the Result.
We ignore the negative sign (it simply shows the inverse relationship between price and quantity) and focus on the absolute value, $1.73$.
Since $1.73 > 1$, the demand for movie theater popcorn is elastic. A 10.53% price decrease led to a larger 18.18% increase in quantity sold.
Elasticity in Action: Real-World Business and Policy
Understanding PED isn't just academic; it has powerful real-world applications.
For Business Pricing Strategy: A company must know the elasticity of its product to set profitable prices.
• If demand is inelastic (e.g., gasoline, cigarettes, certain medicines), a price increase can lead to higher total revenue. Even though they sell slightly fewer units, the higher price per unit more than makes up for it.
• If demand is elastic (e.g., restaurant meals, brand-name clothing, airline tickets for vacation), a price decrease can be a better strategy. The large increase in quantity sold can boost total revenue, as seen in "Black Friday" sales.
For Government Taxation: Governments use elasticity when deciding what to tax.
• Goods with inelastic demand (like tobacco and alcohol) are often heavily taxed ("sin taxes"). Because people still buy them despite the higher price, the government collects stable, high tax revenue.
• Taxing goods with elastic demand can backfire. If a city raised ticket taxes on tour buses too high, tourists might choose to visit a different city, and total tax revenue could fall.
Example Story: The Coffee Shop Dilemma. Maria owns a coffee shop near a school. She sells her special iced coffee for $4 and sells 200 per week. A new competitor opens across the street, selling a similar drink for $3.50. Maria's sales drop to 140 per week. The demand for her specific iced coffee is elastic because students have a close substitute. To compete, Maria might need to lower her price or add unique value (like loyalty points) to make her product seem less substitutable, thereby making demand for her shop more inelastic.
Important Questions
A: Absolutely. Elasticity is not a fixed number. For example, the demand for gasoline is very inelastic in the short term (you can't immediately change your car or commute). But over several years, it becomes more elastic as people have time to adapt by buying electric cars, moving, or finding other transportation. Also, the definition of the "product" matters. The demand for "coffee" in general is inelastic, but the demand for "Starbucks Caramel Macchiato" is very elastic because there are many other coffee options.
Q: How does elasticity affect total revenue?
A: The relationship is crucial and follows a simple rule:
- If demand is elastic ($PED > 1$), a price decrease will increase total revenue, and a price increase will decrease total revenue.
- If demand is inelastic ($PED < 1$), a price increase will increase total revenue, and a price decrease will decrease total revenue.
- If demand is unit elastic ($PED = 1$), total revenue does not change when the price changes.
This is why businesses need to estimate elasticity before changing prices.
A: This is a great observation. The formula gives a negative number because of the Law of Demand: when price goes up, quantity demanded goes down (a negative divided by a positive is negative). Economists usually drop the negative sign and talk about the absolute value for simplicity. We are interested in the magnitude of responsiveness, not the direction, which we already know. So a PED of $-3$ is simply called $3$ and is very elastic.
Conclusion
Footnote
[1] Insulin: A hormone vital for people with diabetes to control their blood sugar levels. It is a classic example of a product with highly inelastic demand because it is essential for health and has few perfect substitutes for many patients.
[2] Demand Curve: A graph showing the relationship between the price of a good and the quantity demanded. It typically slopes downward from left to right, illustrating the Law of Demand.