Elastic Demand: When Price Changes Make a Big Difference
The Math Behind the Reaction: Calculating Price Elasticity of Demand
At its heart, elastic demand is a measured relationship. The tool economists use is called the Price Elasticity of Demand (PED)[1]. It's a number that tells us just how sensitive the quantity demanded is to a change in price. The formula is:
Because price and quantity demanded usually move in opposite directions (when price goes up, quantity demanded goes down), the PED value is typically negative. However, for simplicity, we often use the absolute value (ignoring the minus sign) when describing how "elastic" demand is.
Here is how we interpret the result:
| If PED (Absolute Value) is... | Demand is... | What It Means |
|---|---|---|
| Greater than 1 (e.g., 1.5, 3.0) | Elastic | Quantity demanded changes by a larger percentage than the price change. Consumers are very responsive. |
| Equal to 1 | Unit Elastic | Quantity demanded changes by the exact same percentage as the price change. |
| Less than 1 (e.g., 0.5, 0.2) | Inelastic | Quantity demanded changes by a smaller percentage than the price change. Consumers are not very responsive. |
What Makes Demand Stretch? Key Influencing Factors
Not all products have elastic demand. Several factors determine whether consumers will strongly react to a price change or barely notice it.
1. Availability of Close Substitutes: This is the most important factor. If a product has many similar alternatives, demand tends to be elastic. For example, if the price of one brand of chocolate chip cookies rises, shoppers can easily switch to another brand. The demand for that specific brand is elastic.
2. Luxury vs. Necessity: Luxuries, like vacations or designer clothing, usually have elastic demand because they are wants, not needs. If prices go up, people can postpone or cancel the purchase without major hardship. Necessities, like insulin for diabetics or basic groceries, have inelastic demand because people need them regardless of price changes.
3. Proportion of Income Spent: Goods that take up a large portion of your budget tend to have more elastic demand. A 10% price increase on a new car (thousands of dollars) will cause a strong reaction. A 10% increase on a pack of pencils (a few cents) will likely go unnoticed.
4. Time Horizon: Demand is usually more elastic over the long run. If gasoline prices spike suddenly, you might still need to fill your tank this week (inelastic in short term). But over a year, you might buy a more fuel-efficient car, use public transportation, or move closer to work, making your demand for gasoline more elastic.
Airfare and Snacks: Elastic Demand in Everyday Life
Let's put theory into practice with two clear examples where demand is typically elastic.
Example 1: Vacation Air Travel. Imagine an airline increases the price of a round-trip ticket for a summer vacation to Florida by 20%. What happens?
- Substitutes: Travelers can choose a different airline, drive, take a train, or pick another vacation destination.
- Luxury: A vacation is often a discretionary expense, not an absolute necessity.
- Income Proportion: Airfare is a significant expense for most families.
Because of these factors, the percentage drop in the number of tickets sold will likely be greater than the 20% price increase. Let's say ticket sales fall by 35%. Using our formula:
$PED = \frac{-35\%}{+20\%} = -1.75$
The absolute value is 1.75 ($>1$), confirming elastic demand. The airline's total revenue (Price x Quantity) would decrease with this price hike.
Example 2: Brand-Name Soda. Consider a 2-liter bottle of a popular brand-name soda. If its price rises by 10% while store-brand and other brand sodas stay the same price, many consumers will switch. The demand for that specific brand is elastic. However, the demand for soda in general might be less elastic, as there are fewer substitutes for the entire category of sugary drinks.
Why It Matters: Business and Policy Implications
Understanding elastic demand isn't just an academic exercise; it has real-world consequences.
For a business selling a product with elastic demand, raising prices can be dangerous. Since consumers are very sensitive, a price increase leads to a proportionally larger drop in sales, which can reduce total revenue. Instead, businesses might focus on strategies like improving their product's uniqueness (reducing substitutes), offering sales (where the percentage drop in price leads to a larger percentage rise in quantity sold), or competing on features other than price.
For government policy, tax decisions are heavily influenced by elasticity. Governments often prefer to place "sin taxes" on goods with inelastic demand (like cigarettes) because they can generate significant revenue without causing a massive drop in consumption. Taxing a good with highly elastic demand, however, could lead to a large decline in sales, hurting the industry and potentially failing to raise the expected revenue.
Important Questions
A: Yes, but it depends on the definition and context. For example, while water is a necessity, the demand for bottled water from a specific brand at a convenience store can be very elastic. If its price doubles, most people will drink tap water, use a water fountain, or buy a different brand. The necessity is hydration, not that specific bottle. So, the broader the category, the more inelastic it tends to be; the more specific the product, the more likely it is to be elastic.
A: Total revenue will increase. Because demand is elastic ($PED > 1$), the percentage increase in the quantity sold will be greater than the percentage decrease in price. The gain from selling many more units outweighs the loss from the lower price per unit. This is why stores have "loss leaders"—deeply discounted items that bring in lots of customers who then buy other things.
A: A demand curve for an elastic product appears flatter or more horizontal. A small change in price (a vertical move) leads to a large change in quantity demanded (a horizontal move). In contrast, an inelastic demand curve is steeper, showing that quantity doesn't change much even with big price moves.
Footnote
[1] PED (Price Elasticity of Demand): A measure of the responsiveness of the quantity demanded of a good or service to a change in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
[2] Absolute Value: The value of a number without regard to its sign (positive or negative). For example, the absolute value of both $-1.5$ and $+1.5$ is $1.5$. In PED, we use the absolute value to focus on the degree of responsiveness.
[3] Substitute Goods: Products or services that can be used in place of each other. When the price of one goes up, the demand for the other increases (e.g., butter and margarine, different smartphone brands).