In economics, price elasticity is a measure of how reactive the marketplace is to a change in price for a given product. However, price elasticity works two ways. While price elasticity of demand is a reflection of consumer behavior as a result of price chance, price elasticity of supply measures producer behavior. Each metric feeds into the other. Both are important when analyzing marketplace economics, but it is price elasticity of demand that companies look to when establishing sales strategy.
Price Elasticity of Demand Compares Change in Consumption to Change in Price
Price elasticity of demand measures the change in consumption of a good as a result of a change in price. It is calculated by dividing the percent change in consumption by the percent change in price. For example, if the price of a name-brand microwave increases 20% and consumer purchases of this product subsequently drop by 25%, the microwave has a price elasticity of demand of 25% divided by 20%, or 1.25. This product would be considered highly elastic because it has a score higher than 1, meaning the demand is greatly influenced by price change.
A score between 0 and 1 is considered inelastic, since variation in price has only a small impact on demand. A product with an elasticity of 0 would be considered perfectly inelastic, because price changes have no impact on demand. Many household items or bare necessities have very low price elasticity of demand, because people need these items regardless of price. Gasoline is an excellent example. Luxury items, such as big-screen televisions or airline tickets, generally have higher elasticity since they are not essential to day-to-day living. (For related reading, see: Why We Splurge When Times Are Good.)
Price Elasticity of Supply
Price elasticity of demand is used by companies to establish their optimal pricing strategy, but the relationship between supply, price and demand can be complicated. If a product has a high elasticity of demand, can a change in production levels help the company selling the item maximize profits? The change in production relative to a change in price is called price elasticity of supply, and it is influenced by many factors. Primary among them are the duration of the price change, availability of substitutes from other sellers, the company's capacity for increased production and delivery, stock availability and complexity of production.
Woolen socks, for example, are not an overly complicated product to manufacture. Production requires few raw materials, and the item is lightweight and easy to ship. Therefore, if a company knows it can stimulate a 30% increase in sales by reducing the price by 20%, it is likely to increase production to reap the maximum profit. However, a small business that sells handmade furniture may have a harder time ramping up production or dealing with increased shipping and delivery activity, so an increase in supply may not be feasible, regardless of price elasticity. (For related reading, see: What types of consumer goods demonstrate the price elasticity of supply?)