What Is Price Elasticity of Demand?
Price elasticity of demand is a measure of the responsiveness of consumers to a change in a product's cost. The more general term demand elasticity measures the impact of a change in any of a variety of factors including the product's price.
The formula for any calculation of demand elasticity is the percentage of change in the quantity that is in demand divided by the percentage change in the economic variable. So, if the price elasticity of demand is being measured, the formula would be the percentage of change in the quantity in demand divided by the percentage change in price.
- Price elasticity of demand is an indicator of the impact of a price change, up or down, on a product's sales.
- Demand elasticity is a more general term, allowing the impact on demand of a number of factors to be estimated.
- Higher price elasticity of demand suggests that consumers are more responsive to a product's price change.
Understanding Price Elasticity of Demand
Like demand elasticity for any factor, price elasticity of demand is typically measured in absolute terms.
If the price elasticity of demand is greater than 1, it is elastic. That is, demand for the product is sensitive to an increase in price. A price increase for a fancy cut of steak, for example, may make many customers choose hamburger instead. A bargain price for the fancy cut will lead many customers to upgrade to the fancy cut.
Tracking price elasticity of demand helps businesses set their production targets as well as adjust their prices.
Price elasticity of demand that is less than 1 is inelastic. Demand for the product does not change significantly after a price increase. For example, a consumer either needs a can of motor oil or doesn't need it. A price change will have little or no effect on demand. But not many will stock up on motor oil if its price decreases.
Demand is said to be "unit elastic" when it equals 1. That means that demand for the product will move proportionately with the price change. If a candy bar's price increases 5% then 5% of its regular buyers will switch to another brand.
How Businesses Use Price Elasticity of Demand
Price elasticity of demand is one of the most common factors calculated by businesses.
Most businesses collect data on the impact of price changes in their industries and use it to calibrate their prices and maximize their profits. In advance of price changes, knowing the price elasticity of demand helps them set production levels correctly.
Another type of demand elasticity is cross-elasticity of demand, which is calculated by taking the percent change in the quantity that is in demand for a product and dividing it by the percentage change of the price for another product. This type of elasticity indicates how demand for a product responds to price changes for other products.
Businesses calculate price elasticity of demand for their products in order to set production targets as well as adjust prices.
Suppose that a soft drink company calculates that the demand for a bottle of its soda increases from 100 to 110 after the price is cut from $2 to $1.50. The price elasticity of demand is calculated as the percentage change in quantity demanded ((110 - 100)/100 = 10%) divided by a percentage change in price ($2 - $1.50 / $2). The price elasticity of demand, in this case, is 0.4. Since the result is less than 1, it is inelastic. The change in price had little impact on the quantity demanded.