What is Price Elasticity of Demand
Price elasticity of demand is an economic measure of the change in the quantity demanded or purchased of a product in relation to its price change. Expressed mathematically, it is:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
Price elasticity is used by economists to understand how supply or demand changes given changes in price to understand the workings of the real economy. For instance, some goods are very inelastic, that is, their prices do not change very much given changes in supply or demand, for example people need to buy gasoline to get to work or travel around the world, and so if oil prices rise, people will likely still buy just the same amount of gas. On the other hand, certain goods are very elastic, their price moves cause substantial changes in its demand or its supply. Here, we will look just at how the demand side of the equation is impacted by fluctuations in price by considering the price elasticity of demand - which you can contrast with price elasticity of supply.
What Is Elasticity?
BREAKING DOWN Price Elasticity of Demand
If the quantity demanded of a product exhibits a large change in response to changes in its price, it is termed "elastic," that is, quantity stretched far from its prior point. If the quantity purchased has a small change in response to its price, it is termed "inelastic"; or quantity didn't stretch much from its prior point.
The more easily a shopper can substitute one product with a rising price for another, the more the price will fall – be "elastic." In other words, in a world where people equally like coffee and tea, if the price of coffee goes up, people will have no problem switching to tea, and so the demand for coffee will fall. This is because coffee and tea are considered good substitutes to each other.
The more discretionary a purchase is, the more its quantity will fall in response to price rises, that is, the higher the elasticity. So, if you are considering buying a new washing machine but the current one still works (it's just old and outdated), and if the prices of new washing machines goes up, you're likely to forgo that immediate purchase and wait either until prices go down or until the current machine breaks down.
On the other hand, the less discretionary a good is, the less its quantity demanded will fall. Inelastic examples include luxury items where shoppers "pay for the privilege" of buying a brand name, addictive products, and required add-on products. Addictive products may include tobacco and alcohol. Sin taxes on these types of products are possible to introduce because the lost tax revenue from fewer units sold is exceeded by the higher taxes on units still sold. Examples of add-on products are ink-jet printer cartridges or college textbooks. These items are usually more necessary (as opposed to discretionary) and lack good substitutes (only HP ink will work in HP printers).
Time also matters. Demand response to price fluctuations is different for a one-day sale than for a price change over a season or year. Clarity in time sensitivity is vital to understanding the price elasticity of demand and for comparing it across different products.
Examples of Price Elasticity of Demand
Generally as rules of thumb, if the quantity of a good demanded or purchased changes more than the price change, the product is termed elastic. (The price changes by +5%, but the demand falls by -10%). If the change in quantity purchased is the same as the price change (say, 10%/10% = 1), the product is said to have unit (or unitary) price elasticity. Finally, if the quantity purchased changes less than the price (say, -5% demanded for a +10% change in price), then the product is termed inelastic.
To calculate the elasticity of demand, let's take a very simple example: Suppose that the price of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers increase their apple purchases by 20%. The elasticity of apples would thus be: 0.20/0.06 = 3.33 - indicating that apples are quite elastic in terms of their demand.