Elasticity of Demand
Revised, December 2017
Ultimately, managerial economics involves calculating value to determine how to best maximize profit. Price elasticity of demand helps to predict the impact of pricing on sales. It measures the responsiveness of demand to changes in price for a particular good.
Economists classify demand as elastic, inelastic or unitary. Price elasticity is a way of studying how price and competing products relate to demand for a particular product or sector; often used to discuss price sensitivity. For example, if consumers will tend to avoid most products they feel are over priced. They may gravitate toward close substitutes for a given product. Usually, if one product can easily be substituted for another; consumers will quickly switch in response to price changes for one or the other. Businesses evaluate price elasticity of demand for various products to help predict the impact of a pricing on product sales. Typically, businesses charge higher prices if demand for the product is price inelastic.
Elastic demand exists when there is a large change in quantity-of-product demanded results from price change. For an “elastic” product, lowering the price of a product may increase consumer exposure, boost sales and boost profits. Protein markets (poultry, beef, fish) may be highly elastic, with budget-minded consumers paying attention to particular offerings at “bargain” prices, one in favor of others. On the other hand, if product is price “inelastic” the price charged tends to be “set” and rarely fluctuates. For example, a custom-built specialty research instrument with a very limited and dedicated market would not generate more buyers or greater sales with a greatly increased volume of product. (A unitary relationship rarely if ever occurs in the real world. This is essentially the theoretical relationship where a perfect one percent change in quantity occurs for every one percent change in price.)
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
The formula for computing elasticity of demand is:
(Q1 – Q2) / (Q1 + Q2)
(P1 – P2) / (P1 + P2)
If the formula creates a number greater than 1, the demand is elastic (quantity changes faster than price); less than 1, demand is inelastic (quantity changes slower than price); and equal to 1, unitary (quantity and price change at the same rate).
If one runs the formula, the price elasticity of demand is simply a number; it is not a monetary value. The number signifies, for example, we are discussing a food-product’s sales and that a 1-percent decrease in price causes an almost 2-times percentage increase in quantity demand, then the demand-quantity percentage increase far outweighs the percentage decrease in price. So, in this example, with the decrease in the price of the product, one sells a lot more product, resulting in greatly increased revenue.
Elasticity of demand is illustrated in Figure 1. Note that a change in price results in a large change in quantity demanded. An example of products with an elastic demand is consumer durables. These are items that are purchased infrequently, like a washing machine or an automobile, and can be postponed if price rises. For example, automobile rebates have been very successful in increasing automobile sales by reducing price.
Close substitutes for a product affect the elasticity of demand. It another product can easily be substituted for your product, consumers will quickly switch to the other product if the price of your product rises or the price of the other product declines. For example, beef, pork and poultry are all meat products. The declining price of poultry in recent years has caused the consumption of poultry to increase, at the expense of beef and pork. So products with close substitutes tend to have elastic demand.
Figure 1. Elastic Demand
Note that a change in price results in only a small change in quantity demanded.
Figure 2. Note that a change in price results in only a small change in quantity demanded.
Detailed explanations of the concept, applications to product market development, and further examples are available in business-development texts and elsewhere on the Internet.