Discover the definition and formula for price elasticity of demand. See some real-world examples of how it is calculated, and find out what it means for demand of a good to be inelastic or elastic.
Setting the Stage
How many times a day or week do you make a decision to buy something based on price? Would your buying habits change if a new dress shirt cost $70 instead of $15? How about if a gallon of milk cost $7 instead of $4? Whether you make five decisions a day or fifty, there is no doubt that price elasticity of demand is playing a major role in your purchases! Let's discuss price elasticity of demand and how it plays a role in the everyday life of consumers or business owners, like you and I.
In talking about the price elasticity of demand, it's worth reviewing the law of demand, which states that more of a good will be demanded, the lower its price, all else constant. Less of a good will be demanded, the higher its price, all else constant. How much more or less is demanded? That is where elasticity comes in.
Definition and Formula
Price elasticity of demand is the measure of the percent change in the quantity of a good demanded divided by the percent change in the price of that good. It is the term economists use to describe how responsive consumers are to a change in price. I bet you can think of an item you wouldn't hesitate to pay more for if the price rose.
How about an item you might not buy any longer if the price increased? That logic and reasoning is exactly what makes up and determines the price elasticity of demand. It is a very important concept in economics and a foundation for many advanced lessons on how individuals and business owners make purchasing decisions. The mathematical equation looks like this:
Ed (Elasticity of Demand) = Percent change in quantity / Percent change in price
Let's look at a quick example. If the price of a good goes up by 20% and the quantity demanded falls by 40%, looking at the equation, you will find that the elasticity is 2, which, plugged into the equation, looks like this: 2 = 40% / 20%. It is important to note that you may often see a negative or minus sign in front of elasticity numbers. For the purposes of this lesson, disregard that and remember that elasticity is often spoken about in positive numbers. So a negative two is actually talked about and referred to as a positive two. So what does that two really mean? Let's explore that now.
When discussing elasticity of demand, it can often be categorized in three common ways. Based on the result we get from our formula, we can define elasticity as:
Elastic - If elasticity is greater than one, a rise in price lowers total revenue; a decrease in price increases total revenue. Price and total revenue move in opposite directions. These are goods that are often very responsive to changes in price, such as non-necessities or goods that we can easily live without. Candy, entertainment, and specific brands of soda are a few examples. For example, if a major league baseball ticket increased in price, many people would likely cut back on going to the game, all else constant. If it goes down, people will go more often and actually increase revenue for the baseball club.
Inelastic - If elasticity is less than one, a rise in price increases total revenue and a good is said to be inelastic. Price and total revenue move in the same direction. These are goods that many consider necessary to everyday living, such as water, gas, toilet paper, and so on. If the price of toilet paper increases, most people will not stop buying toilet paper.
To summarize, an inelastic good is a good where if the price goes up, people will only slightly reduce demand of a particular product; and if the price goes down, people will only slightly increase demand of a particular good. Many business owners wish to sell inelastic goods or services. They know that if they raise their price, they won't lose many customers and ultimately, they will make more money.
Unitary elastic - A good is unitary elastic when it is exactly one. Said another way, the percent change in quantity equals the percent change in price. A rise in the price results in absolutely no change to total revenue. This is more of an economic concept in theory. In the real world, demand for almost all goods will either be elastic or inelastic.
Let's see how this all relates in the real world. The first is a grocery store owner who is thinking of raising the price on a gallon of milk so he can increase his total revenue. If the grocery store owner knows from previous experience that raising the price 10% will decrease the quantity purchased by 5%, should he do it? Let's find out by calculating the elasticity and plugging the numbers into the equation: 5% / 10% = .5. This tells us that milk is inelastic because it is less than 1.
If the grocery store raises prices on milk, they will increase their total revenue. Another way to think about it is that a 10% rise in the price more than covers the 5% drop in the actual gallons of milk sold. On the other hand, if the grocery store lowers the price, the total revenue will fall. The increased demand or additional gallons of milk sold will not be enough to make up for the drop in prices across the board.
Now let's consider the movie theater owner who is thinking about raising her prices to capture more revenue. Hypothetically consider that the industry statistics say that a 10% rise in the price will result in an 18% drop in people going to the movie. Should the theater owner raise prices? If we take 18% / 10%, we get 1.8. From our definitions, we know that 1.8 means the product is elastic. An elastic product means that raising prices will lower total revenue.
So the answer is no. If the theater owner raises prices, her total revenue will actually go down. The rise in price will not make up for all the lost ticket sales. What could she consider to increase revenue? If you said lower prices, you are correct. Total revenue can be increased for an elastic product by lowering the price of the good.
Understanding the elasticity of demand will help you understand how people make individual choices. If you are a business owner, it will help you estimate how changes in price will affect how busy your store is and how much more or less revenue you will bring in.
Price elasticity of demand is the measure of the percent change in the quantity of a good demanded divided by the percent change in the price of that good. It is the term economists use to describe how responsive consumers are to a change in the price. The equation is Ed (Elasticity of Demand) = Percent change in quantity / Percent change in price.
When we use the equation and plug the numbers, we will get one of three results. A number greater than one means demand for the product is elastic. A rise in prices will decrease total revenue; a drop in prices will increase total revenue.
An elasticity of less than one means demand for a product is inelastic. A rise in prices will increase total revenue, and a decrease in prices will lower total revenue. And finally, elasticity of exactly one means that demand is unitary elastic and that a rise in price will have no effect on total revenue. It will not increase or decrease.
There are many other factors that can affect sales and the quantity demanded for a product, but understanding the price elasticity of demand and how it is calculated is a great starting point. It can help businesses decide whether they should increase or decrease their price to drive revenue.
Once you are done with this lesson you should be able to:
- Recall the law of demand
- Describe the price elasticity of demand and state the formula
- Explain the three categories of demand elasticity
- Understand how to determine if a good is elastic, inelastic, or unitary elastic