Calculating Price Elasticity of Demand | Definition, Formula, Example, Importance
Price Elasticity of Demand Definition
The price elasticity of demand measures the change in demand, as a result of a change in the price of a product or service.
When a business decides to change the price of a product or service, they need to consider what effect this price change will have on the demand.
For example:
- Will they make more profit by lowering the price which will increase demand?
- Or could they raise the prices and not see any change in demand?
The basic premise of a business is to sell products and services at a price that is higher than their costs. If they can achieve this, then the business will be profitable.
Put simply, profit is just the result of the relationship between cost, volume and price.
For example, the volume of goods sold will affect the cost per unit. If the volume increases, then the fixed overheads can be spread over more units, so the cost per unit will decrease.
The price elasticity of demand focuses on the connection between price and volume, and the subsequent effect on a business’s profit.
Formula for the Price Elasticity of Demand
When calculating Price Elasticity of Demand, the following formula is used:
Price Elasticity of Demand = Change in Quantity Demanded % / Change in Price %
Note that the change in quantity demanded is a percentage of the original demand. Also, the Change in Price is a percentage of the original demand.
For example, if the demand increased from 200 sales a day, to 230 sales a day, the Change in Quantity Demanded % would be 15% (ie an increase of 30, divided by the original demand number of 200)
Also, if the price decreased from £50 to £40, the Change in Price % would be 20% (ie a decrease of £10, divided by the original price of £50).
How is Price Elasticity of Demand Measured?
There are three main types of price elasticity of demand: inelastic, elastic, and unit elastic
Inelastic Demand
If the percentage change in demand is less than the percentage change in price, then the price elasticity will be lower than 1. This shows that the demand is insensitive to price changes.
A useful method of remembering this is to say that INelastic demand = INsensitive to price
This means that:
- Revenue decreases when price is reduced
- Revenue increases when price increases
PED < 1 = Inelastic product
Elastic Demand
If the percentage change in demand is higher than the percentage change in price, then the price elasticity will be greater than 1. This shows that the demand is sensitive to price changes.
This means that:
- Revenue increases when price is reduced
- Revenue decreases when price increases
PED > 1 = Elastic product
Unit Elastic
This means that a certain percentage change in price leads to an equal percentage change in demand.
For example, decreasing the price by 10% would result in a 10% increase in demand.
PED = 1 = Unit Elastic product
Perfectly Inelastic
If the price elasticity = 0, then it is said to be ‘perfectly’ inelastic. This means that the demand won’t change, regardless of price.
This is just theoretical, as there wouldn’t be any real world examples of goods or services that would sell the same amount, even with colossal price increases.
Price Elasticity of Demand Example
Question
The sales of a retailer fall from 20 per day to 12 per day when the price of the product goes up from £0.40 to £0.60. What is the Price Elasticity of Demand?
Answer
% change in quantity = decrease of 8 / original demand 20 = 40%
% change in price = increase of 20 / original price 40 = 50%
Price Elasticity of Demand = 0.40 / 0.50 = 0.8
Therefore, the demand can be described as being inelastic
What Are The Factors Affecting Price Elasticity of Demand?
It’s important to note that price elasticity of demand can vary across different markets, products, and consumer segments.
These factors collectively influence how sensitive consumers are to price changes and their willingness to adjust their purchasing behavior.
Factors that can affect price elasticity of demand would include:
Consumer Information
The buyers in the market might not be aware of similar products within the market that could influence their purchasing decision. For example, a customer looking for a local florist might not know all of the florists their area, so might just choose the one that they drive past every day.
Availability of Substitutes
The Price Elasticity of Demand for a product or service with a large number of substitutes available would be very high.
If a particular market has a large number of similar products available, then a small increase in price would likely compel the consumer to look for an alternative product at a cheaper price.
For example, if a supermarket increases the price of their apples, the customer may feel compelled to either buy a different type of apple at the same supermarket, or go to another supermarket to buy the original type of apples.
Complementary Products
Complementary goods are products which are used together. For example, razors and razors blades. These combinations of product would require the consumer to purchase a particular brand of razor blade to fit the razor, and would regularly need a replacement.
For this reason, the price elasticity of demand for these products would be inelastic.
Disposable Income
The current situation of the overall economy would affect total demand. For example, during a recession, consumer spending of luxury items would typically decrease, as consumers prioritise essentials over indulgent spending.
Necessities
Basic ‘staples’ such as bread and milk would usually be very price inelastic. This is because these items are seen as fundamental and therefore often willing to pay higher prices for these item
Habit and Routine
Some products are typically bought out of habit and routine, and therefore are usually very price inelastic. For example, a consumer may buy the same brand of alcohol each week, and would not want to substitute for a different brand. So any price change would not change this consumer’s habit.