Defining Price Elasticity of Demand

The price elasticity of demand (PED) measures the change in demand for a good in response to a change in price.

Key Points

The PED is the percentage change in quantity demanded in response to a one percent change in price.
The PED coefficient is usually negative, although economists often ignore the sign.
Demand for a good is relatively inelastic if the PED coefficient is less than one (in absolute value).
Demand for a good is relatively elastic if the PED coefficient is greater than one (in absolute value).
Demand for a good is unit elastic when the PED coefficient is equal to one.

The price elasticity of demand (PED) is a measure that captures the responsiveness of a good's quantity demanded to a change in its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all other determinants of demand are held constant.

The formula for the coefficient of PED is:

$PED\quad =\quad \frac { \%\quad change\quad in\quad quantity\quad demanded }{ \%\quad change\quad in\quad price\quad } \\ \\ $

The law of demand states that there is an inverse relationship between price and demand for a good. As a result, the PED coefficient is almost always negative. However, economists tend to ignore the sign in everyday use. Only goods that do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.

The numerical values for the PED coefficient could range from zero to infinity. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a less than proportional effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one. In this case, changes in price have a more than proportional effect on the quantity of a good demanded.

A PED coefficient equal to one indicates demand that is unit elastic; any change in price leads to an exactly proportional change in demand (i.e. a 1% reduction in demand would lead to a 1% reduction in price).

A PED coefficient equal to zero indicates perfectly inelastic demand. This means that demand for a good does not change in response to price.

Perfectly Inelastic Demand

When demand is perfectly inelastic, quantity demanded for a good does not change in response to a change in price.

Finally, demand is said to be perfectly elastic when the PED coefficient is equal to infinity. When demand is perfectly elastic, buyers will only buy at one price and no other.

Perfectly Elastic Demand

When the demand for a good is perfectly elastic, any increase in the price will cause the demand to drop to zero.

Measuring the Price Elasticity of Demand

The price elasticity of demand (PED) is calculated by diving the percentage change in quantity demanded by the percentage change in price.

Key Points

PED captures the change in quantity demanded in response to a change in the good's own price (as opposed to the price of some other good).
The formula for price elasticity yields a value that is negative, pure, and ranges from zero to negative infinity.
The result provided by the formula will be accurate only if the changes in price and quantity demanded are small.

The price elasticity of demand (PED) captures how price-sensitive consumers are for a given product or service by measuring the responsiveness of quantity demanded to changes in the good's own price. This is in contrast to measuring the responsiveness of the good's demand to a change in price for some other good (a complement or substitute), which is called the cross-price elasticity of demand. The own-price elasticity of demand is often simply called the price elasticity.

The following formula is used to calculate the own-price elasticity of demand:

$Elasticity\quad =\quad \frac { \%\quad Change\quad in\quad Quantity\quad Demanded\quad }{ \%\quad Change\quad in\quad Price }$

The formula above usually yields a negative value because of the inverse relationship between price and quantity demanded. However, economists often disregard the negative sign and report the elasticity as an absolute value. For example, if the price of a good increases by 5 percent and the quantity demanded decreases by 5 percent, then the elasticity at the initial price and quantity is -5%/5% = -1. This number is likely to be reported simply as 1.

There are a few other important points to note about the coefficient value provided by this formula. First, the elasticity coefficient is a pure number, meaning that it does not have units of measurement associated with it. Second, the coefficient value can range from zero to negative infinity. Finally, the result provided by the formula will be accurate only when the changes in price and quantity are small. The result will be less accurate when the changes are large.

Since PED is based off of percent changes, the starting nominal quantity and price matter. At low prices and high quantities, the PED is therefore more inelastic. For example, a drop in the price of $1 from a starting price of $100 is a 1% drop, but if the starting price is $10, it is a 10% drop. Similarly, at high prices and low quantities, PED is more elastic .

Price Elasticity of Demand and Revenue

PED is based off of percent changes, so the starting nominal values of price and quantity are significant.

Determinants of Price Elasticity of Demand

A good's price elasticity of demand is largely determined by the availability of substitute goods.

Key Points

A good with more close substitutes will likely have a higher elasticity.
The higher the percentage of a consumer's income used to pay for the product, the higher the elasticity tends to be.
For non-durable goods, the longer a price change holds, the higher the elasticity is likely to be.
The more necessary a good is, the lower the price elasticity of demand.

The price elasticity of demand (PED) is a measure of how much the quantity demanded changes with a change in price. The PED for a given good is determined by one or a combination of the following factors:

Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity. When several close substitutes are available, consumers can easily switch from one good to another even if there is only a small change in price . Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.
Proportion of the purchaser's budget consumed by the item: Products that consume a large portion of the purchaser's budget tend to have greater elasticity. The relative high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes. In contrast, demand will tend to be inelastic when a good represents only a negligible portion of the budget.
Degree of necessity: The greater the necessity for a good, the lower the elasticity. Consumers will attempt to buy necessary products (e.g. critical medications like insulin) regardless of the price. Luxury products, on the other hand, tend to have greater elasticity. However, some goods that initially have a low degree of necessity are habit-forming and can become "necessities" to consumers (e.g. coffee or cigarettes).
Duration of price change: For non-durable goods, elasticity tends to be greater over the long-run than the short-run. In the short-term it may be difficult for consumers to find substitutes in response to a price change, but, over a longer time period, consumers can adjust their behavior. For example, if there is a sudden increase in gasoline prices, consumers may continue to fuel their cars with gas in the short-run, but may lower their demand for gas by switching to public transportation, carpooling, or buying more fuel-efficient vehicles over a longer period of time. However, this tendency does not hold for consumer durables. The demand for durables (cars, for example) tends to be less elastic, as it becomes necessary for consumers to replace them with time.
Breadth of definition of a good: The broader the definition of a good, the lower the elasticity. For example, potato chips have a relatively high elasticity of demand because many substitutes are available. Food in general would have an extremely low PED because no substitutes exist.
Brand loyalty: An attachment to a certain brand (either out of tradition or because of proprietary barriers) can override sensitivity to price changes, resulting in more inelastic demand.

Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures the change in demand for one good in response to a change in price of another good.

Key Points

Complementary goods have a negative cross-priceelasticity: as the price of one good increases, the demand for the second good decreases.
Substitute goods have a positive cross-price elasticity: as the price of one good increases, the demand for the other good increases.
Independent goods have a cross-price elasticity of zero: as the price of one good increases, the demand for the second good is unchanged.

The cross-price elasticity of demand shows the relationship between two goods or services. More specifically, it captures the responsiveness of the quantity demanded of one good to a change in price of another good. Cross-Price Elasticity of Demand (EA,B) is calculated with the following formula:

$E_{A,B} = \frac { \% Change\; in\; Quantity\; Demanded\; for\; Good\; A }{ \%\; Change\; in\; Price\; of\; Good\; B }$

The cross-price elasticity may be a positive or negative value, depending on whether the goods are complements or substitutes. If two products are complements, an increase in demand for one is accompanied by an increase in the quantity demanded of the other. For example, an increase in demand for cars will lead to an increase in demand for fuel. If the price of the complement falls, the quantity demanded of the other good will increase. The value of the cross-price elasticity for complementary goods will thus be negative.

Complements

Two goods that complement each other have a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls.

A positive cross-price elasticity value indicates that the two goods are substitutes. For substitute goods, as the price of one good rises, the demand for the substitute good increases. For example, if the price of coffee increases, consumers may purchase less coffee and more tea. Conversely, the demand for a substitute good falls when the price of another good is decreased. In the case of perfect substitutes, the cross elasticity of demand will be equal to positive infinity.

Substitutes

Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises.

Two goods may also be independent of each other. In this instance, if the price of one good changes, demand for the other good will stay constant. For independent goods, the cross-price elasticity of demand is zero: the change in the price of one good with not be reflected in the quantity demanded of the other.

Independent

Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant.

Income Elasticity of Demand

Key Points

The income elasticity of demand is the ratio of the percentage change in demand to the percentage change in income.
Normal goods have a positive income elasticity of demand (as income increases, the quantity demanded increases).
Inferior goods have a negative income elasticity of demand (as income increases, the quantity demanded decreases).

The income elasticity of demand (YED) measures the responsiveness of demand for a good to a change in the income of the people demanding that good, ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in income:

$YED=\quad \frac { \%\quad change\quad in\quad quantity\quad demanded }{ \%\quad change\quad in\quad real\quad income }$

If an increase in income leads to an increase in demand, the income elasticity of that good or service is positive. A positive income elasticity is associated with normal goods. In contrast, if a rise in income leads to a decrease in demand, the good or service has a negative income elasticity of demand. A negative income elasticity is associated with inferior goods.

High income elasticity of demand (YED>1): An increase in income is accompanied by a proportionally larger increase in quantity demanded. This is typical of a luxury or superior good.
Unitary income elasticity of demand (YED=1): An increase in income is accompanied by a proportional increase in quantity demanded.
Low income elasticity of demand (YED<1): An increase in income is accompanied by less than a proportional increase in quantity demanded. This is characteristic of a necessary good.
Zero income elasticity of demand (YED=0): A change in income has no effect on the quantity bought. These are called sticky goods.
Negative income elasticity of demand (YED<0): An increase in income is accompanied by a decrease in the quantity demanded. This is an inferior good (all other goods are normal goods). The consumer may be selecting more luxurious substitutes as a result of the increase in income.

Definition of Price Elasticity of Supply

The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good.

Key Points

Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:$Elasticity \;= \; \frac{\%\; Change\; in\; quantity}{\%\; Change\; in\; price}$
The impact that a price change has on the elasticity of supply also directly impacts the elasticity of demand.
Inelastic goods are often described as necessities, while elastic goods are considered luxury items.
The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.

In economics, elasticity is a summary measure of how the supply or demand of a particular good is influenced by changes in price. Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:

$Elasticity \;= \; \frac{\%\; Change\; in\; quantity}{\%\; Change\; in\; price}$

The price elasticity of supply (PES) is the measure of the responsiveness in quantity supplied (QS) to a change in price for a specific good (% Change QS / % Change in Price). There are numerous factors that directly impact the elasticity of supply for a good including stock, time period, availability of substitutes, and spare capacity. The state of these factors for a particular good will determine if the price elasticity of supply is elastic or inelastic in regards to a change in price.

The price elasticity of supply has a range of values:

PES > 1: Supply is elastic.
PES < 1: Supply is inelastic.
PES = 0: The supply curve is horizontal; there is no response of demand to prices. Supply is "perfectly inelastic."
PES = $\infty$(i.e., infinity): The supply curve is vertical; there is extreme change in demand in response to very small change in prices. Supply is "perfectly elastic."

Inelastic goods are often described as necessities. A shift in price does not drastically impact consumer demand or the overall supply of the good because it is not something people are able or willing to go without. Examples of inelastic goods would be water, gasoline, housing, and food.

Elastic goods are usually viewed as luxury items. An increase in price for an elastic good has a noticeable impact on consumption. The good is viewed as something that individuals are willing to sacrifice in order to save money. An example of an elastic good is movie tickets, which are viewed as entertainment and not a necessity.

The price elasticity of supply is determined by:

Number of producers: ease of entry into the market.
Spare capacity: it is easy to increase production if there is a shift in demand.
Ease of switching: if production of goods can be varied, supply is more elastic.
Ease of storage: when goods can be stored easily, the elastic response increases demand.
Length of production period: quick production responds to a price increase easier.
Time period of training: when a firm invests in capital the supply is more elastic in its response to price increases.
Factor mobility: when moving resources into the industry is easier, the supply curve in more elastic.
Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied. If cost rise rapidly the stimulus to production will be choked off quickly.

The result of calculating the elasticity of the supply and demand of a product according to price changes illustrates consumer preferences and needs. The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.

Price elasticity over time

This graph illustrates how the supply and demand of a product are measured over time to show the price elasticity.

Perfectly Inelastic Supply

A graphical representation of perfectly inelastic supply.

Measuring the Price Elasticity of Supply

The price elasticity of supply is the measure of the responsiveness of the quantity supplied of a particular good to a change in price.

Key Points

The priceelasticity of supply = % change in quantity supplied / % change in price.
When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic.
PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: if the supply curve is vertical, and there is no response to prices. PES = infinity: if the supply curve is horizontal.

The price elasticity of supply (PES) is the measure of the responsiveness of the quantity supplied of a particular good to a change in price (PES = % Change in QS / % Change in Price). The intent of determining the price elasticity of supply is to show how a change in price impacts the amount of a good that is supplied to consumers. The price elasticity of supply is directly related to consumer demand.