Understanding the Price Elasticity of Demand

# Understanding the Price Elasticity of Demand

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Jaya Sharma
Assistant Manager - Content
Updated on Feb 21, 2024 23:52 IST

Price elasticity of demand is the change in demand for a product with regards to the change in its price. If a product has elastic demand, the change in demand is large when there is a change in price. In case, the product has an inelastic demand, the change in demand is small when there is a change in price.

## What is Price Elasticity of Demand?

We have already read the definition of price elasticity of demand. Let us now understand the concept with an example.

Imagine you are at your favourite store looking at the price of chocolate bars. If the store decides to increase the price of the chocolate bars, you might think twice about buying as many as you usually do, or you might decide not to buy them at all if they become too expensive. On the other hand, if the store lowers the price, you might feel like buying more chocolate bars than usual because they are cheaper.

Price elasticity is a way to measure how much the demand for something changes when its price goes up or down. If a product is "elastic," it means that a small change in price leads to a big change in how much of it people buy. If our chocolate bars have elastic demand, a small increase in price could make a lot of people stop buying them.

If a product is "inelastic," it means that price changes do not affect how much of it people buy. For example, if gasoline prices go up, most people will still buy it because they need it to get around, making gasoline relatively inelastic.

## Price Elasticity of Demand With Diagram

Following diagrams represent elastic and inelastic demands:

## Types of Price Elasticity of Demand

The following are the types of price elasticity of demand:

1. Elastic Demand
2. Unitary Elastic Demand
3. Inelastic Demand

## Elastic Demand

Elastic demand is an economic situation where the demand for a product or service changes compared to a change in its price. In simpler terms, if the price of something goes up or down, the amount people are willing or able to buy changes a lot. This concept is a key part of understanding how will consumers react to price changes in the market.

When demand is elastic, a small increase in price leads to a large decrease in quantity demanded. Conversely, a small decrease in price causes a large increase in the quantity demanded. This sensitivity to price changes is often seen in products or services that have many substitutes or are considered non-essential. For example, if the price of a particular brand of ice cream goes up, people might easily switch to another brand or forego ice cream altogether, showing elastic demand for that brand.

Elastic demand is quantitatively measured by the price elasticity of demand (PED) formula, which calculates percentage change in quantity demanded divided by percentage change in price. In case the absolute value of this calculation is greater than 1, the demand is considered elastic. This means the product's demand is highly responsive to price changes, indicating that consumers are quite sensitive to price adjustments in their purchasing decisions.

### 1.1 Unit Elastic Demand

Unit elastic demand occurs when a percentage change in quantity demanded of a product or service is exactly equal to the percentage change in its price. This means that any change in price leads to an equal proportional change in the quantity demanded. In the world of economics, when we say demand is unit elastic, we're describing a balanced scenario where consumers' responsiveness to price changes is perfectly proportional.

Suppose, the price of a product increases by 10%, and as a result, the demand for that product decreases by 10%, the demand for this product would be considered unit elastic. Similarly, if the price decreases by a certain percentage and the demand increases by the same percentage, that also indicates unit elastic demand.

The price elasticity of demand (PED) formula, which is percentage change in quantity that is demanded divided by percentage change in price, measures this relationship. A PED value of exactly 1 indicates unit elastic demand. This value tells us that the product sits right at the threshold between elastic and inelastic demand, showing a direct one-to-one response to price changes.

Unit elastic demand is relatively rare compared to elastic and inelastic demand because it requires a precise balance in consumer behavior. Products with unit elastic demand are in a unique position because changes in their prices directly affect the total revenue in a neutral way; the revenue remains unchanged because the proportional increase in price is exactly offset by a proportional decrease in quantity demanded, and vice versa.

### 1.2 Relatively Elastic Demand

It describes a situation where the demand for a product or service is more sensitive to changes in its price. In this case, a small percentage change in the price leads to a larger percentage change in the quantity demanded. This means that consumers are quite responsive to price changes, and even a minor adjustment in price can result in a significant increase or decrease in how much of the product they buy.

For example, imagine a situation where the price of a particular type of luxury coffee decreases by 5%, and as a result, the demand for this coffee increases by 15%. This scenario illustrates relatively elastic demand because the percentage change in quantity demanded (15%) is greater than the percentage change in price (5%).

The price elasticity of demand (PED) is used to measure this relationship, with the formula being the percentage change in quantity demanded divided by percentage change in the price. When the absolute value of PED is greater than 1, it indicates relatively elastic demand. This higher value signifies that the product's demand is highly responsive to changes in price.

Relatively elastic demand often occurs in markets with many substitutes available or for luxury items that people can easily do without if prices rise. It highlights the importance of pricing strategies for businesses, as small changes in price can lead to large changes in the quantity sold, affecting overall revenue and market share.

For businesses, understanding that their product has relatively elastic demand means that they need to carefully consider the impact of price changes on demand and revenue. It also suggests that competitive pricing and marketing strategies can significantly influence consumer purchasing decisions in these markets.

## 2. Unitary Elastic Demand

Unitary demand, also known as unit elastic demand, occurs when percentage change in quantity demanded is exactly equal to percentage change in price, resulting in a price elasticity of demand (PED) of exactly 1. This means that any change in the price of a product or service leads to a proportional and equal change in the quantity demanded. In practical terms, if the price of a product increases by a certain percentage, the demand for that product decreases by the same percentage, and vice versa.

An example of unitary demand could involve a specific category of goods, but it's important to note that finding pure examples in the real world is challenging because consumer behavior can be influenced by many factors besides price, such as income changes, preferences, and the availability of substitutes. However, for illustrative purposes, consider a scenario where a streaming service raises its monthly subscription price by 10%, and as a result, sees a 10% decrease in subscribers. This scenario would indicate a unitary demand for the subscription service.

Unitary demand is significant for businesses and economists because it represents a point where total revenue remains unchanged despite changes in price. If a company increases its prices, the decrease in quantity sold is exactly proportional, so the total revenue (price multiplied by quantity) stays the same. Similarly, if the company decreases its prices, the increase in quantity sold is also exactly proportional, leading to no change in total revenue.

Moving away from this point can either increase elasticity, making demand more sensitive to price changes, or decrease elasticity, making demand less sensitive to price changes.

## 3. Inelastic Demand

Inelastic demand refers to a situation where the demand for a product or service changes very little in response to changes in its price. This means that even if the price goes up or down, the quantity of the product that people buy doesn't change much. Inelastic demand is often observed in products or services that are considered necessities or have fewer substitutes available.

For example, consider essential medications for chronic conditions. Even if the price of these medications increases, people who need them will still continue to buy them because they don't have many alternatives and the product is essential for their health. Similarly, the demand for basic utilities like water and electricity is inelastic because these services are essential, and consumers have limited alternatives.

The price elasticity of demand (PED) measures inelastic demand quantitatively. It calculates percentage change in quantity demanded compared to a percentage change in price. If the absolute value of PED is less than 1, the demand is considered inelastic. This indicates that the product's demand is not very responsive to price changes, showing that consumers are relatively insensitive to price adjustments in their purchasing decisions.

Inelastic demand highlights the consumers' necessity or dependency on a product, implying that businesses and policymakers can raise prices without significantly affecting the overall demand for such products. However, it also means that lowering prices won't significantly increase demand, which can influence pricing strategies and policy decisions.

### 3.1 Perfectly Inelastic Demand

Perfectly inelastic demand describes a situation where the demand for a product or service remains constant regardless of changes in its price. This means that no matter how much the price goes up or down, the quantity demanded stays exactly the same. In a graph of demand versus price, perfectly inelastic demand is represented by a vertical line, indicating that the demand does not change as the price changes.

An example of perfectly inelastic demand could be a life-saving medication for individuals with a particular condition. For these individuals, no matter the cost, they will continue to purchase the same amount of medication because it is essential for their survival. The price elasticity of demand (PED) for a product with perfectly inelastic demand is 0, reflecting that price changes have no impact on the quantity demanded.

Perfectly inelastic demand is a theoretical extreme and is rare in real-world markets. However, it is a useful concept for understanding the range of possible consumer responses to price changes. It highlights situations where consumers have no alternatives or where the product is an absolute necessity, making their purchasing decisions insensitive to price.

## 3.2 Relatively Inelastic Demand

Relatively inelastic demand occurs when the demand for a product or service changes only slightly in response to changes in its price. In this scenario, a significant percentage change in price leads to a much smaller percentage change in the quantity demanded. This means that consumers are not very responsive to price changes, and their purchasing behavior remains relatively stable even as prices fluctuate.

For instance, consider the demand for gasoline. In case the price of gasoline increases by 20%, the quantity demanded might only decrease by 5%. This situation illustrates relatively inelastic demand because the percentage change in quantity demanded (5%) is much smaller than the percentage change in price (20%).

The price elasticity of demand (PED) measures this relationship, with the formula being percentage change in quantity demanded divided by price change percentage. When the absolute value of PED is less than 1, it indicates relatively inelastic demand. This lower value signifies that the product's demand is not highly responsive to changes in the price.

Relatively inelastic demand is associated with essential goods and services including basic food items, utilities, and certain medications, where there are few substitutes available, or the product is a necessity regardless of price.

A product with relatively inelastic demand means recognizing that price changes will not significantly impact the quantity sold. This can inform pricing strategies, tax policies, and subsidy decisions, especially for essential commodities where demand is expected to remain stable despite price changes.

### In Summary: Types of Price Elasticity of Demand

 % Change in quantity demanded/ % Change in price Type 0 Perfectly Inelastic Less Than 1 Inelastic 1 Unitary Greater Than 1 Elastic Infinity Perfectly Elastic

## Calculation of Price Elasticity of Demand

Let's calculate the price elasticity of demand (PED) with a simple example:

Imagine a coffee shop decides to decrease the price of its signature coffee from \$5.00 to \$4.50. As a result of this price decrease, the quantity of coffee sold per day increases from 100 cups to 120 cups.

Step 1: Calculating the percentage change in quantity demanded.

First, find the change in quantity demanded: 120 cups - 100 cups = 20 cups.

Next, divide the change in quantity by the original quantity: 20 / 100 = 0.2.

Finally, convert it to a percentage: 0.2 * 100 = 20%.

Step 2: Calculating the percentage change in price.

First, find the change in price: \$4.50 - \$5.00 = -\$0.50.

Next, divide the change in price by the original price: -\$0.50 / \$5.00 = -0.1.

Finally, convert it to a percentage: -0.1 * 100 = -10%.

Step 3: Calculate the price elasticity of demand (PED).

PED is percentage change in quantity demanded divided by the percentage change in price.

So, PED = 20% / -10% = -2.

The PED in this example is -2, which means the demand for coffee is elastic. This indicates that for every 1% decrease in the price of the coffee, the quantity demanded increases by 2%. The negative sign is typical in PED calculations and reflects an inverse relationship between price and quantity demanded according to law of demand.

## How Price Elasticity of Demand is Measured?

Price Elasticity of Demand (PED) is measured by calculating percentage change in the quantity demanded of the product or service divided by the percentage change in its price. This formula gives us a clear picture of how sensitive the demand for a product is to price changes. If a small price change causes a big change in demand, the product is considered to have high elasticity.

## What Price Elasticity of Demand Measures?

PED measures responsiveness of the quantity demanded of a good and service to a change in its price. It tells us how much the demand for a product will go up or down when its price changes. This measurement helps businesses and economists understand consumer behaviour and how it might shift with pricing strategies.

## Can Price Elasticity of Demand be Negative?

Yes, price elasticity of demand can be negative. In fact, it usually is. This is because the law of demand indicates an inverse relationship between price and quantity demanded—meaning, as price goes up, demand usually goes down, and vice versa.

## When Price Elasticity of Demand is Negative?

PED is negative when an increase in price leads to a decrease in demand. This is the typical scenario because, in most cases, consumers will buy less of something if its price goes up. The negative sign just shows that the direction of change in quantity demanded is opposite to the direction of change in price.

## Why Price Elasticity of Demand is Negative?

The reason why PED is negative is because of the basic economic principle that, generally, as the price of a good or service increases, consumers will demand less of it, and as the price decreases, they will demand more. The negative sign reflects this inverse relationship between price and quantity demanded.

## When Price Elasticity of Demand is Less than 1?

When PED is less than 1, it indicates that the demand for a product is inelastic. This means that the percentage change in demand is lesser than percentage change in price. In other words, consumers are not very sensitive to price changes, and their buying habits don't change much even when prices go up or down.

## Who uses Price Elasticity of Demand?

A wide range of people use Price Elasticity of Demand including the following:

• Businesses and Marketers: They use it to set prices for their products and services, aiming to maximize profits by understanding how price changes might affect sales volumes.
• Economists: They analyze the overall health of the economy and predict how changes in prices can affect consumer spending and economic growth.
• Policy Makers: They use it to understand the potential impact of taxes, subsidies, and other policies on the demand for goods and services.