Price Elasticity of Demand

Imagine you are in a store and an item that you normally buy is currently on a 50% off sale. It would not be surprising if you decided to ‘stock up’ on this item and buy more of it to reap the benefits as you will use this item anyway. But what about if an item you don’t normally use is on an 80% off sale? Would you still buy more than two items? To answer this question, we need to use the concept of the price elasticity of demand. Let’s learn about it. 

Price Elasticity of Demand Price Elasticity of Demand

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Table of contents

    Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in the own price of a good.

    The ‘law’ of demand states that as the price of a good falls, the quantity demanded increases as consumers are willing to buy more units of a good at a lower price. The reverse is also true. As the price of a good rises, the quantity demanded decreases as consumers are willing to buy fewer units of a good at a higher price.

    Figure 1 below shows a movement along the demand curve for a price rise and a price fall.

    Price Elasticity of Demand Movement along the demand curve StudySmarter OriginalsFig. 1 - Movement along the demand curve

    Consider a price increase from P1 to P2, which leads to a decrease in the quantity demanded from Q1 to Q2. A price decrease from P1 to P3 leads to an increase in the quantity demanded from Q1 to Q3. The proportion in which the quantity demanded will respond to price changes will be different not only for different levels of price changes but also will vary along the curve. This responsiveness is measured by the price elasticity of demand.

    The formula for calculating the price elasticity of demand

    Price elasticity of demand is calculated as a percentage change in the quantity demanded divided by a percentage change in the price of a good.

    The formula for the price elasticity of demand (PED) is:

    PED = % Δ Quantity demanded% Δ Price

    You can find a percentage change in a variable by using the following formula:

    %Δ=New value - Old valueOld value*100%

    Let’s imagine the price of refrigerators rises from £20 to £21 (a rise of 5%), whilst the quantity demanded falls from 100 to 95 (a fall of 5%). Price elasticity of demand is then equal to: 5% over 5% = 1 in absolute value. We often use an absolute value for the price elasticity of demand for convenience, but its true value will always be negative. This is because of the law of demand: the quantity demanded of a good always falls when its price rises. Thus, the correct calculation would be -5% over 5%, which would give us a value of -1.

    Types of price elasticity of demand

    There are three types of demand based on how much the quantity demanded of a good changes when its price changes.

    These are:

    • Unitary price elastic demand

    • Price inelastic demand

    • Price elastic demand

    Think of price elasticity of demand as the steepness of the demand curve (its slope).

    Unitary price elastic demand

    Demand is unitary elastic (absolute value of elasticity equal to 1) if a change in the own price of a good leads to a proportionate change in the quantity demanded.

    Larry enjoys having a full English breakfast and consumes bacon every morning. Due to supply issues, the price of bacon has gone up by 100% and Larry decides to not consume bacon anymore. He reduces his bacon consumption by 100% (the same percentage as the price increase) as his demand has unitary price elasticity. Calculation: 100% / 100% = 1.

    This type of demand is drawn as a line at a 45-degree angle to the horizontal axis as shown in the first diagram of Figure 2 below.

    Price inelastic demand

    Demand is price inelastic (elasticity is less than 1 in absolute value) if a change in the own price of a good leads to a less than proportionate change in the quantity demanded.

    John is a fan of Apple products. Whenever a new iPhone comes out he is the first one to pre-order it. If the price of Apple iPhones increases by 20%, John will still buy the same amount of iPhones. His demand would decrease, according to the law of demand, but by only 2% compared to the price change. This is because his demand for iPhones is price inelastic. Calculation: 2%/100% = 0.02.

    Consider an increase in the price from P1 to P2 as shown in Figure 2 across the three figures. In the case of price inelastic demand, shown in the second diagram, the price increase would reduce quantity demanded by less compared to demand with unitary elasticity.

    Price elastic demand

    Demand is price elastic (elasticity is greater than 1 in absolute value) if a change in the own price of a good leads to a more than proportionate change in the quantity demanded.

    Kayla likes wearing jewellery. Due to an oversupply in the market, the price of jewellery decreases by 20%. Kayla rushes to buy more jewellery, increasing her demand by 60%. Her quantity demand increases by more compared to the price change. This is because her demand for jewellery is price elastic. Calculation: 60%/20% = 3.

    Consider an increase in the price from P1 to P2 as shown in Figure 2 across the three diagrams. In the case of price elastic demand, shown in the third diagram, the price increase would reduce quantity demanded by more compared to demand with unitary elasticity.

    Price Elasticity of Demand Three types of demand elasticity StudySmarterFig. 2 - Three types of demand elasticity

    How does the price elasticity vary along a linear demand curve?

    Price elasticity of demand varies not only between different goods but also along the demand curve for an individual good as Figure 3 shows. At point 1 demand is unitary elastic. Anywhere along the demand curve between point 1 and point 2 demand is elastic. Demand is infinitely elastic at point 2. Anywhere along the curve between point 1 and point 3 demand is inelastic. Demand has zero elasticity at point 3.

    Price Elasticity of Demand Elasticities along a linear demand curve StudySmarterFig. 3 - Elasticities along a linear demand curve

    What are the special cases of the price elasticity of demand?

    There are two special cases of the price elasticity of demand:

    • Perfectly inelastic demand

    • Perfectly elastic demand

    Demand is perfectly inelastic when its elasticity is equal to zero.

    This happens when no matter how much the price of a good increases or decreases, the quantity demanded will stay the same. Perfectly price inelastic demand is shown in Figure 4.

    In the market for inhalers for people suffering from asthma, demand would be perfectly price inelastic. No matter how much the price of inhalers rises, demand will stay the same as people suffering from asthma depend on them.

    Price Elasticity of Demand Perfectly price inelastic demand curve StudySmarterFig. 4 - Perfectly price inelastic demand curve

    Demand is perfectly elastic when its elasticity is equal to infinity.

    This happens when the consumers will demand any quantity at a single price. Perfectly elastic demand is shown in Figure 5.

    In a perfectly competitive market where there is a lot of suppliers with homogeneous products, demand is perfectly price elastic. If one supplier raises the price of their potatoes, they will simply lose all their customers. Consumers will switch to other suppliers due to all potatoes being the same.

    Price Elasticity of Demand Perfectly price elastic demand curve StudySmarterFig. 5 - Perfectly price elastic demand curve

    How does the price elasticity of demand affect the total revenue of a supplier?

    Price elasticity of demand is taken into account by producers in their pricing decisions. They consider whether increasing or decreasing the price of their product will lead to an increase or a decrease in their total revenue. In other words, the supplier will try to maximise the total revenue they receive from selling their good or service.

    As you can see in Figure 6 below, a supplier’s total revenue varies with the total output produced. This happens because price elasticity varies along a linear demand curve, which is also a firm’s average revenue (AR) curve. The prices vary along the demand curve together with the price elasticity of demand.

    At point A the demand is perfectly elastic and total revenue (TR) is equal to zero. Between point A and B the demand is elastic and TR is increasing reaching its maximum at point B. Point B is also the point where marginal revenue (MR) is equal to zero. Between point B and point C demand is inelastic and TR starts declining and eventually reaches zero at point C. Point C is also the point where average revenue (AR) is equal to zero. Demand at point C becomes perfectly inelastic. Therefore, the firm will try to produce its output at point B where total revenue is maximised and where MR=0.

    Price Elasticity of Demand Price elasticity of demand effects on total revenue StudySmarterFig. 6 - Price elasticity of demand effects on total revenue

    Example: the effect of price elasticity of demand on supplier’s revenue

    Consider the following demand equation: Q = 100 – 2*P

    We will now calculate the effect of a pricing decision on a supplier’s revenue. The initial price of a product is 30 at which 40 units of a product are demanded (Q=100-2*30=40). This is represented by point A on the demand curve in Figure 7 below.

    Price Elasticity of Demand PED and total revenue StudySmarterFig. 7 - PED and total revenue

    The current total revenue the supplier is making is P*Q = 30*40 = 1200.

    The supplier is thinking of introducing a 50% sale promotion (reducing the price to 15) in hope of increasing the quantity demanded, thereby increasing revenue. At the new price of 15 consumers will be willing to buy 70 units of the product. This is represented by point B on the demand curve in Figure 7. The new revenue would then be equal to 15*70 = 1050.

    Despite a large potential increase in the quantity demanded, the supplier’s revenue would decrease if they implement the 50% sale. Why? This is because reducing the price to 15 takes us to the inelastic part of the demand curve, which is beyond the point of unitary elasticity. The point of unitary elasticity for this demand curve is at Q=50 and P=25 at point C in Figure 7. It is located at the midpoint of the demand curve.

    Check your understanding. Could a supplier have lowered their price whilst increasing revenue? Can you find a price where revenue would be greater than it was initially?

    The answer is yes. Any price below the current price of 30, but not below 25, in fact, will result in higher revenue for the supplier. The revenue will be maximised at a price of 25. Any deviation below or above 25 would lead to a reduction in revenue for the supplier. This is generally true for all linear demand curves.

    Effect of price elasticity of demand on consumer expenditure

    Total supplier revenue is equal to total consumer expenditure on a good or service. The following rule will help you easily identify if demand is price elastic, price inelastic, or has a unitary price elasticity:

    • If the total amount spent by consumers on a particular good or service falls when the price increases, demand is price elastic.
    • If the total amount spent by consumers on a particular good or service rises when the price increases, demand is price inelastic.
    • If the total amount spent by consumers on a particular good or service remains constant when the price increases, demand has unitary price elasticity.

    Price elasticity of demand - Key takeaways

    • Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in the own price of a good.
    • Price elasticity of demand is calculated as a percentage change in the quantity demanded divided by a percentage change in the price of a good.
    • There are three types of demand based on how much the quantity demanded of a good changes when its price changes: unitary price elastic demand, price inelastic demand, price elastic demand.
    • Demand is unitary elastic if a change in the own price of a good leads to a proportionate change in the quantity demanded.
    • Demand is price inelastic if a change in the own price of a good leads to a less than proportionate change in the quantity demanded.
    • Demand is price elastic if a change in the own price of a good leads to a more than proportionate change in the quantity demanded.
    • Price elasticity of demand varies along a linear demand curve.
    • There are two special cases of the price elasticity of demand: perfectly inelastic demand and perfectly elastic demand.
    • Price elasticity of demand is taken into account by producers in their pricing decisions.

    Frequently Asked Questions about Price Elasticity of Demand

    What is price elasticity of demand?

    Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in the own price of a good.

    How do you calculate price elasticity of demand?

    Price elasticity of demand is calculated as a percentage change in the quantity demanded divided by a percentage change in the price of a good.

    How does price elasticity affect demand?

    If demand is price elastic, the total amount spent by consumers (quantity demanded) on a good falls when the price increases. If demand is price inelastic, the total amount spent by consumers (quantity demanded) on a good rises when the price increases.

    What are the types of price elasticity of demand?

    There are three types of the price elasticity of demand: unitary price elasticity, inelastic demand, elastic demand.

    Test your knowledge with multiple choice flashcards

    What value(s) does the unitary price elasticity of demand take?

    What value(s) does the price elasticity for inelastic demand take?

    What value(s) does the price elasticity for elastic demand take?

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