Let’s pretend that you sell jeans and diamond rings. I know it is a weird combination, but I need you to help me out here.
You increased the price of both products.
While jeans sales haven’t dropped at all, the sales of diamond rings plummeted.
But how is that possible? While one product’s sales dropped, the other one was unaffected.
This is what price elasticity of demand explains, and with our calculator, you can even calculate how much your product demand is affected by price changes.
Understanding Price Elasticity of Demand
Price elasticity of demand measures how responsive the quantity demanded of a good is to changes in its price. By knowing the responsiveness of consumers to price changes, you can make informed decisions on pricing strategies to find an optimal price.
Elasticity can be categorized as elastic, inelastic, or unitary elastic.
- Elastic demand: A small price change leads to a significant change in quantity demanded.
- Inelastic demand: A large price change results in a slight change in quantity demanded.
- Unitary elastic: Price changes proportionally affect the quantity demanded.
When a product is perfectly elastic, any price change will cause the quantity demanded to drop to zero. On the other hand, perfectly inelastic demand means the quantity demanded remains the same regardless of price changes.
Various factors influence elasticity:
- Availability of substitutes: If close substitutes are available, demand tends to be more elastic because consumers can easily switch to alternatives if the price rises. This is also known as cross-price elasticity.
- Necessity vs luxury: Necessities tend to have inelastic demand because consumers need to buy them regardless of price. Luxuries have more elastic demand because they are not essential, and consumers can forego them if prices rise.
- Income: Products that comprise a large proportion of a consumer’s income usually have more elastic demand. Small changes in the price of such products significantly impact the consumer’s budget.
- Time: Demand can be more elastic over the long term as consumers adapt.
- Brand Loyalty: Strong brand loyalty can make demand more inelastic, as loyal customers are less sensitive to price changes.
The Price Elasticity of Demand Formula
The basic formula for PED is:
PED = % Change in Quantity Demanded / % Change in PriceMathematically, it can be expressed as:
PED = (ΔQuantity / Quantity) / (ΔPrice / Price)Where:
- Price: Initial price
- Quantity: Initial quantity
- ΔPrice: Change in price (Final Price – Initial Price)
- ΔQuantity: Change in quantity demanded (Final Quantity – Initial Quantity)
Using the Midpoint Formula
The midpoint method provides a more accurate result by averaging the initial and final values:
PED = ((Final Quantity - Initial Quantity) / ((Initial Quantity + Final Quantity) / 2)) / ((Final Price - Initial Price) / ((Final Price + Initial Price) / 2))This method reduces the impact of the direction of the change. Our calculator uses the midpoint method for better precision.
Applying the Formula With an Example
Suppose the price of a product increases from $10 to $12, and as a result, the quantity demanded decreases from 100 units to 80 units.
First, calculate the percentage change in quantity demanded:
% Change in Quantity Demanded = ((80−100) / 100) × 100 = −20%Next, calculate the percentage change in price:
% Change in Price = ((12−10) / 10) × 100 = 20%Now, use the PED formula:
PED = −20% / 20% = −1Let’s also use midpoint calculation formula to showcase the difference between the two methods
PED = ((80 - 100) / ((100 + 80) / 2)) / ((12 - 10) / ((12 + 10) / 2))
PED = (-20 / 90) / (2 / 11)
PED = -0.2222 / 0.1818
PED = -1.2222The negative sign indicates the inverse relationship between price and quantity demanded. In this case, using regular calculation gives us the absolute value is 1, meaning the demand is unitary elastic, but using the midpoint formula we get PED of -1.2222 which means its elastic.
But what do other values mean?
Interpretation of PED Values
The value of PED helps determine how responsive the demand for a product is to price changes:
- Elastic Demand (PED > +-1):
- The percentage change in quantity demanded is greater than in price. Consumers are highly responsive to price changes. For example, luxury goods often have elastic demand because a slight change in price leads to a significant change in the quantity demanded.
- Inelastic Demand (PED < +-1):
- The percentage change in quantity demanded is less than in price. Consumers are not very responsive to price changes. Essential goods like food and gasoline often have inelastic demand because people need to buy them regardless of price changes.
- Unitary Elastic Demand (PED = +-1):
- The percentage change in quantity demanded equals the percentage change in price. The total revenue remains constant when the price changes.
- Perfectly Elastic Demand (PED = ∞):
- Quantity demanded changes infinitely with any price change. This is a theoretical extreme where consumers will only buy at one price and none at any other.
- Perfectly Inelastic Demand (PED = 0):
- The quantity demanded does not change regardless of price changes. This is another theoretical extreme, where consumers will buy the same amount regardless of price.