Price Elasticity of Demand: Definition, Types & Examples
Price Elasticity of Demand Definition
Price Elasticity of Demand (PED) measures how consumers change their behaviour when prices change. In other words, it identifies the relationship between price, demand, and how it reacts when prices change.
- Price elasticity of demand measures how consumers react to a change in price.
- There are five types of price elasticity of demand: perfectly inelastic, inelastic, perfectly elastic, elastic, and unitary.
- Price elasticity of demand can be calculated by dividing the percentage change in quantity demanded by the percentage change in price.
If we take an example of price elasticity of demand – a business may need to know what impact raising its prices will have. It would be pretty pointless in raising prices if profits were to decline. So calculating the price elasticity of its product gives a good indication of how higher prices will impact its bottom line. This can be calculated using the formula below:
Price Elasticity of Demand Formula
Price elasticity of demand can be calculated by dividing the percent change in demand by the percent change in price.
Calculating Price Elasticity of Demand
Let us now take an example of price elasticity of demand and how it is calculated. There is a small bakery that sells 100 loaves of bread per week for $2 each. The bakery decides to raise its prices to $2.20, but as consumers look elsewhere because of higher prices, it now only sells 80 loaves.
We must first work out the change in quantity. In this case, it has changed from 100 to 80.
We can work out % Change in Quantity Demanded by using the following formula:
So for this example:
% Change in Quantity Demanded (80 — 100 / 100) 100
Which equals -20
We can then work out % Change in Price using the formula:
So for this example:
% Change in Price ($2.20 – $2 / $2) * 100
Which equals 10
So Price Elasticity of Demand – 20 / 10 = – 2
So Price Elasticity of Demand = – 2
Types of Price Elasticity of Demand
From the example above, we reached a price elasticity of demand of -2. However, what does that mean? Well first of all, it is important to highlight that we do not consider negatives. That means the actual figure is 2 – this is so that the final figure fits within the type of price elasticity.
There are five types of price elasticity of demand. They are:
- Perfectly Elastic Demand
- Elastic Demand
- Perfectly Inelastic Demand
- Inelastic Demand
- Unitary Demand
When looking at the results from the calculation, they fall into the following buckets based on the price elasticity of demand.
In reality, ‘perfect elasticity’ and ‘perfect inelasticity’ do not actually exist and are just hypothetical models. The main types of price elasticity come in two common forms: inelastic demand, and elastic demand – with a third, but uncommon type: unitary demand.
Let us look at what they mean:
1. Inelastic Demand
Inelastic demand is where the price elasticity of demand is less than 1, which means that customers are largely unreactive to changes in price. For example, there may be 100 customers who buy a Ferrari for $200,000. If Ferrari was to increase its prices to $250,000 and 99 customers buy it, then the product is very inelastic. This is because customers do not care too much about the price.
Inelastic demand may occur as a result of limited substitute goods. For example, the local supermarket may only offer one type of bread. The only other place to go is miles away, so there may also be an element of opportunity cost. To get a similar product, the consumer will have to spend time and money on fuel to get there. As a result, the supermarket may be able to raise prices substantially before consumers start going elsewhere.
As we can see from the chart above – demand hardly reacts to a change in price. At $0.25, 3 bagels are demanded at that price. However, the price rises to $1.50, with demand falling to only 2. So although the price has risen by 600 percent, demand has only fallen by 33 percent. Therefore, demand is inelastic because it does not respond significantly to the price.
Factors affecting Inelastic Price Elasticity of Demand
1. Infrequent purchases
It might be the song from your favourite artist or a new mobile phone – consumers are willing to spend more because it is a one off purchase. Paying a little extra for a one off purchase has a different psychological impact when compared to paying extra for a good that the consumer purchases every day.
2. No substitutes
Consumers have little choice but to fill their cars up with petrol. So even if the price of petrol doubled, they still need to buy it to get around. There is simply a lack of substitutes, so they are forced to buy the good no matter the price. The only alternative is just not to drive, which is not really an option for many.
3. Geographical location
Some products/services are able to achieve a ‘geographical monopoly’, whereby consumers have little choice. For instance, we only need to look at football or baseball games as examples – customers can only buy food and drink available in the stadium. The consumer’s willingness to pay is much greater because there is no alternative, with an element of convenience.
Some products are necessary to live, so consumers have to pay however much it costs. For example, consumers have to pay for their medication no matter what it costs. Without it, they may fall gravely ill and need hospital treatment. There are also other necessities such as utilities, food, and water that are all necessary to live and which may in some cases be more prone to inelastic demand.
Products such as mince pies, turkey, and ice cream are generally seasonal. Consumers eat more ice cream in the summer and more mince pies near Christmas. As a result, consumers are willing to spend more because they receive a greater utility during the seasons — perhaps because of the seasonal supply, or, the greater satisfaction received during different times of year, for example, ice cream during the summer.
Examples of Inelastic Demand
- Rail tickets
- Apple iPhone
2. Elastic Demand
When a product or service has elastic demand, it means that customers are very responsive to price. So if the local Pretzel store starts charge an extra 5 cents and it loses half its customers, we can conclude that demand is very elastic. Consumers are unwilling to spend more and therefore go elsewhere instead.
In short, products/services with elastic demand have more emphasis placed on price than any other factor. Issues such as quality are largely negated in favour of the lowest price.
We can consider insurance as a prime example; at least specific types such as car and home insurance. There is little difference between offerings, and comparison websites have become popular for this very reason. Consumers are extremely price-sensitive and are happy to shop around to find a good deal.
As we can see from the chart above, demand is significantly sensitive to price. At $1.00, 2 doughnuts are demanded at that price. However, when the price falls to $0.80, demand increases significantly to 6 doughnuts. So although the price has fallen by 20 percent, demand has increased by over 300 percent. Demand is, therefore, elastic because demand responds significantly to the price.
Factors affecting Elastic Price Elasticity of Demand
1. Homogenous product
If a product/service is relatively similar, customers are more likely to shop around and be reactive to price changes. Insurance is a good example. As prices go up, some consumers will look to change to a cheaper provider. Even a few dollars increase can lead to consumers going on the web to look up comparative prices for a similar policy.
2. Many Substitutes
When there are many other products available, a higher price for one makes the others more appealing. For example, there are hundreds of types of chocolates and chocolate bars. Any price differentiation beyond the norm can lead to consumers choosing an alternative.
3. Low Switching Costs
If there is no cost associated with switching, it makes the decision to purchase a substitute good more likely; allowing demand to fluctuate more. If prices go up for KitKats, there is no cost applied if you no longer buy one. So there is no financial penalty for buying a substitute. By contrast, phone contracts do the exact opposite and lock consumers in for up to 2 years.
4. Luxury / Non-necessary
Goods or services that are luxury do not need to be brought, so consumers can be more sensitive to price.
Examples of Elastic Demand
- Airline tickets
3. Unitary Demand
Unitary Demand is the theory that as price increases by X%, demand falls by an equal X%. Let us take an example. A television manufacturer sells 100 televisions for $50,000. That works out as $500 per unit. It decides to raise its price by 10% to $550. At the same time, demand falls by an equal 10%; meaning it only sells 90 televisions.
In reality, there are no examples of unitary demand. The reason being is that human demand is non-linear. That is to say that there is not a direct relationship between price and demand.
There are other factors at play such as quality and availability of substitute goods. So although a good may become 10 percent cheaper, many will still prefer product X because it is their favorite. For example, Coca-Cola may increase its price by 10%. Demand will not necessarily fall by 10% because many consumers will still prefer it to Pepsi and are willing to pay the extra price.
Price Elasticity of Demand FAQs
Price Elasticity of demand refers to the relationship between price and demand, and how demand reacts when prices change.
Price Elasticity of Demand is calculated using the formula:
PED = % Change in Quantity Demanded / % Change in Price
There are three types of price elasticity: inelasticity, elasticity, and unitary. If a goods demand is elastic, it means that demand for it is extremely reactive to a change in the price. For instance, the price of a newspaper may increase by 10%, but this is enough to push customers towards a competitor.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.