What’s Price Elasticity of Demand?
Price elasticity of demand measures the quantity sensitivity required to change the price. It is calculated by dividing the percentage change in quantity demanded by the price change percentage. If the price elasticity of demand is (a) higher than 1, demand is considered elastic, (b) equal to 1, demand is unit-elastic and (c) less than 1 demand is inelastic.
Is it important to know Price Elasticity of Demand?
Price elasticity of demand is the most popular measure of demand elasticity, others being demand income elasticity and demand cross elasticity. Understanding the price elasticity of demand is important to a company in determining the price that optimizes its revenue. It tells us whether a price increase will result in an increase in revenue. It also tells us whether a company can apply price discrimination strategy.
What are the factors that can affect the price elasticity of demand?
A producer's total revenue is equal to the product of the quantity demanded and the price. Change in revenue due to price change depends on the price elasticity of demand for the product. Following are the effect on total revenue under different price elasticity scenarios: if demand is elastic, demand price elasticity is greater than 1 and a one percent increase in price will result in more than one percent change in demand quantity.
- If demand is inelastic, demand price elasticity is lower than 1 and a price increase of one percent will result in less than one percent change in demand quantity.
- If demand is unit-elastic, the price elasticity is equal to 1 and a price increase of one percent will result in exactly one percent change in the quantity demanded.
How Do You Calculate Price Elasticity of Demand?
The most widely accepted formula for calculating price elasticity of demand is the midpoint formula. In conventional economies, demand for a product is traditionally modeled as a convex curve; the change in demand for the product shifts as you move to the left or right of the curve. The formula of the midpoint attempts to reach the address. Since we have both the old and the new price-demand points, we infer that the curve passed through the midpoint of the two.
We compare the aggregate price change with the price and quantity sold at the midpoint to get the average rate of change. This is generally expressed as:
Midpoint Price Elasticity Formula:
This formula is implemented on our Price Elasticity of Demand Calculator.
Why is Price Elasticity of Demand Usually Negative?
Because demand for a product generally increases as the price is lowered and decreases as the price increases. The price change affects the likelihood of consumers using substitute products or taking steps to reduce their aggregate demand. The extent to which this occurs gives us valuable information about the nature of consumer demand.
The price elasticity of demand value can be interpreted into several buckets:
- Elastic Demand: a change in price will result in a significant decrease in demand, sufficient to offset the decrease in unit price, and thus drive an increase in aggregate revenue for the product. Demand is often elastic when there are close substitutes for a product and small price changes improve the relative value offered by the product in question.
- Unitary Elastic: unit demand will increase as prices change, but aggregate revenue will remain constant.
- Inelastic Demand: A price change will result in a decrease in demand but a decrease in overall revenue.
- Perfectly inelastic: price change has no effect on demand. In the real world, this would be something consumers need to survive or cannot be replaced by any other reasonable means. This has implications for pricing: if the price is lowered, you will see a drop in aggregate revenue without an increase in demand offsetting.
- Giffen Goods / Veblen Goods: Special cases where demand for a product increases as prices rise.
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