The market is constantly fluctuating based on a few different factors, with supply and demand being two of the primary driving forces. When a product enters the market, the price is most often determined by the supply and demand of a product.
Of course, when the price of a product changes, this can cause a ripple effect in the supply and demand of said product. So, how does one measure these types of changes?
The answer is by calculating the price elasticity of demand.
The price elasticity of demand is essentially a measurement of the change in the demand for a product in relation to a price change. In other words, the sensitivity of demand and quantity of a product to a price change. It is calculated through particular formulas and delivered as a percentage amount.
Continue reading below to see how to calculate price elasticity of demand and more about the elasticities of the market.
Quick Answers
- Price elasticity of demand is used to measure shifts in the demand for a product due to price changes.
- The formula for price elasticity of demand is “% Change in Quantity ÷ % Change in Price”.
- There are said to be five categories of elasticities: perfectly inelastic, inelastic, unitary elastic, elastic, and perfectly elastic.
- Goods that see a change in demand with a price change are said to be elastic. Goods that don’t see much change in demand as prices change are considered inelastic.
- It is beneficial to calculate the price elasticity of demand for a product, as it can allow a business to make informed decisions regarding pricing strategies and policies, analyze the market and competition, and ensure a steady revenue.
- Elasticity can be affected by factors like the length of price change, the necessity of goods, the general cost of the goods, and more.
Formula to Calculate Price Elasticity of Demand
Now that we have a bit of understanding of this concept, let’s look at the formula to calculate the price elasticity of demand.
The basic formula is:
Let’s look at a simple example to make the elasticity of the price formula more clear:
Example: An apple stand typically sells 100 apples a month at a price point of $1.00 per apple. Due to rising costs, the apple stand opted to increase its price to $1.20 per apple. They are now only selling 85 apples per month.
So, the price of apples saw a 20% increase, and the demand dropped by 15%. Now, let’s plug this into the formula.
So, this price change led to an elasticity of less than 1%. There is no codified threshold, but the common belief is that any change under 1% indicates inelasticity.
It is important to note that this is the simplest formula to calculate the price elasticity of demand, but other formulas go into further detail.
One such formula is the Midpoint Method, which uses the average percent change in both quantity and price.
The advantage is that the formula will show the same elasticity between price points, whether there is an increase or decrease.
The Types of Price Elasticity of Demand
Depending on the percentage outcome of the formula, a demand curve can be one of three types. These are detailed below:
- Perfectly elastic: Price changes lead to the demand for a product declining to zero.
- Elastic: An elastic demand means that changes in price create a significant change in the demand for a product.
- Unitary elastic: Unitary elasticity is where a percentage change in price is matched by an equal percentage shift in demand.
- Inelastic: Changes in price result in a smaller percentage change in demand.
- Perfectly inelastic: Price changes result in no changes to demand.
What is the Value of Knowing Price Elasticity of Demand?
Some may be wondering what all of these complex formulas and explanations amount to for actionable business information.
It may seem like a lot of nebulous data, but these calculations can be used for essential decisions within a business, including:
- Informed decisions about pricing strategies: Calculating how a price change has or could impact the demand for a product can allow a business to make informed changes. Instead of blindly making price changes based on others in the market, they can change what works for their goods. Additionally, it can allow a business to find and set the price point that will result in maximum revenue while also being competitive.
- Improving customer image: Through carefully calculated pricing based on this formula, a business can price fairly while maintaining a competitive edge. This can help them to stand out to customers over other brands and companies.
- Taxation: The government uses this formula to assign tax rates. They will often impose higher taxes on goods with inelastic demand, as they will not experience much demand change. This means that the government can count on them to bring in more revenue. Good with an elastic demand will be on the opposite side of this.
- Market analysis: The formula price elasticity of demand can be used to analyze several facets of the market, including its condition related to certain goods, level of competition, alternative products available, and more. This data can be used to determine strategies for current goods, as well as other markets that may be worth exploring.
What Factors Affect Price Elasticity of Demand?
The price elasticity of demand can be affected by several factors, with four common ones including the following.
Type of goods (necessity or luxury)
The price elasticity of demand will typically be lower on goods that are a necessity, such as medicines or medical devices. The elasticity will be higher on goods considered to be a luxury. Additionally, discretion can play a significant role in the elasticity of demand.
An example would be a consumer considering buying a new car, but their current vehicle is working fine. If the price of vehicles goes up, they are likely to hold off on purchasing a new car until theirs breaks or prices come back down.
Length of price change
The length of time of a price change can play a significant role in consumer elasticity. The change in demand will be much different for a
For example, if a consumer’s favorite ice cream goes up by a dollar for the summer, they may decide to deal with the price change or find an alternative for the season. Whereas a permanent price increase may cause them to switch brands.
Availability of substitutes or alternatives
Price elasticity of demand can be affected if consumers have substitute options available that are similar to the product. If alternatives are available, the demand would be considered elastic. If there are no substitutes for the good, it will result in inelastic demand.
A good example of this is with technology. A consumer who wants a MacBook will unlikely buy a cheaper Windows laptop, as it is not a suitable enough alternative.
How much income is spent on the product
The general price point of goods can play a role in the demand elasticity as well. If the goods are relatively inexpensive and not a significant portion of a person’s income, their purchase may be unchanged by a price change. Whereas goods that cost a larger proportion of a person’s income, consumers are less likely to have an elastic demand to price changes.
Let’s look at the ice cream example from above. If consumers love their favorite ice cream enough, they are often willing to continue buying it after a price change. On the other hand, if a consumer has their car detailed for an affordable price previously and it jumps up, they may start cleaning their car themselves.
Wrapping Up
We hope that this detailed look into the price elasticity of demand will allow you to make more informed decisions for your business. By employing the formula above, you can make accurate price changes that will maximize revenue and keep consumers happy.
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