What Does Elasticity of Demand Measure? Formula and Example

What Does Elasticity Of Demand Measure August 05, 2020

Chloe Henderson

Writer

A product's price can have a significant impact on consumer buying habits and sales. By calculating the elasticity of demand, organizations can determine just how flexible an item's popularity is and how much they can alter the cost without affecting the volume of sales.

While some goods can fluctuate in price significantly and still retain consumers, others have a very rigid limit in which management can change prices before demand decreases.

Therefore, companies should learn how to calculate the elasticity of demand for each product in order to maximize revenue and minimize the risk of losing sales.

What is Price Elasticity?

Price elasticity refers to the impact on sales factors, such as revenue, when an item's price is altered. Alternatively, the price elasticity of demand (PED) focuses on the effect price change has on consumer demand.

PED measures the consumers' receptivity of a product's price change by dividing the percentage of demand by the cost percentage change. This calculation allows businesses to see how altering costs can affect sales. The PED formula is also used by economists to better understand how supply and demand changes correlate in macroeconomics.

For example, goods such as gasoline are inelastic, meaning its cost fluctuation does not deter customers or distributors. Therefore, inelastic products are able to maintain their regular supply and demand relationship. On the other hand, products such as luxury items are elastic because a significant change in price directly impacts supply or demand.

Typically, inelastic goods are products or services that the majority of consumers need to perform standard functions. Elastic products are often inessential items that customers may want but do not need. Goods can also be classified as unitary, in which the price change percentage proportionally changes the quantity demand percentage.

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To calculate whether an item is elastic, inelastic, or unitary, values are entered into the PED formula-

% Change in Quantity Demanded / % Change in Price = Price Elasticity of Demand

The quotient from this formula determines a product's elasticity-

Infinity = Perfectly Elastic
Greater than 1 = Elastic
1 = Unitary
Less than 1 = Inelastic
0 = Perfectly Inelastic

For example, a flower store raises its price on a bouquet of roses from $30 to $45. At the original price, the shop was selling an average of 25 bouquets a week, but after the price change, the sales volume dropped to 15.

In order to use the price elasticity formula, the difference in quantity and price must first be calculated using the midpoint method-

[(Q2-Q1)/[(Q2+Q1)/2]] / [(P2-P1)/[(P2+P1)/2]= Midpoint method for elasticity

In this formula, Q represents the initial and changed quantities of demand, while P represents the respective prices. Therefore, this example should be set up as-

% Change in Quantity= (15 - 25) / [(15 + 25) / 2] x 100 = - 50%

% Change in Price = (45 - 30) / [(45 + 30) / 2] x 100 = 40%

Price Elasticity of Demand = -50% / 40% = 1.25

While the true answer if -1.25, the price elasticity calls for the absolute value of the quotient. This means any negative value is converted to positive by simply removing the negative sign. Therefore, if the price elasticity is 1.25, then the bouquet of roses is considered to be elastic, meaning changing the cost directly affects its customer demand.

Factors that Affect Price Elasticity of Demand

The elasticity of a product can be improved by managing various factors to ensure demand is maintained even if the business chooses to increase the price. Some of the crucial elements that impact an item's PED include-

Availability of Alternate Products

When a company supplies a wide variety of similar products or services, the goods have greater elasticity. This is because customers can easily choose a substitute when their typical product of choice increases in price, even if the cost change is minuscule. On the other hand, if no alternatives are available to consumers, the demand change will likely be inelastic.

Item's Cut of Purchaser's Budget

Goods that take up a significant amount of the customer's budget tend to have greater elasticity than products with minimal cost. The high cost of items can cause consumers to look elsewhere for substitutes to find the most economical option. However, if a good or service only consumes a small portion of the budget, the purchaser is more likely to overlook slight cost fluctuations, creating an inelastic demand.

Level of Necessity

The higher the product's necessity level, the lower the elasticity. For example, consumers are more likely to buy gasoline, prescriptions, and staple food items regardless of higher or lower price changes because they are essential. On the contrary, luxury items are considered to be inessential and are more likely to experience drops in demand due to price increases, making them highly elastic.

However, some consumers make a habit of purchasing elastic items to the point that they become essential items, such as cigarettes. In this case, some luxury items may become inelastic to specific consumers.

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Duration of Price Change

Demand elasticity also depends on a good's durability and how frequently its price changes. For example, while fuel is often inelastic if the price of gasoline remains inflated for an extended amount of time it may become elastic. People who are unable to afford the gasoline prices long-term may switch to more economical means, such as public transportation or car-pooling.

However, this trend does not hold true for durable goods, such as cars. Durable goods can remain inelastic throughout short and long-term price changes because it becomes necessary to replace them over time.

Definition of the Product

Products with vague descriptions have minimized elasticity because they are able to encompass a variety of goods. For example, bread has demand elasticity because it includes all types and brands of bread. However, food, in general, has low elasticity as there is no substitute.

Brand Loyalty

Brands with loyal customers can generally avoid demand fluctuations due to price changes, thus remaining inelastic. Therefore, new brands can potentially become inelastic once they establish a loyal clientele that is willing to purchase items regardless of price. This is especially true for high-end brands that offer unique experiences to consumers.

Understanding the elasticity of demand for particular products and services allows businesses to have realistic expectations when changing their pricing strategies. By calculating PED and considering its effect on forecasted demand, companies can accurately alter costs to optimize customer demand and sales.