What Does Elasticity of Demand Measure? Formula and Example
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.
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
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
- Item's Cut of Purchaser's Budget
- Level of Necessity
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.
- Duration of Price Change
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
- Brand Loyalty
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.
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