Price Elasticity of Demand

Starting with the price elasticity of demand, we need to understand what elasticity means. Elasticity refers to whether consumers are dependent on a specific product or brand. Or if they’re willing to switch to a different product or brand. Essentially, elasticity measures a consumer’s flexibility.

If the consumers are very elastic, they’re very flexible, meaning they’re comfortable switching to other brands or products. Conversely, if they’re inflexible, then they’re inelastic, indicating they want to stay with the same product. Think of it like a rubber band. A rubber band is very flexible, or elastic, and it’s the same concept with consumers and the products they desire.

There’s a key concept to understand for price elasticity of demand: when the price of a good increases, the quantity demanded always decreases. With price elasticity of demand, the question isn’t, “Did the quantity demanded decrease?” because it always decreases with an increase in price. Rather, the question is, “How sensitive is the change in price to the change in quantity demanded?” In other words, “By how much did the quantity demanded decrease?”

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

Let’s consider an example of a pizza company. If a pizza company raises its price by 10%, and now consumers want 20% fewer pizzas, this means that consumers are very elastic with pizzas (20% / 10% = 2 price elasticity). We express the price elasticity of demand as a positive number, in this case, it would be 2. Anything over 1 is considered elastic. With elastic demand, an increase in price will cause total revenue to decrease.

Now, let’s discuss an example of inelastic demand. Prescription medication is a typical product that often has very inelastic demand. Inelasticity implies that consumers are inflexible. For various reasons, they continue buying a specific product or brand, even when the price increases.

Even in this situation, when the price increases, the quantity demanded will still decrease, but the decrease is smaller than the price increase. In other words, total revenue will increase.

In this example of prescription medication, let’s say the price of a medication increases by 10% and the quantity demanded decreases by only 1%. This means a 1% price increase causes a 0.1% quantity demanded decrease. The price elasticity of demand is only 0.1 (0.1%/1%). Once again, this is positive, anything less than 1 is inelastic, indicating we have inelastic demand.

Study Tip: Price Elasticity of Demand > 1 = Elastic Demand; Price Elasticity of Demand < 1 = Inelastic Demand