In economics, the price elasticity of demand (PED) is defined as the degree to which the desire for something changes as its price rises.
In other words, it measures the relationship between a change in the quantity demanded of a good or service and the change in its price.
The term elasticity is used to denote sensitivity to price changes.
To be more precise, price elasticity measures the percentage change in quantity demanded when, holding everything else constant, the price of a specific good or service is increased by one percent.
The coefficient of PED is calculated by using the following formula:
Price Elasticity of Demand = % change in Quantity Demanded / % change in Price
A product or service is considered to be elastic when the PED is >1 and therefore it is highly responsive to price changes. It means that even a small change in its price leads to a large change in the quantity demanded.
On the other hand, demand is considered inelastic when the PED is <1, and even large changes in its price lead to only a small change in quantity demanded.
There are also several further divisions that help to better describe the peculiarities of every situation. Those are: Perfectly Elastic Demand (∞), Perfectly Inelastic Demand ( 0 ), Relatively Elastic Demand (> 1), Relatively Inelastic Demand (< 1), Unitary Elasticity Demand (= 1).
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In determining PED the overriding factor is the willingness and ability of consumers to postpone immediate consumption decisions concerning the good or service and to search for substitutes after a price change.
In addition to this fundamental factor, we find others that can contribute to influencing the elasticity of demand after a change in price.
One additional but very important factor to look at, to determine the entity of PED, is whether the good or service can be considered a discretionary purchase. In fact, the more discretionary the purchase, the more the quantity demanded will fall in response to price rises, which means that its elasticity is higher.
A discretionary purchase is an expense that is more related to the “wants” than the “needs” of a business or a household. It could be for example the decision to buy a new TV, while you already have a functioning TV but you would like to buy a new one because is bigger and has a better screen. In this case, you do not need the new TV, you could keep using your current one, therefore if the price of the new TV increases, you will be more likely to not buy it, waiting for a better deal.
Moreover, the availability of substitutes is very important as well, in fact, if there are many substitutes readily available, the elasticity tends to be high. Substitutes are goods and services that can give a similar benefit to the buyer as the good or service that has changed its price, one example of substitutes are butter and margarine. If there is an increase in the price of butter, consumers will start buying more margarine because it is usually cheaper and serves a similar purpose, therefore butter producers have to be careful to not raise prices too much because the elasticity is high and consumers can easily switch to buy a substitute which is readily available.
Another factor to look at is the duration. It relates to the duration of the price increase, in fact, for most goods and services, we see a higher degree of elasticity when price changes hold longer. This does not hold for every product on the market, especially for those goods that are more necessary, but however, it can be a factor in many cases.
Speaking of necessity, it can be another factor as well, because if a good or service is highly necessary, people will try to buy it no matter the price change. This is the case of many pharmaceuticals that are necessary to stay alive.
Other factors can be brand loyalty, of course, the higher it is the more inelastic the demand will be, the percentage of income, if the price of the product represents a high percentage of the buyer’s income, the demand will be more elastic, and finally, whether the good or service is addictive, in fact, the more addictive it is, the more inelastic PED will be.
Why is it useful?
Price elasticity of demand is a useful tool used very often by economists and entrepreneurs.
In fact, for economists, it is helpful to look at the PED because it can help them to understand the working of the real economy, and the peculiarities of the market for certain goods and services.
Specific products, especially those that are basic necessities are very inelastic because people have no choice, they cannot stop buying food or electricity. On the other hand, there are other more superfluous goods and services that tend to have very elastic demand.
Then, for entrepreneurs and managers, to calculate the PED of the goods and services that they sell is very important because it can help them to make better pricing decisions and to understand how they can effectively maximize their profits.