The price elasticity of demand measures the responsiveness of the customers to any change in the cost of the product. It can be well understood by a general term demand elasticity which measures the impact of a change in any of the factors including the price of the product.
In order to calculate the elasticity of demand, you estimate the percentage change in the quantity that is in demand by the percentage change in the economic variable. Hence, if you are measuring the price elasticity of demand, the formula will be as shown below.
Price elasticity of demand = Percentage chance in the quantity / Percentage change in price.
Understanding the price elasticity of demand
The elasticity of demand is measured in absolute terms. When the price elasticity of demand is more than 1, it is known as elastic demand and it means that the demand for the product is sensitive to a change in price. An increase in price might make customers move to a different product. It is applicable in various present-day situations with respect to products and services. A lot of consumers move to a different product when there is a minor change in the price of essential goods that are consumed regularly. There is also a shift in the consumers when a hotel increases the room tariff.
Keeping a watch on the elasticity of demand will help businesses set the production target and adjust the prices. The price elasticity of demand that is less than 1 is inelastic. It means that the demand for a product does not change after an increase in price. This can be related to fuel. A consumer will either need it or not need it. The change in price will not affect demand. Consumers who own vehicles will need fuel and any change in price will have no impact on the demand. And not many will stock up on fuel when the price decreases.
Example of price elasticity of demand
Let us take an example here. Let us assume that a company calculates that the demand for a bottle of cola increases from 200 to 210 once the price is reduced from $2 to $1.50. The price elasticity of demand is shown as a percentage change in quantity divided by percentage change in price. Hence, it will be 10%/ $2. The price elasticity of demand is 0.4. Now, this is lower than 1 which means it is inelastic and the change in price has minimal impact on the demand of the product.
When the elasticity is equal to 1, the demand is known as unit elastic. It means that the demand for the product will move in the direction of the price change. Hence, when the price of candy increases by 5%, 5% of buyers will move to a different brand.
Impact of price elasticity of demand on businesses
The elasticity of demand is a common factor calculated by a business. A lot of businesses gather data on the impact of price change in their industries and they use this information to calibrate the price and maximize the profits. Knowing the elasticity of demand will help set the right production level in a business.
Uber is a real-life example of elasticity of demand. It uses surge pricing when the demand is high. At peak times, the demand will be less price elastic, and Uber increases the average fare. It is done so as to encourage more drivers to take additional rides and meet the demand needs. People will be willing to pay in peak times and Uber takes advantage of the same. However, Uber has been heavily criticized for the policy.
There is one more type of demand elasticity which is known as cross elasticity. It is calculated by taking the percentage change in the quantity in demand for a product and dividing it with a percentage change in the price for another product. It shows the impact on the demand for a product to the price change for other products.
All businesses use price elasticity of demand for their products and set the right prices and production levels. Perfectly elastic demand and perfectly inelastic demand rarely exist. It is usually more than 1 or less than 1 in the current market situations. The same is applicable to supply.
- The price elasticity of demand shows the impact of a price change on the sales of a product.
- High elasticity shows that consumers are more responsive to the price change.
- Demand elasticity shows the impact on demand due to various factors.
- The price elasticity of demand more than 1 is known as elastic demand.
- The price elasticity of demand less than 1 is known as inelastic demand.