Understanding the price elasticity of demand

Knowing a little bit about how economics works means you can be in better control of your money, and your financial future. Retailers and banks make rational business decisions based on economic theory, and in their own interests.

Understanding some of this theory can help you avoid getting trapped by business behavior that is unfriendly to consumers. It also helps you understand why you make certain financial decisions so that you can make better choices in the future.

In this article, we look at price elasticity, a central microeconomic principle that determines a lot of both consumer and business behavior. So, what is price elasticity, and how does it affect you? Let’s take a look.

What is price elasticity?

Almost everyone is sensitive to price. The richest billionaire might not care about the cost of a cup of Starbucks coffee, but poor and middle-class families will. Yet even the billionaire will be sensitive to some prices, think the price of an executive jet, for example.

This sensitive to a price can be highly quantifiable, especially where a lot of a good or service is sold, and where many consumers are involved. Price elasticity then shows exactly how sensitive a consumer is to the price of a product, and how that price sensitivity works.

For example, some products have very dramatic responses to changes in price. If the price goes up slightly, product sales drop dramatically. These could be products which are desirable, but not essential. Other products will still sell, even if prices go up dramatically, but may sell just a bit less. Think gas at the fuel pump, for example.

Calculating the price elasticity of demand

Price elasticity of demand boils down to a simple number, derived from a simple calculation. To find this number you divide the percent change in quantity demanded by the percentage change in price asked. The result is the price elasticity of demand.

1 Price elasticity
Price elasticity: the change in quantity demanded divided by the change in price

So, say a furniture company raised the price of a chair from $ 1,000 to $1,300. This is a 30% increase in the price. If it sells 90 chairs instead of 100 that presents a 10% drop in the demand for the chair.

Plug these numbers into the equation above and you’ll get a price elasticity of demand of -0.33. We usually throw away this negative sign because it is the ratio that counts, not the direction of the ratio.

What does this number mean? It’s simple: the higher this ratio, the more likely a consumer will reduce their spending on the product. On the flip side, the lower this number the less likely a price change will mean sales drop.

The different types of price elasticity

Economic theory around price elasticity is quite elaborate and we’ll cover a few of the more interesting points too. For example, there are different types of price elasticity of demand, determined by the size of the number. You could look at these as “zones” of elasticity and these zones help classify price sensitivity. The zones are:

  • Perfectly elastic demand. Demand is perfectly elastic when the quantity consumers buy drops by an unlimited or infinite quantity as the price goes up. It is also known as infinite price elasticity of demand. This rarely happens in real life so it is really of theoretic importance.
  • Perfectly inelastic demand. Opposite to infinitely elastic demand, perfectly inelastic demand involves a product where the demand stays the same, regardless of what happens to the price. It’s presented by price elasticity of zero. Again, we don’t really find this extreme level of price elasticity, so it’s more theoretical than practical.
    2 Perfectly inelastic demand
    Perfectly inelastic demand
  • Relatively elastic demand. As the name suggests, relatively elastic demand means that the change in demand is bigger than the change in price. So, demand will change to a higher degree than the percentage change in price. This type of price elasticity of demand will usually be seen around luxury goods, which are optional to purchase but nonetheless desirable at the right price.
  • Relatively inelastic demand. The opposite of relatively elastic demand, relatively inelastic demand happens when a change in price has a modest effect on the quantity demand. So, demand will change proportionally less compared to the change in price. Essential goods such as bread, salt and rice would have this type of price elasticity.
  • Unit elastic price elasticity of demand. Here, demand changes in lock-step with prices. For every percentage point that price rises or drops, demand rises or drops. Like the first two types of price elasticity of demand, unitary elasticity of demand is theoretical, you don’t see this type of price elasticity in real life.
    Unit price elasticity of demand

So now you know roughly how price elasticity can vary amongst products. It really depends on the consumer preferences towards a particular product or service: does this product matter in their daily lives, or can they get by without it if prices go up? The same for products and services traded between businesses.

Factors that determine the price elasticity of demand

Demand is a complex topic that is affected by a range of variables. First, let’s look at the general laws of demand, and see how consumers and buyers in the broad adjust their purchasing preferences.

The laws of demand

It’s worth looking at the broader laws that define consumer demand because these also bear down on the price elasticity of demand. There are five laws in all:

  • Price of related goods. We’re not talking about just goods who are the exact same instead with related goods we consider goods that are often purchased together, like cars and fuel for example. This relates to price elasticity in that when cars become cheaper, fuel will be in higher demand.
  • Buyer’s income. People’s spending power will affect demand, with more money consumers can buy more, irrespective of price. So, businesses will watch income numbers because this will affect price elasticity, making some products more or less elastic so businesses, in turn, have more or less price flexibility.
  • What consumers want. The perception of consumers counts, whether it is the perception of future value or indeed whether a purchase is fashionable. In other words, do consumers think the value of an item will rise in the future? If so, this can make prices less elastic.
  • Consumers preferences. If consumers prefer a certain item above another it will make the item less price elastic, whereas the less preferred item will be more price elastic. Businesses can, therefore, modify the price elasticity of demand by promoting and advertising a product. Consumers, in turn, should be aware that price elasticity is a product of popularity, not just intrinsic value.
  • Size of the market. With more buyers in the market for a product, the demand for that product will rise. If the population in a city rises but the supply for housing stays the same the demand and hence price for housing will rise. A larger market for a product, keeping everything else constant, will result in lower price elasticity of demand.

Demand is clearly a complex topic that involves a lot of different variables. As a consumer, you should be aware of what affects your desire for a product in order to make better buying decisions.

Additional considerations for price elasticity

Looking specifically at price elasticity rather than demand in the broad a few other important factors come into play. These are narrower in scope but equally important:

  • Availability of substitutes. Consider a range of fresh bread loaves on a shelf. If one of the brands goes up in price consumers will simply choose its substitute: a similar quality loaf from another brand. Here, prices are very elastic. If the only substitute is a frozen loaf, prices will be less elastic.
  • The necessity of the good. Goods that are optional in nature will be more price elastic as consumers will simply buy less of the good when the prices go up in order to manage their budgets. Essential food products, on the other hand, will be relatively less price elastic as consumers still need to eat.
  • Time to find alternatives. How easy is it for a consumer to find an alternative to a product? If the only store in a remote mountain village raises its prices for bread the local residents will likely keep on paying the associated prices, making the bread in that store price inelastic. However, on a busy New York street with several retailers, the price of bread will be highly price elastic.
  • Consumer habits. Products that are addictive or habit-forming will be less price elastic. If consumers buy something out of habit they are more likely to put up with a price rise, whereas goods involving purchasing decisions could easily see a drop in demand if prices rise.
    4 Consumer habits also affect price elasticity of demand

As you can see price elasticity is affected by a number of factors closely related to consumer thinking and consumer behavior. A business will analyze these factors and set prices accordingly. In turn, as a consumer, you should be aware of your pricing blind spots.

Why price elasticity of demand matters

We’ve already hinted at why price elasticity is important for both businesses and consumers. Let’s take a closer look at how the real-world economy by first examining why businesses need to take heed of price elasticity

Importance of price elasticity for businesses

Businesses will consider the price elasticity of demand when setting prices because setting the right price means generating maximum profits. In particular, price elasticity theory affects business decisions in these ways:

  • Price elasticity theory can let a business calculate the total revenue based on a set price. By analyzing the price elasticity of demand a business can determine total revenue at each price and accordingly optimize pricing for maximum profit.
  • By taking a closer look at price elasticity a business can maximize profits through price discrimination. Prices can be customized for people in different income groups, alongside a product which is customized to reflect the price – even if the relationship Is not altogether linear. Think the difference between the pricing and the in-flight experience for economy and premium economy seats, for example.
  • A business can pass tax through to a consumer or pay some of the tax itself. Cigarette companies pass most of the taxes on a product across to a consumer because its products are relatively price inelastic, due to its habit-forming effects.

Of course, by understanding the finer details of price elasticity and by collecting intricate data on consumers, a business can further maximize profits. For example, a business can grow to understand to what extent competitors’ products are substitutes, and how this affects price elasticity.

Likewise, the overall state of the economy will affect the price elasticity of a business’s product, so a business must keep an eye on economic forecasts before making price adjustments.

Why consumers should heed price elasticity

First, consumers should understand that prices have been very carefully calculated by a business to the express benefit of that business, not the benefit of the consumer. Prices do not necessarily reflect value but instead reflect the behavior of consumers as set out by the theories of price elasticity.

For that reason, you as a consumer should carefully think through the value of a product and compare it to the price on offer before buying. Think those premium economy seats, for example. The price may be very attractive compared to a business class flight, which is the view the airline wants you to take. But is the experience in premium economy really worth the extra money above economy?

Price elasticity theory can also help consumers shed light on their own behavior, better understanding why they make certain purchasing decisions. In doing so you, as a consumer, can avoid falling into some of the typical consumer behavior traps and instead get better value for every dollar you spend.

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