What is Price Elasticity?
Price elasticity is a measure of how sensitive a buyer or seller is to changes in prices — The more elastic, the more sensitive they are.
🤔 Understanding price elasticity
Price elasticity is a microeconomics term that tells you how sensitive the demand for a good is to changes in price. While the law of supply and the law of demand establish the direction of the relationship a product has between price and quantity, price elasticity tells you how strong that relationship is. In other words, it describes the slope of the supply and demand curves. If price elasticity is high, a small change in price will have a big impact on the amount purchased or sold. If it is low, even significant changes in prices might not change the volume of sales by much.
Mathematically, the price elasticity of demand is expressed like this:
% Change in Quantity / % Change in Price = Price Elasticity of Demand
Have you ever noticed that the price of a bottle of water is far higher in the airport than it is at the grocery store? That is price elasticity at work. Because you are not allowed to bring your own water through security, and because there is limited competition within the airport, your options are limited. If you want that bottle of water, you are far less price-sensitive than you would be while in town. In other words, your demand for a bottle of water is relatively inelastic — Thus retailers can jack up the prices at the airport and still sell plenty of water.
Price elasticity is like how hard it is to stretch a rubber band…
There is usually some wiggle room in the price people are willing to pay. You can probably stretch that price a little bit without losing your customers. But, if you pull on it too hard, they will break. Price elasticity is a way to measure how much room there is to stretch and how close to the breaking point consumers might be. It applies to businesses as well. There is only so much additional cost of business that can be absorbed before the whole thing falls apart.
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How do you calculate the price elasticity?
Price elasticity is the ratio of a percentage change in price and a percentage change in quantity. You calculate it by dividing the two.
Because the formula uses percentage change, the expanded formula is:
The law of demand tells us that we should expect an increase in price to cause a decrease in sales. Therefore, one of the values should be positive and the other should be negative — Meaning that the price elasticity of demand is almost always a negative value. Values closer to zero indicate items that are not very responsive to price changes, and larger negative values represent more sensitivity.
On the supply side, the price-quantity relationship is positive (a higher price results in more volume being supplied). So, the price elasticity of supply will be a positive number. Values closer to zero are not very responsive to price changes, and larger values represent more sensitivity.
Let’s look at an example. Say you own a pizza shop, and you are considering changing the price on your pies. Right now, you are selling a 12-inch single-topping for $10. You are contemplating increasing the price to $12 to generate more revenue. That is a 20% increase in the price ($12 / $10 – 1 = 0.2). Last week, you sold 1,000 pizzas. To find out if increasing the price will truly increase your gross revenues, you need to understand how your customers will react. You can be pretty sure that raising the price will not attract more people. But how much business will you lose?
After changing the price, you only sell 685 pizzas during the next week. Now we can calculate the price elasticity of demand for your product.
Change in quantity = 685 / 1000 - 1 = -0.315 Change in price = $12 / $10 - 1 = 0.2 Price Elasticity = -0.315 / 0.2 = -1.575
Because the value is less than -1, it means that people are relatively sensitive to the price you charge. Maybe you have some competition that gets the business you lose. In the end, a value less than negative one means you ended up losing revenue on the move ($10 x 1,000 = $10,000 vs $12 x 685 = $8,220). And depending on your gross profit margin, your profits might have gone down too.
What are the types of price elasticity?
When discussing price elasticity, there are five common terms that might come up:
- Perfect elasticity
- Perfect inelasticity
- Unit elasticity
- Own-price elasticity
- Cross-price elasticity
In theory, a tiny increase in price could result in a 100% loss of sales — Which would be a price elasticity value approaching infinity. Such a situation would be called “perfect elasticity.” On the other end of the spectrum, an extremely large price increase could result in no lost sales at all. That would generate a price elasticity value of zero and would be called “perfectly inelastic.”
If a product has a proportional response between price changes and quantity changes (i.e., a 20% increase in price resulted in a 20% decrease in sales), it would be called “unit elastic.”
When calculating the volume response to a price change of the same product, it is technically called its “own-price elasticity.” Sometimes, a difference in the price of one good can change the sales of another. You can express that relationship by calculating the cross-price elasticity. The calculation is identical as the own-price elasticity, except you use the price change in the other object and the volume change in the product of interest.
% Change in the Quantity of a Good / % Change in the Price of the Other Good = Cross-Price Elasticity
What factors affect price elasticity?
A product’s elasticity depends on a few factors. On the supply side, business is typically sensitive to the cost of production. If there is a limited amount of materials available to make a product, the cost of supply will likely escalate quickly if the company tries to increase production. Such a situation would make the product very inelastic, meaning that it would require a significant increase in the price to make ramping up production worthwhile.
In other circumstances, there may be ample factors of production available for the product, allowing a company to increase output without suffering a great deal of additional cost. In that case, the supply would be quite elastic.
But, it’s on the other side that the story is more often told — The price elasticity of demand (aka PED). And, there are generally three chapters to tell.
Luxury vs. Necessity
If the thing a person is considering purchasing is something they can live without, they are likely to be more sensitive to the price. While there are complicating factors, this rule is generally true.
Something that a person requires is much more challenging to cut out of their budget. For example, if the price of milk goes up, it is more likely that the consumer will reduce spending on candy so that they can pay for that milk. In that case, milk would have inelastic demand. On the other hand, if the price of candy increased, this person might opt not to buy it because it no longer works within their budget. In that case, the own-price elasticity of candy is high. In this scenario, milk would be a basic necessity, and the sweets would be viewed as a luxury good.
Some items are very inelastic although they are not basic needs. Products with addictive qualities fall into this category. For example, cigarettes and alcohol have very low price elasticity.
Another factor that affects price elasticity is the ability to replace a good with another product. If one pizza shop increases its price, you can usually go to the shop down the street or get something else for dinner. Easily substituted products have high own-price elasticity. It is for this reason that competition tends to drive down prices. And, more competitive products have less control over the amount they can charge. In the extreme, fungible products like commodities have no pricing power at all. Any business trying to charge a higher price for the exact same product would lose all of its customers.
Finally, a product tends to become more elastic as a consumer is satiated. A person leaving the desert might trade everything they own for a gallon of water. But, they will be far less desperate for a second gallon, and even less so for a third. In general, price elasticity falls as you move down the demand curve. The top portion of the curve tends to be somewhat inelastic — Which implies that raising your prices may increase your profits. Alternatively, a high-volume product tends to have a low price and can be found toward the bottom of the demand curve. In that case, raising the rate will typically result in significant lost sales — Which could result in lower business profits or even create losses.
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