What is price elasti­city of demand? Formula and ex­plan­a­tion

The price elasti­city of demand indicates how flexibly the market responds to price changes of a product or service. It is a key metric for making informed business decisions, such as cal­cu­lat­ing prices.

What is price elasti­city?

The most important reference points for pricing in a free market are supply and demand. The price elasti­city of demand indicates how sensitive the demand for specific goods or services is to price changes. To determine this, the per­cent­age values for both price and demand changes are cal­cu­lated and compared.

A price increase normally leads to a decline in demand, as consumers no longer want or can afford to spend money on the product or service in question. Likewise, a price cut often results in greater demand. In these cases, we can observe price-elastic demand because the demand strongly depends on pricing and can fluctuate ac­cord­ingly.

The situation is different when it comes to price increases for essential goods, such as staple foods, life-saving med­ic­a­tions, or rental housing. In these cases, consumers cannot easily forego con­sump­tion or switch to sub­sti­tute products. As a result, demand remains re­l­at­ively stable even with price increases – a char­ac­ter­ist­ic of price-inelastic demand.

From these examples, it can be concluded that price elasti­city primarily depends on whether and how many sub­sti­tute goods are available. If a good or service can easily be replaced by a cheaper al­tern­at­ive, the price elasti­city of demand is very high. Con­versely, if customers rely heavily on the con­sump­tion good, the price elasti­city is cor­res­pond­ingly low.

How to calculate price elasti­city of demand

To obtain a com­par­able value for various goods and services, the per­cent­age change in demand is divided by the per­cent­age change in price. This results in the following price elasti­city of demand formula:

For price-elastic demand, the resulting value is larger than one, whereas the value is less than one for price-inelastic demand. If the value is exactly one, demand and price correlate with each other directly pro­por­tion­ately. In reality, this is very unlikely or only possible as a result of observing price elasti­city over just a short period of time. The value zero is likewise ex­ceed­ingly rare. This value would mean that price changes have no effect on demand what­so­ever. A typical example for this com­pletely price-inelastic demand are price increases for vital medicines, like insulin for diabetics.

The following graph shows how price and the quantity demanded correlate:

Example cal­cu­la­tion

A baker raises the price of his apple pie from $1.10 to $1.25 per slice. Before in­creas­ing the price, he sold 45 apple pie slices every day. Now he only sells 36.

Price increase from $1.10 to $1.25 = 13.6%

Decline in demand from 45 to 36 apple pie slices per day = 20%

Dividing the decline in demand by the price increase results in the value 1.47. Demand is therefore sig­ni­fic­antly price-elastic. For the baker, this means that he loses more revenue due to the lower sales than he gains with the higher price. Here, it therefore makes more sense to reduce rather than increase prices.

This example shows how a reduction in the sales price for products and services with a high price elasti­city of demand can be used to increase the overall revenue of a company.

Please note the legal dis­claim­er for this article.