Price Elasticity of Demand Explained for Dummies

 

What is the meaning of elasticity? 

  Elasticity refers to the ability of an object to stretch and return to its original shape and size when the forces affecting the changes in size and shape are removed.   

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What is Price Elasticity of Demand (PED)? 

  Price elasticity of demand (PED) is a term used in economics to describe the degree to which the demand for a product or service changes when the price changes. Put differently, PED explains the relationship between price and demand, describing the behaviour of consumers in response to a change in the price of a service or product.    According to Economics Help.org, price elasticity of demand ‘measures the responsiveness of demand after a price change.’ (Accentuation by the article writer.)     Conversely, price elasticity of supply (PES) measures the behaviour of producers of goods and providers of services in response to a change in the price of products or services.   

Explaining price elasticity of demand 

  Economists and analysts use price elasticity to determine how price changes affect supply and demand for goods and services.   

• Calculation of price elasticity of demand (PED) 

Price elasticity of demand is calculated by using the following formula:  PED = Percentage change (%Δ) in quantity demanded/percentage change (%Δ) in price.    The formula can be explained in greater detail, namely:  PED = [(Q1 - Q0)) / (Q1 + Q0) / 2] / [(P1 - P0) / (P1  + P0) / 2]    Where:  Q1 = Final (new) quantity  Q0 = Initial (old) quantity  P1  = Final (new) price  P0 = Initial (old) price  (Q1 + Q0) / 2 = Average quantity  (P1 + P0) / 2 = Average price    For example, If the price of a product increases by 15%, causing demand for it to fall by 25%, PED will be calculated as follows:  PED = Percentage change in quantity demanded/Percentage change in price          = -25/15          = -1.67    Notably, price elasticity of supply (PES) is measured by dividing the percentage change in quantity supplied by the percentage change in price.    Together, PED and PES are used in combination to answer the question: What goods are produced at what prices?    The availability of a substitute for a product or service influences its elasticity. When there are no suitable or high-quality substitutes and the product or service is essential, the demand will remain the same when the price rises, making it inelastic. In other words, an increase in price will not harm demand.    Also, a product or service is viewed as inelastic when a decrease in price does not increase demand considerably.     The more elastic consumer demand is for a product or service, the greater the chance that consumers (buyers) will buy less when the price changes.    Typically, the more competitive a market is, the more elastic it is. A competitive market is described as ‘a market structure where competition [among consumers] is at the highest possible level.’ (WallStreetMojo)   

Types of price elasticity of demand 

  There are three main types of price elasticity of demand (PED: price elastic demand, price inelastic demand, and unit elasticity. In addition, the following two types will also be explained: perfectly price inelastic demand and perfectly price elastic demand.   

• Price elastic demand 

If the price elasticity of demand is greater than 1, the product or service is price elastic, meaning there is a significant - or proportionally large - decrease in quantity demanded.   For example, if the quantity demanded of a luxury watch falls from 400 to 200 when its price increases from R2 500 to R3 000, the PED of the watch would be calculated as follows:  PED = [(Q1 - Q0)) / (Q1 + Q0) / 2] / [(P1 - P0) / (P1  + P0) / 2]          = [(200 - 400) / (200 + 400) / 2] / [(3 000 - 2 500) / (3 000 + 2500) / 2]          = [-200 / 300] / [500 / 4 250]          = 3.7    The PED of the luxury watch is 3.7, which is considered elastic.  Examples of products for which the PED tend to be elastic are luxury goods and non-essential goods that have several substitutes (such as sports cars and fashion items). They are typically referred to as ‘price sensitive.’   

• Price inelastic demand 

When the PED of a product or service is less than 1, its PED is viewed as inelastic. This means that the percentage change in demand for a product or service is less than the percentage change in price of the product or service.    Inelastic demand happens when price changes cause a disproportionately slight change in quantity demanded. Goods with price-inelastic demand are called ‘price insensitive.’    Examples of ‘price-insensitive’ goods are, amongst others, water, fuel (petrol and diesel), and medication, which are essential goods that consumers cannot substitute. Addictive products - like cigarettes and drugs - are also part of this group.     Example:  The demand for a pack of 20 cigarettes of a certain brand declines from 3500 to 2800 when the prices increase from R60 to R65.  The PED for the pack of cigarettes will look as follows:  PED = [(Q1 - Q0)) / (Q1 + Q0)/2] / [(P1 - P0) / (P1  + P0) / 2]          = [(2 800 - 3 500) / (2 800 + 3 500) / 2] / [(65 - 60) / (65 + 60) / 2]          = [-700/3 150] / [5 / 63]          = 0.28    The PED of the pack of cigarettes is 0.28, which is considered inelastic.   

• Unit elasticity 

Unit elasticity, also called unit elastic demand, occurs when the PED of a product equals 1. This means that the percentage change in demand is equal to the percentage change in price.   However, unit elasticity is more of a theoretical economic concept because goods with a unit elasticity are rare in markets nowadays.    Example:  The quantity demanded of product A declines from 2 000 to 1 600 while its price increases from R160 to R200. The PED of product A will be determined as follows:  PED = [(Q1 - Q0)) / (Q1 + Q0) / 2] / [(P1 - P0) / (P1  + P0) / 2]          = [(1 600 - 2 000) / (1 600 + 2000) / 2] / [(200 - 160) / (200 + 160) / 2]          = [-400 / 1 800] / [40 / 180]          = 1    The PED of product A is 1, which makes it unit elastic.   

• Perfectly price inelastic demand 

A product with a perfectly price-inelastic demand (also referred to as perfectly inelastic demand), has a PED of 0. Hence, the product is considered perfectly inelastic, implying that a change in price would not affect a change in demand.   An alcoholic drink, in the case of an alcoholic, may be an example of such a product.   

• Perfectly price-elastic demand 

If the price elasticity of demand is calculated and the result is infinite, the product is said to be perfectly elastic, meaning price changes lead to demand falling to zero.     

What affects the price elasticity of demand? 

  Several factors affect the price elasticity of demand. Some of these factors are the availability of substitutes, duration of price changes, urgency, level of brand loyalty, addictive substances, and the amount of income spent on the product.   

• Availability of substitutes 

If a customer can substitute one product for another, the price of the substituted product will fall. For instance, during tough economic times, consumers can start to use soya or lentils as an alternative protein source for meat.    Another example is when people substitute coffee with energy drinks, which also contain caffeine.     People who enjoy carbonated soft drinks with a cola flavour can substitute Coca-Cola with Pepsi-Cola when the price of Coca-Cola rises. The demand for Pepsi-Cola will increase. and demand for Coca-Cola will fall. The opposite is also true.    There are several definitions for a substitute good/product, of which the following two are good examples: 

• Market Business News: ‘Substitute goods are identical, similar, or comparable to another product, in the eyes of the consumer. Substitute goods can either fully or partly satisfy the same needs of the customers. Therefore, they can replace one another, so the consumer believes.’  
• Study.com: ‘A substitute good is any product or service that replaces another product or service with little to no noticeable difference to a customer.’  

(Accentuations in both quotations by the article writer.)   

• Duration of price changes 

The duration of price changes also influences the PED. Customers respond differently to price fluctuations when it is a one-day sale, compared to a price change that last for longer periods, such as a season or a year.    It is important to recognise time sensitivity to understand the price elasticity of demand and to apply it to various products. Customers may go along with a seasonal price fluctuation instead of changing their habits.    

• Urgency 

A lack of urgency in demand for a product implies that the product is not a basic need. When a product’s price increases, customers postpone purchases of the product. Hence, the demand will tend to be elastic.     Regarding convenience products, also called consumer goods (such as milk, bread, cleaning products, and toothpaste), there is a need to buy these products frequently. Thus, regardless of price changes, there will be a demand for these products. However, with the tight economic conditions, customers look for specials, do thorough research and plan well before making a purchase.    Demand for consuming goods tends to be price inelastic.    Concerning emergency products, customers have no option but to buy the specific emergency product. There is nothing special or unique about these products, but the timing and situation make emergency products extremely useful and urgent for a customer. Put differently, emergency products are bought by a customer promptly during an emergency or a critical need for a specific product.     For example, loadshedding (in South Africa) has made items such as candles, torches, and portable LED lights emergency products. In many businesses and households, generators or inverters have become indispensable items.   

• Level of brand loyalty 

Brand loyalty refers to a situation when a person chooses to repeatedly purchase a product manufactured by the same company despite competitors’ efforts to lure them away with exclusive offers.     Brand loyalty is typically based on perception, meaning customers will constantly buy the same product because they judge it as superior to other similar and available products.    Products with a strong brand image (such as Nike, Adidas, Pepsi-Cola, and Coca-Cola) will have inelastic demand because consumers are prepared to pay extra for these products.   

• Addictive substances 

Addictive substances such as cigarettes, alcohol, and electronic cigarettes (E-cigarettes) have price-inelastic demand because customers are willing to pay, regardless of the price of the product.   

• The amount of income spent on the product 

If a considerable proportion of income is spent on the product, the demand is typically price elastic. For instance, when consumers spend a high percentage of their income on a vehicle, vehicles have price elastic demand.   

Relevance and importance of price elasticity of demand 

  Price elasticity of demand (PED) is especially useful to manufacturers in production planning, allocation of resources, and future expansion.    Business managers need to understand price elasticity because it helps in analysing the relation between a product’s price and the matching demand at that specific price.     Understanding the PED for goods and services enables businesses to make informed and financially sound decisions about pricing strategies.     PED provides sellers with information about consumer pricing sensitivity.    Simply Economics concludes, saying: ‘… it is crucial that companies understand the PED value for the good they sell because it affects their total revenue.’ 

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