The concept of Price Elasticity of Demand can be defined as an economic measure of the change in the quantity demanded or purchased of the products offered by the firm in relation to its price change. It is expressed mathematically as:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
The theory of Price elasticity is used by various economists to understand how supply or demand changes given changes in the price of the products in the market and to understand the workings of the real economy.
For example, some goods and products are quite inelastic, that is, their prices do not change very much given changes in supply or demand, like people need to buy gasoline to get to work or travel around the world, and if oil prices rise, people are still likely to buy just the same amount of gas. Whilst, on the other hand, certain goods are very elastic, their price moves cause of the substantial changes in its demand or its supply in the market.
Here, we will look just at how the demand side of the equation is impacted by fluctuations in prices of the product by considering the price elasticity of demand which you can contrast with price elasticity of the supply of the product.
Breaking Down Price Elasticity of Demand :
If the quantity demanded of a product showcases a large change in response to changes in its price, it is termed as elastic in nature, meaning that the quantity is stretched far from its prior point. If the quantity purchased has a small change in response to its price increase or decrease, it is termed as inelastic in nature or quantity did not stretch much from its prior point.
The more easily a shopper can substitute one product with a rising price for another one, the more the price will fall or be elastic.
In other words, in a world where people equally like to binge on coffee and tea, if the price of coffee goes up, people will have no problem switching to tea, and so the demand for coffee will fall considerably. This is because coffee and tea are considered good substitutes to one another.
The more discretionary a purchase is in its nature, the more its quantity will fall in response to the price rise, that is, the higher the elasticity. For example, if you are considering buying a new washing machine but the current one is still working and it is just old and outdated in nature, and if the prices of new washing machines goes up, you are likely to forgo that immediate purchase and wait either until its prices go down or until the current washing machine breaks down.
On the other hand, the less discretionary a good is in its nature, the less its quantity demanded will fall.
Inelastic examples include luxury items where customers pay for the privilege of buying a brand name, addictive products, and required add-on products available in the market.
Time also matters in this situation as demand response to price fluctuations is different for the one-day of sale than for a price change over a season or the entire year.
Clarity in time sensitivity is quite vital to understanding the Price Elasticity of Demand and for comparing it across different products available in the market.
Price Elasticity of Demand is the responsiveness of quantity demanded to a change in the price of the goods offered in the market. The demand for a product can be elastic or inelastic in nature depending on the rate of change in the demand by the customers with respect to the change in the price.
Demand is said to be elastic demand as it has a greater proportionate response to a smaller change in price. Whilst demand is inelastic when there is little movement in demand with a big change in the price of the products.
Price Elasticity of Demand is also the slope of the demand curve and we can calculate the slope as rise over run.
Factors Affecting the Price Elasticity of Demand :
If there is a greater availability of substitutes of the product, then it is likely to be more elastic in nature. For instance, if the price of one soda brand goes up, people can turn to other brands available in the market. So, a small change in the price of the product is likely to cause a greater fall in quantity demanded by the customers.
If a good is a necessity, then the demand tends to be quite inelastic. For instance, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity for one and all.
Over a period of time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes to it.
The demand for addictive or habitual products is usually inelastic in nature and this is because the consumer has no choice but no pay whatever the producer is demanding. For example, if the price for a pack of cigarettes goes up, it will likely not have any effect on its demand in the market.
Uses of Price Elasticity of Demand :
- It allows the company to predict the change in total revenue with a projected change in price in the market.
- Firms can charge different prices in different markets if the elasticities differ in income groups of that specific target market. This practice is referred to as price discrimination. For instance, airlines have segmented airplane seats into different classes such as the economy, business, and first in order to charge the less price sensitive customer a higher price for premium and special seats.
- It allows a company to decide how much tax to pass on to a consumer. If a product is inelastic in nature, then the firm can force the customer to the pay the required tax. This is a common tactic used by cigarette manufacturers who pass on any health tax directly to the customer of the product.
- It also enables the government to predict the impact of taxation policies on the products.