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Even in the case of “necessities,” there eventually reaches a point when consumers are unwilling to pay more for the product or service. This is known as price elasticity—the measure of how demand changes in response to a change in price.
What is Price Elasticity?
Price elasticity describes how much the demand for a product or service changes when its price is altered.
It can be either elastic (responsive to price changes) or inelastic (unresponsive to price changes).
In other words, it measures how sensitive consumers are to price increases and decreases—the basics of which can be explained using a supply and demand curve.
Several factors impact how elastic or inelastic the demand for a product is:
- Availability of substitutes (i.e., the number of competing products or services on the market)
- Proportion of income spent on a product or service by consumers
- Necessity of the product (i.e., whether it is a “want” or a “need”)
- Urgency in the moment of purchase
- Length of time since the price change (i.e., whether consumers have had enough time to adjust to the new price)
Price elasticity plays a significant role in price optimization and discount management for all businesses. Demand may drop drastically when prices are too high, decreasing revenue and profits. When prices are too low, there is no incentive to buy more products or services, and sales remain stagnant.
- Price Elasticity of Demand: The measure of how demand for a product or service changes when its price is altered (e.g., does the demand increase or decrease in response to price changes?)
- Price Elasticity of Supply: The measure of how a change in price impacts the amount of a product or service supplied (e.g., a manufacturer’s production capacity).
- Price Sensitivity: The degree to which buyers react to changes in the price of a good or service.
Understanding Price Elasticity of Demand
Price elasticity of demand is the economic concept that measures how consumers respond to price changes.
Economists and businesses have discovered that some goods and services are inelastic—a price increase doesn’t hurt demand, and a price reduction or sales discount won’t boost demand much.
Other products are the opposite—even small changes in pricing can dramatically impact sales and revenue.
The potential to drive revenue growth through pricing means this concept is an integral part of a successful business strategy.
In a sense, a business’s main goal is demand inelasticity. And they can achieve that through brand loyalty, product differentiation, and creating customer value through meaningful services.
The Importance of Price Elasticity of Demand
Understanding and considering price inelasticity of demand is crucial when creating a pricing strategy, as it can affect a business’s sales, revenue, and profits.
The more elastic the demand for a product or service is (i.e., the more sensitive consumers are to changes in price), the more likely it is that businesses will adjust their pricing strategies in order to optimize their profits.
On the other hand, when demand is inelastic (i.e., consumers are not sensitive to changes in price), businesses won’t need to adjust their pricing strategies as drastically to keep up with market demand.
Regardless of the level of elasticity, understanding how demand for a product responds to changing prices is crucial for businesses to maximize profits.
Types of Price Elasticity of Demand
There are five types of price inelasticity of demand. They are categorized based on the number calculated from the price elasticity equation.
- Perfectly Inelastic: The demand does not change regardless of the price—the elasticity is 0.
- Inelastic: The demand is slightly but insignificantly affected by changes in price—the coefficient lies between 0 and 1.
- Unit Elasticity: The demand is affected in the same proportion as the price—the coefficient is 1.
- Elastic: The demand is significantly affected by price changes—the coefficient is greater than 1.
- Perfectly Elastic: Price changes result in demand dropping to zero—the elasticity coefficient is infinite/unlimited.
Perfect elasticity and inelasticity are theoretical concepts. In reality, every good or service is somewhat elastic or inelastic, and some are closer to one side of the spectrum than the other.
How to Calculate Price Elasticity of Demand
The basic elasticity formula for price elasticity of demand is as follows:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
For example, if the demand for a product falls by 20% and the price increases by 10%, the calculation would be:
Price Elasticity of Demand = -20% / 10% = -2
The result is -2, which means that the demand for this product is elastic. There will a decrease in quantity demanded equal to two times the rise in price.
Example of Price Elasticity of Demand
The airline industry is a prime example of fluctuating price elasticity of demand.
Depending on the time of year and destination of the flight, demand could be either elastic or inelastic.
- During holidays, airline pricing increases, as does the demand for travel. Since travel is more of a necessity during these times, the demand is inelastic and consumers will pay more for a flight.
- On weekdays, airline pricing decreases, and demand also tends to be lower. Since travel is less common on weekdays, raising prices would result in fewer people booking flights, meaning the demand is elastic.
Airlines determine their pricing using pricing engines, which are sophisticated computer systems that factor in supply and demand to optimize the price and maximize profits.
Pricing engines adjust prices multiple times a day based on numerous variables, such as the number of seats available, flight dates/times, market competition, etc.
Understanding Price Elasticity of Supply
Price elasticity of supply describes the responsiveness of a good or service’s supply to a change in its price.
According to the Law of Supply, more people will make or sell a product when its price goes up. This means that there will be more of the product available, and people can buy it.
When product pricing goes down, fewer people make or sell it, so there is less of it available to buy.
When the supply of a product is elastic, an increase in price will cause a significant increase in supply.
If the supply of that product is inelastic, that same increase in price will not result in much of an increase in supply.
In short, price elasticity of supply shows how quickly a producer can shift its production levels to meet consumer demand.
If a producer can’t keep up with increasing demand, prices will continue to rise with demand in perpetuity as the product becomes more scarce.
The Importance of Price Elasticity of Supply
Price elasticity of supply is important for different reasons than price elasticity of demand.
While the latter affects how much consumers are willing to pay for a product, the former affects how quickly and efficiently producers can meet that demand.
If producers can’t adjust their production levels quickly enough, there could be a shortage of products in one area or an oversupply in another.
The relationship between elasticity of supply and demand is a delicate balance that can help businesses maximize profits while ensuring they meet customer needs.
This is why it’s important for producers to understand their price elasticity of supply—it helps them make better decisions about production plans and pricing strategies to achieve revenue optimization.
Types of Price Elasticity of Supply
Price elasticity of supply can be broken into five main categories described by its respective price elasticity formula.
- Perfectly Inelastic: When the supply doesn’t change, no matter how much the price fluctuates (e.g., precious metals, bitcoin, and other finite resources), the coefficient is zero.
- Relatively Inelastic: When the supply changes slightly with a dramatic change in price, the coefficient is between 0 and 1. Goods that are relatively inelastic in this sense include nuclear power, natural gas, and electricity, which require a high degree of know-how to set up.
- Unit Elastic: When the percentage change in supply equals the percentage increase or decrease in price, the coefficient is 1. This type of elasticity applies to most manufactured goods, from cars and electronics to furniture and clothing.
- Relatively Elastic: When the supply changes more than proportionally with a change in price, the coefficient is greater than 1. When a product is in this category, it means that producers can ramp up their production levels to meet demand. Many food items fall into this category since they can be manufactured quickly and on a large scale.
- Perfectly Elastic: When the supply is endless, it isn’t responsive to price changes. In these cases, the coefficient is infinite. As such, you will never find an example of perfect elasticity in the real world. However, some digital goods, such as software and music downloads, come close.
How to Calculate Price Elasticity of Supply
The formula for calculating this is similar to that of price elasticity of demand.
Price Elasticity of Supply = % Change in Supply / % Change in Price
For example, let’s say the price of a product goes up by 10%, and the supply increases by 15%. The price elasticity of supply for that product is 1.5 (15 / 10).
This number indicates that the supply is relatively elastic—it has increased more than proportionally with the price increase.
Examples of Price Elasticity of Supply
- Diamonds are an interesting example of price elasticity of supply.
- Diamonds are not rare, but their supply is closely controlled by a few large companies.
- These companies have used their market power to keep diamond prices artificially high.
- But diamonds have poor resale value. And with a worldwide increase in wealth levels and reductions in poverty levels, more and more people are buying them.
- In normal cases, this would cause an increase in quantity supplied, but because of the tight control of diamond producers, the supply does not match demand.
- The tight market control has resulted in a relatively inelastic supply curve for diamonds—the manufacturers cannot increase production to meet the increased demand.
- This helps explain why diamond prices have stayed high despite the increase in demand, and why their value on the secondary market is so low.
People Also Ask
What is a good price elasticity?
A good price elasticity has a coefficient of 1 or higher. This indicates that the supply can increase proportionally with changes in price, which helps maximize profits and revenue. If the coefficient is below 1, it indicates that the supply cannot keep up with changes in prices, which can lead to lower revenue.
What are the major determinants of price elasticity of demand?
Several factors impact price elasticity of demand, including:
* The availability of substitutes: If there are a lot of substitutes, demand is likely to be more elastic.
* Luxuries vs. necessities Necessities tend to have inelastic demand, while luxuries have more elastic demand.
* The time frame: Demand is usually more elastic over the long term than in the short term.
* How does price elasticity affect pricing?
* The proportion of a buyer’s income that is spent on the good: If a good makes up a large portion of a buyer’s income, demand is likely to be inelastic.
What is cross-price elasticity?
Cross-price elasticity is a measure of how changes in the price of one good affect the demand for another. For example, computer monitors and keyboards (two complementary products) likely have a negative cross-price elasticity. An increase in the price of one good can increase the demand for the other, since people buying a new monitor will also need to buy a keyboard.