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Price Elasticity

Describing the relationship between price and quantity

What is Price Elasticity?

Price elasticity refers to how a good’s price changes when the quantity of the good changes. Price elasticity of demand refers to how changes in quantity demanded affect the price of a good, and price elasticity of supply refers to how changes in quantity supplied affect price.

 

Price Elasticity

 

Price Elasticity of Demand

There are three main types of Price Elasticity of Demand: elastic, unit-elastic and inelastic. Before delving deeper into the subject, a sound understanding of the laws of supply and demand is recommended.

To calculate the Price Elasticity of Demand (PED), we use the following equation:

 

Price Elasticity of Demand Formula

 

Where:

% Change in Quantity Demanded is calculated as (New Quantity – Old Quantity)/Old Quantity

% Change in Price is calculated as (New Price – Old Price)/Old Price

PED is always provided as an absolute value, or positive value, as we are interested in its magnitude.

 

Elastic Demand

Elastic demand occurs when changes in price cause a disproportionately large change in quantity demanded. For example, a good with elastic demand might see its price increase by 10%, but demand drop by 30% as a result. Goods that experience this kind of demand are labeled as “price sensitive,” and are typically non-essential or luxury goods that have many substitutes (such as luxury cars, restaurant meals, handbags, etc.).

A good is considered to be “elastic” when its PED is greater than 1. For example, if the quantity demanded of a handbag drops from 300 to 200 when a price increases from $500 to $550, the handbag’s PED would be:

 

Elastic PED

 

The PED of the good is 3.33, which is considered to be elastic.

A good with perfectly elastic demand would have a PED of infinity, where even minuscule changes in price would cause an infinitesimally large change in demand.

 

Inelastic Demand

Inelastic demand occurs when changes in price cause a disproportionately small change in quantity demanded. For example, a good with inelastic demand might see its price increase by 30%, but demand drop by only 10% as a result. Goods that experience this kind of demand are labeled as being “price insensitive,” and are typically essential goods that consumers have no substitutes for (such as water, medication, cigarettes, etc.).

A good is considered to be “inelastic” when its PED is less than 1. For example, if the quantity demanded of a cancer treatment drug drops from 1,000 to 900 when a price increases from $500 to $900, the drug’s PED would be:

 

PED Inelastic

 

The PED of the good is 0.125, which is considered to be inelastic.

A good with perfectly elastic demand would have a PED of 0, where even huge changes in price would cause no change in demand.

 

Unit Elastic Demand

Unit elastic demand occurs when changes in price cause a proportional change in quantity demanded. For example, a good with inelastic unit elastic demand might see its price increase by 30%, and demand would also drop by 30%. Such goods are more difficult to find in markets today, and unit elastic demand is more of a theoretical economics concept. Nonetheless, a good with unit elastic demand could exist.

A good is considered to be “Inelastic” when its PED is equal to 1. For example, if the quantity demanded of a good drops from 1,000 to 800 when a price increases from $90 to $99, the good’s PED would be:

 

PED Unit Elastic

 

The PED of the good is 1which is considered to be unit elastic.

 

Price Elasticity of Supply

Price elasticity of supply (PES) works in the same way that PED does. Equations to calculate PES are the same (except that the quantity used is the quantity supplied), and the following categorizations hold true:

  • Elastic supply will have a PES of more than 1
  • Inelastic supply will have a PES of less than 1
  • Unit-Elastic supply will have a PES equal to 1

 

However, we need to be mindful that supply slopes upwards while demand slopes downwards. Thus,

  • Elastic PES would mean that increases in the quantity supplied will lead to disproportionately large increases in price, and vice versa.
  • Inelastic PES would mean that increases in the quantity supplied will lead to disproportionately small increases in price, and vice versa.
  • Unit-Elastic PES would mean that increases in the quantity supplied will lead to proportionately large increases in price, and vice versa.

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Gross Domestic Product (GDP)
  • Market Cap to GDP Ratio (the Buffett Indicator)
  • Fiscal Policy
  • Debt vs Equity Financing

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