Price Elasticity of Demand

Elasticity of demand redirects here. For income elasticity, see income elasticity of demand.
For cross elasticity, see cross elasticity of demand. For wealth elasticity, see wealth elasticity
of demand.
Price elasticity redirects here. It is not to be confused with Price elasticity of supply.

Price elasticity of demand (PED or E ):

It is a mea-sure used in economics to show the responsiveness, or elasticity, of the quantity
demanded of a good or service to a change in its price, ceteris paribus. More precisely, it
gives the percentage change in quantity demanded in re-sponse to a one percent change in
price (ceteris paribus)
Price elasticities are almost always negative, although an-alysts tend to ignore the sign even
though this can lead to ambiguity. Only goods which do not conform to the law of demand,
such as Veblen and Gien goods, have a positive PED. In general, the demand for a good is
said to be inelastic (or relatively inelastic ) when the PED is less than one (in absolute value):
that is, changes in price have a relatively small eect on the quantity of the good demanded.
The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than
one (in absolute value): that is, changes in price have a relatively large eect on the quantity
of a good demanded.
Revenue is maximized when price is set so that the PED is exactly one. The PED of a good
can also be used to predict the incidence (or burden) of a tax on that good. Various research
methods are used to determine price elasticity, including test markets, analysis of histor-ical
sales data and conjoint analysis.
1. Definition
It is a measure of responsiveness of the quantity of a raw good or service demanded to
changes in its price.The formula for the coefficient of price elasticity of demand for a good is:
dQ/Q e p = dP /P
The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the law of demand.For
example, if the price increases by 5% and quantity demanded decreases by 5%, then the
elasticity at the initial price and quantity = 5%/5% = 1. The only classes of goods which
have a PED of greater than 0 are Veblen and Gien goods. Although the PED is negative for

the vast majority of goods and services, economists often refer to price elasticity of demand
as a positive value (i.e., in absolute value terms).
This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a
good, i.e., the elas-ticity of demand with respect to the goods own price, in order to
distinguish it from the elasticity of demand for that good with respect to the change in the
price of some other good, i.e., a complementary or substitute good. The latter type of
elasticity measure is called a cross-price elasticity of demand.
As the difference between the two prices or quantities increases, the accuracy of the PED
given by the formula above decreases for a combination of two reasons. First, the PED for a
good is not necessarily constant; as ex-plained below, PED can vary at dierent points along
the demand curve, due to its percentage nature. Elastic-ity is not the same thing as the slope
of the demand curve, which is dependent on the units used for both price and quantity.
Second, percentage changes are not sym-metric; instead, the percentage change between any
two values depends on which one is chosen as the starting value and which as the ending
value. For example, if quantity demanded increases from 10 units to 15 units, the percentage
change is 50%, i.e., (15 10) 10 (con-verted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the percentage change is 33.3%, i.e., (10 15) 15.Two
alternative elasticity measures avoid or minimize these shortcomings of the basic elasticity
formula: point-price elasticity and arc elasticity.
1.1 Point-price elasticity of demand:
Point elasticity of demand method is used to determine change in demand within same
demand curve, basically a very small amount of change in demand is measured through point
elasticity.( Maharjan, R.) One way to avoid the accuracy problem described above is to
minimise the dierence between the starting and ending prices and quantities. This is the
approach taken in the definition of point-price elasticity, which uses differential calculus to
calculate the elasticity for an infinitesimal change in price and quantity at any given point
onthe

Ed =

Qd

dQd
dP

In other words, it is equal to the absolute value of the first derivative of quantity with respect
to price (dQ /dP) multiplied by the points price (P) divided by its quantity (Q ).[15]
In terms of partial-dierential calculus, point-price elas-ticity of demand can be defined as
follows:[16] let x(p; w) be the demand of goods x1; x2; : : : ; xL as a function of parameters
price and wealth, and let xl(p; w) be the de-mand for good l . The elasticity of demand for
good xl(p; w) with respect to price pk is
@xl(p;
w)
E

xl;pk = @pk

@ log xl(p;
w)

pk
xl(p;
w)

= @ log pk

However, the point-price elasticity can be computed only if the formula for the demand
function, Qd = f(P ) , is known so its derivative with respect to price, dQd/dP , can be
determined.
1.2 Arc elasticity
A second solution to the asymmetry problem of having a PED dependent on which of the two
given points on a demand curve is chosen as the original point will and which as the new
one is to compute the percent-age change in P and Q relative to the average of the two prices
and the average of the two quantities, rather than just the change relative to one point or the
other. Loosely speaking, this gives an average elasticity for the section of the actual
demand curvei.e., the arc of the curvebetween the two points. As a result, this measure is
known as the arc elasticity, in this case with respect to the price of the good. The arc
elasticity is defined math-ematically as:[13][17][18]
P1+P2
2Q
d
Ed = +Qd1 2

Qd

P1 + P2

Qd

P =

d1 + Qd2

2
This method for computing the price elasticity is also known as the midpoints formula,
because the av-erage price and average quantity are the coordinates of the midpoint of the
straight line between the two given points.[12][18] This formula is an application of the midpoint
method. However, because this formula im-plicitly assumes the section of the demand curve
between those points is linear, the greater the curvature of the ac-tual demand curve is over
that range, the worse this ap-proximation of its elasticity will be.[17][19]
By Devashish Mukherjee (Debite Solution) United Insti-tute of Management. Naini
Allahabad.
2

History

The illustration that accompanied Marshalls original definition of PED, the ratio of PT to Pt
Together with the concept of an economic elasticity co-ecient, Alfred Marshall is credited
with defining PED (elasticity of demand) in his book Principles of Eco-nomics, published
in 1890.[20] He described it thus: And we may say generally: the elasticity (or
responsiveness) of demand in a market is great or small according as the amount demanded
increases much or little for a given fall in price, and diminishes much or little for a given rise
in price.[21] He reasons this since the only universal law as to a persons desire for a
commodity is that it diminishes...
but this diminution may be slow or rapid. If it is slow...
a small fall in price will cause a comparatively large in-crease in his purchases. But if it is
rapid, a small fall in price will cause only a very small increase in his pur-chases. In the
former case... the elasticity of his wants, we may say, is great. In the latter case... the elasticity
of his demand is small.[22] Mathematically, the Marshallian PED was based on a point-price
definition, using dier-ential calculus to calculate elasticities.[23]
3

Determinants

The overriding factor in determining PED is the willing-ness and ability of consumers after a
price change to post-pone immediate consumption decisions concerning the good and to
search for substitutes (wait and look).[24] A number of factors can thus aect the elasticity of
de-mand for a good:[25]
Availability of substitute goods The more and closer the substitutes available, the higher the
elasticity is likely to be, as people can easily switch from

one good to another if an even minor price change is made; [25][26][27] There is a strong
substitution eect.[28] If no close substitutes are available, the substitution eect will be
small and the demand inelastic.[28]
Breadth of definition of a good The broader the defi-nition of a good (or service), the lower
the elas-ticity. For example, Company Xs fish and chips would tend to have a relatively
high elasticity of de-mand if a significant number of substitutes are avail-able, whereas
food in general would have an ex-tremely low elasticity of demand because no substitutes exist.[29]
Percentage of income The higher the percentage of the consumers income that the products
price repre-sents, the higher the elasticity tends to be, as peo-ple will pay more attention
when purchasing the good because of its cost; [25][26] The income eect is substantial.[30]
When the goods represent only a negligible portion of the budget the income eect will
be insignificant and demand inelastic,[30]
Necessity The more necessary a good is, the lower the elasticity, as people will attempt to
buy it no matter the price, such as the case of insulin for those who
need it.[10][26]
Duration For most goods, the longer a price change holds, the higher the elasticity is likely
to be, as more and more consumers find they have the time and in-clination to search for
substitutes.[25][27] When fuel prices increase suddenly, for instance, consumers may still fill
up their empty tanks in the short run, but when prices remain high over several years,
more consumers will reduce their demand for fuel by switching to carpooling or public
transportation, investing in vehicles with greater fuel economy or taking other measures.
[26]
This does not hold for consumer durables such as the cars themselves, how-ever;
eventually, it may become necessary for con-sumers to replace their present cars, so one
would expect demand to be less elastic.[26]
Brand loyalty An attachment to a certain brandeither out of tradition or because of
proprietary barriers can override sensitivity to price changes, resulting in more
inelastic demand.[29][31]
Who pays Where the purchaser does not directly pay for the good they consume, such as
with corpo-rate expense accounts, demand is likely to be more inelastic.[31]

Interpreting values of price elas-ticity coecients

Elasticities of demand are interpreted as follows:[10]

Perfectly inelastic demand[10]

Perfectly elastic demand[10]

A decrease in the price of a good normally results in an increase in the quantity demanded by
consumers because of the law of demand, and conversely, quantity demanded decreases when
price rises. As summarized in the table above, the PED for a good or service is referred to by
dif-ferent descriptive terms depending on whether the elas-ticity coecient is greater than,
equal to, or less than 1. That is, the demand for a good is called:
relatively inelastic when the percentage change in quantity demanded is less than the
percentage change in price (so that E > - 1);

unit elastic, unit elasticity, unitary elasticity, or uni-tarily elastic demand when the
percentage change in quantity demanded is equal to the percentage change in price (so
that E = - 1); and
relatively elastic when the percentage change in

4
quantity demanded is greater than the percentage change in price (so that E < - 1).[10]
As the two accompanying diagrams show, perfectly elas-tic demand is represented
graphically as a horizontal line, and perfectly inelastic demand as a vertical line. These are
the only cases in which the PED and the slope of the de-mand curve (P/Q) are both
constant, as well as the only cases in which the PED is determined solely by the slope of the
demand curve (or more precisely, by the inverse of that slope).[10]
5

Relation to marginal revenue

The following equation holds:

(
)
1
R = P 1 Ed
where
R' is the marginal
revenue
P is the
price
Proof:
TR
=
Total
Revenue
@T
(P Q) = P + @
R
@ Q
P
@
R = @Q = Q
P
Q

@
Q

@
P
=

@
P = P )

Q) Ed

Ed =

@
Q
P
Ed Q

@
Q

@
Q
@
P
R =

1
P
E
P + Q Ed Q = P 1
d )
On a graph with both a demand curve and a marginal rev-enue curve, demand will be elastic
at all quantities where marginal revenue is positive. Demand is unit elastic at the quantity
where marginal revenue is zero. Demand is inelastic at every quantity where marginal
revenue is negative.[32]
(

Eect on total revenue

See also: Total revenue test

A firm considering a price change must know what eect the change in price will have on
total revenue. Revenue is simply the product of unit price times quantity:
Revenue = P Qd

Generally any change in price will have two eects:[33]

The price eect For inelastic goods, an increase in unit price will tend to increase revenue,
while a decrease in price will tend to decrease revenue. (The eect is reversed for elastic
goods.)
The quantity eect An increase in unit price will tend to lead to fewer units sold, while a
decrease in unit price will tend to lead to more units sold.
6

EFFECT ON TOTAL REVENUE

Elastic zone

Unit elastic
Inelastic zone
D
Q
Revenue

Decreasing PED
A set of graphs shows the relationship between demand and to-tal revenue (TR) for a linear
demand curve. As price decreases in the elastic range, TR increases, but in the inelastic
range, TR decreases. TR is maximised at the quantity where PED = 1.
For inelastic goods, because of the inverse nature of the relationship between price and
quantity demanded (i.e., the law of demand), the two eects aect total revenue in opposite
directions. But in determining whether to in-crease or decrease prices, a firm needs to know
what the net eect will be. Elasticity provides the answer: The percentage change in total
revenue is approximately equal to the percentage change in quantity demanded plus the
percentage change in price. (One change will be positive, the other negative.) [34] The
percentage change in quantity is related to the percentage change in price by elasticity: hence

the percentage change in revenue can be calculated by knowing the elasticity and the
percentage change in price alone.
As a result, the relationship between PED and total rev-enue can be described for any good:
[35][36]

When the price elasticity of demand for a good is perfectly inelastic (E = 0), changes in
the price do not aect the quantity demanded for the good; rais-ing prices will always
cause total revenue to increase. Goods necessary to survival can be classified here; a
rational person will be willing to pay anything for a good if the alternative is death. For
example, a person in the desert weak and dying of thirst would

easily give all the money in his wallet, no matter how much, for a bottle of water if he
would otherwise die. His demand is not contingent on the price.
When the price elasticity of demand for a good is relatively inelastic ( 1 < E < 0), the
percentage change in quantity demanded is smaller than that in price. Hence, when the
price is raised, the total rev-enue increases, and vice versa.
When the price elasticity of demand for a good is unit (or unitary) elastic (E = 1), the
percent-age change in quantity demanded is equal to that in price, so a change in price
will not aect total rev-enue.
When the price elasticity of demand for a good is relatively elastic ( - < E < 1), the
percentage change in quantity demanded is greater than that in price. Hence, when the
price is raised, the total rev-enue falls, and vice versa.
When the price elasticity of demand for a good is perfectly elastic (E is ), any
increase in the price, no matter how small, will cause the quantity de-manded for the
good to drop to zero. Hence, when the price is raised, the total revenue falls to zero. This
situation is typical for goods that have their value defined by law (such as fiat currency);
if a 5 dollar bill were sold for anything more than 5 dol-lars, nobody would buy it, so
demand is zero.
Hence, as the accompanying diagram shows, total rev-enue is maximized at the combination
of price and quantity demanded where the elasticity of demand is unitary.[36]
It is important to realize that price-elasticity of demand is not necessarily constant over all
price ranges. The linear demand curve in the accompanying diagram illustrates that changes
in price also change the elasticity: the price elasticity is dierent at every point on the curve.
5

with
tax
S

D
with
tax

witho
ut tax

Incidence on
consumers Amount of
witho
tax per unit
ut tax
Incidence
on
producers
P
with tax
Qwithout
Q tax

When demand is more inelastic than supply, consumers will bear a greater proportion of the
tax burden than producers will.
so they would stop buying the good or service in ques-tion completelyquantity demanded
would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so
they would be forced to pay all of it themselves.[37]
In practice, demand is likely to be only relatively elas-tic or relatively inelastic, that is,
somewhere between the extreme cases of perfect elasticity or inelasticity. More generally,
then, the higher the elasticity of demand com-pared to PES, the heavier the burden on
producers; con-versely, the more inelastic the demand compared to PES, the heavier the
burden on consumers. The general prin-ciple is that the party (i.e., consumers or producers)
that has fewer opportunities to avoid the tax by switching to alternatives will bear the greater
proportion of the tax burden.[37] In the end the whole tax burden is carried by individual
households since they are the ultimate owners of the means of production that the firm
utilises (see Cir-cular flow of income).
PED and PES can also have an eect on the deadweight loss associated with a tax regime.
When PED, PES or both are inelastic, the deadweight loss is lower than a comparable
scenario with higher elasticity.
7

Eect on tax incidence

Main article: tax incidence

PEDs, in combination with price elasticity of supply (PES), can be used to assess where the
incidence (or bur-den) of a per-unit tax is falling or to predict where it will fall if the tax is
imposed. For example, when de-mand is perfectly inelastic, by definition consumers have no
alternative to purchasing the good or service if the price increases, so the quantity demanded
would remain constant. Hence, suppliers can increase the price by the full amount of the tax,
and the consumer would end up paying the entirety. In the opposite case, when demand is
perfectly elastic, by definition consumers have an infi-nite ability to switch to alternatives if
the price increases,
8

Optimal pricing

Among the most common applications of price elasticity is to determine prices that maximize
revenue or profit.
8.1 Constant elasticity and optimal pricing
If one point elasticity is used to model demand changes over a finite range of prices, elasticity
is implicitly as-sumed constant with respect to price over the finite price range. The equation
defining price elasticity for one prod-uct can be rewritten (omitting secondary variables) as a
linear equation.

LQ = K + E LP
where
LQ = ln(Q); LP = ln(P ); E is the elasticity, and K is a constant.
Similarly, the equations for cross elasticity for n products can be written as a set of n
simultaneous linear equations.
LQl = Kl + El;k

LP k

where
11 NOTES
8.3 Limitations of revenue-maximizing and profit-maximizing pricing strate-gies
In most situations, revenue-maximizing prices are not profit-maximizing prices. For example,
if variable costs per unit are nonzero (which they almost always are), then a more complex
computation of a similar kind yields prices that generate optimal profits.
In some situations, profit-maximizing prices are not an optimal strategy. For example, where
scale economies are large (as they often are), capturing market share may be the key to longterm dominance of a market, so maxi-mizing revenue or profit may not be the optimal
strategy.
l and k = 1; : : : ; n; LQl = ln(Ql); LP l = ln(P l) , and Kl are constants; and appearance
of a letter index as both an upper index and a lower index in the same term implies
summa-tion over that index.
This form of the equations shows that point elasticities as-sumed constant over a price range
cannot determine what prices generate maximum values of ln(Q) ; similarly they cannot
predict prices that generate maximum Q or max-imum revenue.
Constant elasticities can predict optimal pricing only by computing point elasticities at
several points, to deter-mine the price at which point elasticity equals 1 (or, for multiple
products, the set of prices at which the point elasticity matrix is the negative identity matrix).
9

Selected price elasticities

Various research methods are used to calculate price elas-ticities in real life, including
analysis of historic sales data, both public and private, and use of present-day surveys of
customers preferences to build up test markets capable of modelling such changes.
Alternatively, conjoint anal-ysis (a ranking of users preferences which can then be
statistically analysed) may be used.[40]

Though PEDs for most demand schedules vary depend-ing on price, they can be modeled
assuming constant elasticity.[41] Using this method, the PEDs for various goodsintended to
act as examples of the theory de-scribed aboveare as follows. For suggestions on why these
goods and services may have the PED shown, see the above section on determinants of price
elasticity.

8.2 Non-constant elasticity and optimal pricing

If the definition of price elasticity is extended to yield a quadratic relationship between
demand units ( Q ) and price, then it is possible to compute prices that maximize ln(Q) , Q ,
and revenue. The fundamental equation for one product becomes
LQ = K + E1

LP + E2

LP 2

and the corresponding equation for several products be-comes

LQl = Kl + E1l;k

LP k + E2l;k

(LP k)2

Excel models are available that compute constant elastic-ity, and use non-constant elasticity
to estimate prices that optimize revenue or profit for one product[38] or several products.[39]