Price Elasticity

TL;DR

Price elasticity measures how much the quantity demanded or supplied changes in response to a price change. It helps you understand consumer sensitivity to price adjustments. You'll use it to predict revenue changes and make better pricing decisions.

1. The Mental Model

Think of price elasticity as a "stretchiness" measure. If demand is "stretchy" (elastic), a small price change leads to a big change in quantity bought. If it's "stiff" (inelastic), a big price change doesn't change quantity much.

2. The Core Material

Price elasticity tells you how responsive quantity is to a price change. We primarily focus on Price Elasticity of Demand (PED), but the concept also applies to supply.

Price Elasticity of Demand (PED)

Photo by Markus Winkler on Pexels

PED measures how much the quantity demanded of a good responds to a change in its price.

The formula for PED is:

$$ \text{PED} = \frac{\%\Delta \text{Quantity Demanded}}{\%\Delta \text{Price}} $$

• $\%\Delta$ Quantity Demanded = $\frac{\text{New Quantity} - \text{Old Quantity}}{\text{Old Quantity}}$
• $\%\Delta$ Price = $\frac{\text{New Price} - \text{Old Price}}{\text{Old Price}}$

Interpreting PED Values:

• PED > 1 (Absolute Value): Elastic Demand
  • Quantity demanded changes by a larger percentage than the price.
  • Consumers are very responsive to price changes.
  • Examples: Luxury items, goods with many substitutes.
• PED < 1 (Absolute Value): Inelastic Demand
  • Quantity demanded changes by a smaller percentage than the price.
  • Consumers are not very responsive to price changes.
  • Examples: Necessities (e.g., medicine, basic food), goods with few substitutes.
• PED = 1 (Absolute Value): Unit Elastic Demand
  • Quantity demanded changes by the same percentage as the price.
• PED = 0: Perfectly Inelastic Demand
  • Quantity demanded does not change at all, regardless of price. (Rare in reality, often theoretical for life-saving drugs).
• PED = $\infty$: Perfectly Elastic Demand
  • Consumers will buy an infinite amount at one price, but nothing if the price changes even slightly. (Theoretical for perfectly competitive markets).

Why the absolute value?
PED is usually negative because demand curves slope downwards (price and quantity demanded move in opposite directions). By convention, economists often use the absolute value to make comparisons easier.

Factors Affecting PED

Photo by Valeria Boltneva on Pexels

graph TD
    A["Availability of Substitutes"] --> B{"PED Value"}
    C["Necessity vs. Luxury"] --> B
    D["Share of Income Spent"] --> B
    E["Time Horizon"] --> B
    F["Definition of the Market"] --> B

    B -- "More Substitutes / Luxury / Large Share / Longer Time / Narrow Market" --> G["More Elastic"]
    B -- "Fewer Substitutes / Necessity / Small Share / Shorter Time / Broad Market" --> H["More Inelastic"]

Total Revenue and PED

Photo by Tiger Lily on Pexels

Understanding PED is crucial for businesses because it helps predict how price changes will affect total revenue (Price × Quantity).

• If demand is elastic (PED > 1):
  • A price increase will decrease total revenue (quantity drops significantly).
  • A price decrease will increase total revenue (quantity rises significantly).
• If demand is inelastic (PED < 1):
  • A price increase will increase total revenue (quantity doesn't drop much).
  • A price decrease will decrease total revenue (quantity doesn't rise much).
• If demand is unit elastic (PED = 1):
  • A price change will not change total revenue.

3. Worked Example

Let's say a local coffee shop raises the price of its popular latte from $4.00 to $4.40. As a result, the daily quantity demanded falls from 200 lattes to 180 lattes.

1. Calculate the percentage change in price:
   $\%\Delta \text{Price} = \frac{4.40 - 4.00}{4.00} = \frac{0.40}{4.00} = 0.10 \text{ or } 10\%$

2. Calculate the percentage change in quantity demanded:
   $\%\Delta \text{Quantity Demanded} = \frac{180 - 200}{200} = \frac{-20}{200} = -0.10 \text{ or } -10\%$

3. Calculate the PED:
   $\text{PED} = \frac{-10\%}{10\%} = -1$

   The absolute value of PED is 1.

Interpretation:
The demand for these lattes is unit elastic. This means that a 10% increase in price led to a 10% decrease in quantity demanded. If the coffee shop were to increase or decrease prices further, their total revenue would likely remain unchanged (at least for small shifts around this price point).

Initial Revenue: $4.00 \times 200 = $800
New Revenue: $4.40 \times 180 = $792 (Slight difference due to using discrete changes rather than arc elasticity, but for this example, the principle holds).

4. Key Takeaways

• Price elasticity measures how responsive quantity demanded or supplied is to a price change.
• PED > 1 (elastic) means consumers are very sensitive to price changes.
• PED < 1 (inelastic) means consumers are not very sensitive to price changes.
• Factors like the availability of substitutes and whether a good is a necessity heavily influence elasticity.
• Knowing PED helps businesses predict how price changes will impact their total revenue.
• If demand is elastic, lowering prices can increase total revenue; if inelastic, raising prices can increase total revenue.

Common Mistakes to Avoid

Photo by KATRIN BOLOVTSOVA on Pexels

• Forgetting to use absolute values when interpreting PED, which is usually negative.
• Confusing a "large" change in quantity with elasticity; it's the percentage change that matters.
• Assuming elasticity is constant along an entire demand curve; it usually changes.
• Thinking that higher elasticity always means "better"; it just describes consumer responsiveness.

5. Now Try It

Imagine you're selling handmade artisanal soaps. Currently, you sell 50 bars a week at $8 each. You're considering a price change. If you raise the price to $10, you expect to sell only 35 bars. Calculate the PED for your soaps. Based on your calculation, should you increase the price to