Price elasticity, also known as price elasticity of demand, measures the change in demand for a good or service, given a price change. A good is said to be elastic if a change in price creates a greater change in demand. The larger the change in demand, the more elastic the good is. There are different types of elasticity, and numerous factors influence it.
A good is elastic if a change in price creates a greater change in demand. Most goods and services have elastic demand. For example, if the price of chairs was raised by 2 percent and the demand decreased by 4 percent, chairs would be considered an elastic good. The higher the change in demand, the greater the price elasticity. Demand is elastic when price elasticity is calculated to be greater than 1. For goods with high elasticity, a price increase will result in a decrease in revenue. This happens because the increase in revenue from the higher price is exceeded by the loss in revenue caused by fewer purchases.
Goods are inelastic when a price change does not create a greater change in demand. Using the chair example, if the price of chairs was raised 2 percent and demand decreased by 1 percent, chairs would be considered inelastic goods. Demand is considered inelastic when price elasticity is calculated to be less than 1. If the price of an inelastic good is increased, revenue will increase. In this case, the extra revenue from a higher price exceeds the revenue lost from fewer purchases.
Factors That Affect Elasticity
Substitute products, degree of necessity and the proportion of a consumer's budget all impact elasticity. The more substitutes a product has, the greater its elasticity will be. This is because when the price increases, consumers have many other similar products to choose from without having to pay the higher price. The greater the necessity of a product, the more inelastic it will be. The classic example is food: Even if the price of food goes up, people will continue to purchase it because it's a necessity. When the cost of a product is a large portion of a consumer's total income, the product will be more elastic. This occurs because a price change has a great impact on their overall financial situation. Products that are a lower portion of total income, like a pack of gum, will be inelastic. Even if the price increases, it does not have a significant impact on the consumer.
Calculating Price Elasticity
To calculate price elasticity, you need to have data on the demand of a product at various prices. You can then calculate elasticity by dividing the change in quantity demanded by the change in price, or (Q2-Q1)/(P2-P1). Your result will often be negative, but for practical purposes, the sign is ignored. For example, if the demand for chairs at a price of $10 is 100, and the demand at $20 is 10, you would calculate elasticity to be -9, or simply, 9. In this example, chairs are a highly elastic good.
- Quick MBA: Price Elasticity of Demand
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George Hariri is a business writer who has been writing in 2011. He has great expertise and experience in the area of new business startup and finance. Hariri studied international business at The George Washington University where he completed his Bachelor of Business Administration. Since then, he has been instrumental in numerous start-up ventures, including several where he acted as CEO.