A Primer on the Price Elasticity of Demand

A Primer on the Price Elasticity of Demand Price elasticity of demand (sometimes referred to simply as price elasticity or elasticity of demand) measures the responsiveness of quantity demanded to a price. The formula for price elasticity of demand (PEoD) is: PEoD (% Change in Quantity Demanded)/(% Change in Price) (Note that price elasticity of demand is different from the slope of the demand curve, even though the slope of the demand curve also measures the responsiveness of demand to price, in a way.) 2:48 Watch Now: How Does Price Elasticity of Demand Work? Calculating the Price Elasticity of Demand You may be asked the question Given the following data, calculate the price elasticity of demand when the price changes from $9.00 to $10.00. Using the chart on the bottom of the page, well walk you through answering this question. (Your course may use the more complicated Arc Price Elasticity of Demand formula. If so, youll need to see the article on Arc Elasticity) First, well need to find the data we need. We know that the original price is $9 and the new price is $10, so we have Price(OLD)$9 and Price(NEW)$10. From the chart, we see that the quantity demanded when the price is $9 is 150 and when the price is $10 is 110. Since were going from $9 to $10, we have QDemand(OLD)150 and QDemand(NEW)110, where QDemand is short for Quantity Demanded. Thus we have: Price(OLD)9Price(NEW)10QDemand(OLD)150QDemand(NEW)110 To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. Its best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD) By filling in the values we wrote down, we get: [110 - 150] / 150 (-40/150) -0.2667 We note that % Change in Quantity Demanded -0.2667 (We leave this in decimal terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price. Calculating the Percentage Change in Price Similar to before, the formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD) By filling in the values we wrote down, we get: [10 - 9] / 9 (1/9) 0.1111 We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand. Final Step of Calculating the Price Elasticity of Demand We go back to our formula of: PEoD (% Change in Quantity Demanded)/(% Change in Price) We can now fill in the two percentages in this equation using the figures we calculated earlier. PEoD (-0.2667)/(0.1111) -2.4005 When we analyze price elasticities were concerned with their absolute value, so we ignore the negative value. We conclude that the price elasticity of demand when the price increases from $9 to $10 are 2.4005. How Do We Interpret the Price Elasticity of Demand? A good economist is not just interested in calculating numbers. The number is a means to an end; in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on demand. Often an assignment or a test will ask you a follow-up question such as Is the good price elastic or inelastic between $9 and $10. To answer that question, you use the following rule of thumb: If PEoD 1 then Demand is Price Elastic (Demand is sensitive to price changes)If PEoD 1 then Demand is Unit ElasticIf PEoD 1 then Demand is Price Inelastic (Demand is not sensitive to price changes) Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is always positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our good is price elastic and thus demand is very sensitive to price changes. Data Price Quantity Demanded Quantity Supplied $7 200 50 $8 180 90 $9 150 150 $10 110 210 $11 60 250