Price Elasticity
of Demand
When the price of a good falls, the quantity
consumers demand of the good typically rises; if it costs less, consumers
buy more. Price elasticity of demand measures the responsiveness of
a change in quantity demanded for a good or service to a change in price.
In economics and business studies, the price elasticity of demand is
an elasticity that measures the nature and degree of the relationship
between changes in quantity demanded of a good and changes in its price.
Mathematically, the Price elasticity of demand is the ratio of the relative
(or percent) change in quantity demanded to the relative change in price.
For most goods this ratio is negative, but in practice the elasticity
is represented as a positive number and the minus sign is understood.
For example, if for some good when the price decreases by 10%, the quantity
demanded increases by 20%, the Price elasticity of demand for that good
will be two.
When the Price elasticity
of demand of a good is greater than one in absolute value, the demand
is said to be elastic; it is highly responsive to changes in price.
Demands with an elasticity less than one in absolute value are inelastic;
the demand is weakly responsive to price changes.
Price elasticity of demand
is rarely constant throughout the ranges of quantity demanded and price.
A good or service can have relatively inelastic demand up to a certain
price, above which demand becomes elastic. Even if automobiles, for
example, were extremely inexpensive, parking or other related ownership
issues would presumably keep most people from owning more than some
"maximum" number of automobiles. For these and other reasons, elasticity
of demand remains valid only over a specific (and small) range of price.
Demand for cars (as well as other goods and services) is not elastic
or inelastic for all prices. Elasticity of demand can change dramatically
across a range of prices.
Various research methods
are used to calculate price elasticity:
Test markets
Analysis of historical sales data
Conjoint analysis
When the price elasticity of demand for a good is inelastic, the percentage
change in quantity is smaller than that in price. Hence, when the price
is raised, the total revenue of producers rises, and vice versa.
When the price elasticity
of demand for a good is elastic, the percentage change in quantity is
greater than that in price. Hence, when the price is raised, the total
revenue of producers falls, and vice versa.
When the price elasticity
of demand for a good is unit elastic, the percentage change in quantity
is equal to that in price. Hence, when the price is raised, the total
revenue remains unchanged. The demand curve is a rectangular hyperbola.
When the price elasticity
of demand for a good is perfectly elastic (Ed is undefined), any increase
in the price, no matter how small, will cause demand for the good to
drop to zero. Hence, when the price is raised, the total revenue of
producers falls to zero. The demand curve is a horizontal straight line.
A banknote is the classic example of a perfectly elastic good; nobody
would pay $10.01 for a $10 bill, yet everyone will pay $9.99 for it.
When the price elasticity
of demand for a good is perfectly inelastic, changes in the price do
not affect the quantity demanded for the good. The demand curve is a
vertical straight line; this violates the law of demand. An example
of a perfectly inelastic good is a human heart for someone who needs
a transplant; neither increases nor decreases in price effect the quantity
demanded (no matter what the price, a person will pay for one heart
but only one; nobody would buy more than the exact amount of hearts
demanded, no matter how low the price is).
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