Price Elasticity

Price Elasticity

Introduction

Businesses know that they face up with demand curves, but rarely they do know what these curves look like. Yet sometimes a business needs to have a good idea of what part of a demand curve looks like if it is to make good decisions. For example, if Rick's Pizza raises its prices by ten percent, what will happen to its revenues? The answer depends on how consumers will respond. Will they cut back purchases a little or a lot? This question of how responsive consumers are to price changes involves the economic concept of elasticity.

Elasticity is a measure of responsiveness. Two words are important here. The word "measure" means that elasticity results are reported as numbers or elasticity coefficients. The word "responsiveness" means that there is a stimulus-reaction involved. Some change or stimulus causes people to react by changing their behavior, and elasticity measures the extent to which people react.

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use the equation:

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

The demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

Four of the most commonly used elasticities are: price elasticity of demand, income elasticity of demand, cross price elasticity of demand and price elasticity of supply.

1. Price elasticity of demand (PED)

Price Elasticity of Demand is a measure of the sensitivity of the quantity variable, Q, to changes in the price variable, P. Elasticity answers the question of how much the quantity will change in percentage terms for a 1% change in the price.