A good's price elasticity of demand (
Ed
Price elasticities are negative except in special cases. If a good is said to have an elasticity of 2, it almost always means that the good has an elasticity of −2 according to the formal definition. The phrase "more elastic" means that a good's elasticity has greater magnitude, ignoring the sign. Veblen and Giffen goods are two classes of goods which have positive elasticity, rare exceptions to the law of demand. Demand for a good is said to be inelastic when the elasticity is less than one in absolute value: that is, changes in price have a relatively small effect on the quantity demanded. Demand for a good is said to be elastic when the elasticity is greater than one. A good with an elasticity of −2 has elastic demand because quantity demanded falls twice as much as the price increase; an elasticity of −0.5 has inelastic demand because the change in quantity demanded change is half of the price increase.[2]
At an elasticity of 0 consumption would not change at all, in spite of any price increases.
Revenue is maximized when price is set so that the elasticity is exactly one. The good's elasticity can be used to predict the incidence (or "burden") of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data and conjoint analysis.
The variation in demand in response to a variation in price is called price elasticity of demand. It may also be defined as the ratio of the percentage change in quantity demanded to the percentage change in price of particular commodity.[3] The formula for the coefficient of price elasticity of demand for a good is:[4] [5] [6]
E\langle=
\DeltaQ/Q | |
\DeltaP/P |
where
P
\DeltaP
Q
\DeltaQ
The price elasticity of demand is ordinarily negative because quantity demanded falls when price rises, as described by the "law of demand".[5] Two rare classes of goods which have elasticity greater than 0 (consumers buy more if the price is higher) are Veblen and Giffen goods.[7] Since the price elasticity of demand is negative for the vast majority of goods and services (unlike most other elasticities, which take both positive and negative values depending on the good), economists often leave off the word "negative" or the minus sign and refer to the price elasticity of demand as a positive value (i.e., in absolute value terms).[6] They will say "Yachts have an elasticity of two" meaning the elasticity is −2. This is a common source of confusion for students.
Depending on its elasticity, a good is said to have elastic demand (> 1),inelastic demand (< 1), or unitary elastic demand (= 1). If demand is elastic, the quantity demanded is very sensitive to price, e.g. when a 1% rise in price generates a 10% decrease in quantity. If demand is inelastic, the good's demand is relatively insensitive to price, with quantity changing less than price. If demand is unitary elastic, the quantity falls by exactly the percentage that the price rises. Two important special cases are perfectly elastic demand (= ∞), where even a small rise in price reduces the quantity demanded to zero; and perfectly inelastic demand (= 0), where a rise in price leaves the quantity unchanged. The above measure of elasticity is sometimes referred to as the own-price elasticity of demand for a good, i.e., the elasticity of demand with respect to the good's own price, in order to distinguish it from the elasticity of demand for that good with respect to the change in the price of some other good, i.e., an independent, complementary, or substitute good.[3] That two-good type of elasticity is called a cross-price elasticity of demand.[8] [9] If a 1% rise in the price of gasoline causes a 0.5% fall in the quantity of cars demanded, the cross-price elasticity is
d | |
E | |
cg |
=(-0.5%)/(+1%)=-0.5.
As the size of the price change gets bigger, the elasticity definition becomes less reliable for a combination of two reasons. First, a good's elasticity is not necessarily constant; it varies at different points along the demand curve because a 1% change in price has a quantity effect that may depend on whether the initial price is high or low.[10] [11] Contrary to common misconception, the price elasticity is not constant even along a linear demand curve, but rather varies along the curve.[12] A linear demand curve's slope is constant, to be sure, but the elasticity can change even if
\DeltaP/\DeltaQ
P=aQ1/E
a
E
Second, percentage changes are not symmetric; instead, the percentage change between any two values depends on which one is chosen as the starting value and which as the ending value. For example, suppose that when the price rises from $10 to $16, the quantity falls from 100 units to 80. This is a price increase of 60% and a quantity decline of 20%, an elasticity of
(-20%)/(+60%) ≈ -0.33
(+25%)/(-37.5%)=-0.67
Two refinements of the definition of elasticity are used to deal with these shortcomings of the basic elasticity formula: arc elasticity and point elasticity.
See main article: arc elasticity. Arc elasticity was introduced very early on by Hugh Dalton. It is very similar to an ordinary elasticity problem, but it adds in the index number problem. Arc Elasticity is a second solution to the asymmetry problem of having an elasticity dependent on which of the two given points on a demand curve is chosen as the "original" point will and which as the "new" one is to compute the percentage change in P and Q relative to the average of the two prices and the average of the two quantities, rather than just the change relative to one point or the other. Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve—i.e., the arc of the curve—between the two points. As a result, this measure is known as the arc elasticity, in this case with respect to the price of the good. The arc elasticity is defined mathematically as:[16] [17] [18]
Ed=
| x | ||||||||||||||
|
\DeltaQd | |
\DeltaP |
=
P1+P2 | x | |||||||||
|
\DeltaQd | |
\DeltaP |
This method for computing the price elasticity is also known as the "midpoints formula", because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points.[15] [18] This formula is an application of the midpoint method. However, because this formula implicitly assumes the section of the demand curve between those points is linear, the greater the curvature of the actual demand curve is over that range, the worse this approximation of its elasticity will be.[19]
The point elasticity of demand method is used to determine change in demand within the same demand curve, basically a very small amount of change in demand is measured through point elasticity. One way to avoid the accuracy problem described above is to minimize the difference between the starting and ending prices and quantities. This is the approach taken in the definition of point elasticity, which uses differential calculus to calculate the elasticity for an infinitesimal change in price and quantity at any given point on the demand curve:[20]
Ed=
dQd | |
dP |
x
P | |
Qd |
In other words, it is equal to the absolute value of the first derivative of quantity with respect to price
dQd | |
dP |
Qd=f(P)
{dQd/dP}
In terms of partial-differential calculus, point elasticity of demand can be defined as follows:[22] let
\displaystylex(p,w)
x1,x2,...,xL
\displaystylex\ell(p,w)
\displaystyle\ell
\displaystylex\ell(p,w)
pk
E | |
x\ell,pk |
=
\partialx\ell(p,w) | ⋅ | |
\partialpk |
pk | |
x\ell(p,w) |
=
\partiallogx\ell(p,w) | |
\partiallogpk |
Together with the concept of an economic "elasticity" coefficient, Alfred Marshall is credited with defining "elasticity of demand" in Principles of Economics, published in 1890.[23] Alfred Marshall invented price elasticity of demand only four years after he had invented the concept of elasticity. He used Cournot's basic creating of the demand curve to get the equation for price elasticity of demand. He described price elasticity of demand as thus: "And we may say generally:— the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price".[24] He reasons this since "the only universal law as to a person's desire for a commodity is that it diminishes ... but this diminution may be slow or rapid. If it is slow... a small fall in price will cause a comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause only a very small increase in his purchases. In the former case... the elasticity of his wants, we may say, is great. In the latter case... the elasticity of his demand is small."[25] Mathematically, the Marshallian PED was based on a point-price definition, using differential calculus to calculate elasticities.[26]
The overriding factor in determining the elasticity is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and look").[27] A number of factors can thus affect the elasticity of demand for a good:[28]
When measuring Marshallian demand—the demand curve holding nominal, rather than real, income constant—the percentage of income a customer spends on a certain good also affects the elasticity. In introductory microeconomics, the distinction between Marshallian and Hicksian (real-value) demand is often ignored, assuming that any particular good will be a small part of the customer's budget, but for large or frequent purchases (e.g. food or transportation) the income effect can become substantial or even dominate the price effect (as for Giffen goods).[34] When the goods represent only a negligible portion of the budget, the income effect is insignificant and does not contribute substantially to elasticity.
The following equation holds:
R'=P\left(1+\dfrac{1}{Ed}\right)
where
R′ is the marginal revenue
P is the price
Proof:
Define Total Revenue as R
R'=
\partialR | |
\partialQ |
=
\partial | |
\partialQ |
(PQ)=P+Q
\partialP | |
\partialQ |
Ed=\dfrac{\partialQ}{\partialP} ⋅ \dfrac{P}{Q} ⇒ Ed ⋅
Q | |
P |
=
\partialQ | |
\partialP |
⇒
P | |
Ed ⋅ Q |
=
\partialP | |
\partialQ |
R'=P+Q ⋅
P | |
Ed ⋅ Q |
=P\left(1+
1 | |
Ed |
\right)
On a graph with both a demand curve and a marginal revenue curve, demand will be elastic at all quantities where marginal revenue is positive. Demand is unit elastic at the quantity where marginal revenue is zero. Demand is inelastic at every quantity where marginal revenue is negative.[35]
See also: Total revenue test.
A firm considering a price change must know what effect the change in price will have on total revenue. Revenue is simply the product of unit price times quantity:
Revenue=PQd
Generally, any change in price will have two effects:[36]
For inelastic goods, an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. (The effect is reversed for elastic goods.)
An increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.
For inelastic goods, because of the inverse nature of the relationship between price and quantity demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is approximately equal to the percentage change in quantity demanded plus the percentage change in price. (One change will be positive, the other negative.)[37] The percentage change in quantity is related to the percentage change in price by elasticity: hence the percentage change in revenue can be calculated by knowing the elasticity and the percentage change in price alone.
As a result, the relationship between elasticity and revenue can be described for any good:[38] [39]
Hence, as the accompanying diagram shows, total revenue is maximized at the combination of price and quantity demanded where the elasticity of demand is unitary.[39]
Price-elasticity of demand is not necessarily constant over all price ranges. The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: the price elasticity is different at every point on the curve.
See main article: article and tax incidence. Demand elasticity, in combination with the price elasticity of supply can be used to assess where the incidence (or "burden") of a per-unit tax is falling or to predict where it will fall if the tax is imposed. For example, when demand is perfectly inelastic, by definition consumers have no alternative to purchasing the good or service if the price increases, so the quantity demanded would remain constant. Hence, suppliers can increase the price by the full amount of the tax, and the consumer would end up paying the entirety. In the opposite case, when demand is perfectly elastic, by definition consumers have an infinite ability to switch to alternatives if the price increases, so they would stop buying the good or service in question completely—quantity demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so they would be forced to pay all of it themselves.[40]
In practice, demand is likely to be only relatively elastic or relatively inelastic, that is, somewhere between the extreme cases of perfect elasticity or inelasticity. More generally, then, the higher the elasticity of demand compared to PES, the heavier the burden on producers; conversely, the more inelastic the demand compared to supply, the heavier the burden on consumers. The general principle is that the party (i.e., consumers or producers) that has fewer opportunities to avoid the tax by switching to alternatives will bear the greater proportion of the tax burden.[40]
PED and PES can also have an effect on the deadweight loss associated with a tax regime. When PED, PES or both are inelastic, the deadweight loss is lower than a comparable scenario with higher elasticity.
Among the most common applications of price elasticity is to determine prices that maximize revenue or profit.
If one point elasticity is used to model demand changes over a finite range of prices, elasticity is implicitly assumed constant with respect to price over the finite price range. The equation defining price elasticity for one product can be rewritten (omitting secondary variables) as a linear equation.
LQ=K+E x LP
LQ=ln(Q),LP=ln(P),E
K
Similarly, the equations for cross elasticity for
n
n
LQ\ell=K\ell+E\ell,k x LPk
\ell
k=1,...c,n,LQ\ell=ln(Q\ell),LP\ell=ln(P\ell)
K\ell
This form of the equations shows that point elasticities assumed constant over a price range cannot determine what prices generate maximum values of
ln(Q)
Q
Constant elasticities can predict optimal pricing only by computing point elasticities at several points, to determine the price at which point elasticity equals −1 (or, for multiple products, the set of prices at which the point elasticity matrix is the negative identity matrix).
If the definition of price elasticity is extended to yield a quadratic relationship between demand units (
Q
ln(Q)
Q
LQ=K+E1 x LP+E2 x LP2
and the corresponding equation for several products becomes
LQ\ell=K\ell+E1\ell,k x LPk+E2\ell,k x (LPk)2
Excel models are available that compute constant elasticity, and use non-constant elasticity to estimate prices that optimize revenue or profit for one product[41] or several products.[42]
In most situations, such as those with nonzero variable costs, revenue-maximizing prices are not profit-maximizing prices.[43] For these situations, using a technique for Profit maximization is more appropriate.
Various research methods are used to calculate the price elasticities in real life, including analysis of historic sales data, both public and private, and use of present-day surveys of customers' preferences to build up test markets capable of modelling such changes.[44] Alternatively, conjoint analysis (a ranking of users' preferences which can then be statistically analysed) may be used.[45] Approximate estimates of price elasticity can be calculated from the income elasticity of demand, under conditions of preference independence. This approach has been empirically validated using bundles of goods (e.g. food, healthcare, education, recreation, etc.).[46]
Though elasticities for most demand schedules vary depending on price, they can be modeled assuming constant elasticity.[47] Using this method, the elasticities for various goods—intended to act as examples of the theory described above—are as follows. For suggestions on why these goods and services may have the elasticity shown, see the above section on determinants of price elasticity.