What is Elasticity of Demand?
Elasticity of Demand is a topic reviewed in good ole’ economics. In short, elasticity of demand refers to how sensitive or responsive consumers are to price changes of a product. If consumers buy more or less of a product due to a change in that products pricing, then the product is considered to have elastic demand. However, if price does not have an effect on consumer demand, then that product is considered to have inelastic demand.
Elasticity of Demand Formula
The formula to determine elasticity of demand is as follows:
(E) Elasticity =
Percent change in quantity demand for product x
Percent change in price for product x
If E is less than 1, demand is considered inelastic
If E is greater than 1, demand is considered elastic
If E equals 1, demand is considered unitary.
It should be noted that unitary elasticity occurs when an increase in sales is offset by the decrease in price, resulting in a situation where revenue remains the same.
As a quick rule of thumb, the following apply when determine elasticity of demand:
If price and revenue increase, then demand is inelastic
If price and revenue decrease, then demand is inelastic
If price increases and revenue decreases, then demand is elastic
If price decreases and revenue increases, then demand is elastic
If price increases or decreases and revenues stay the same, then elasticity is unitary
Sample Elasticity of Demand Problem
shoeBurger has decided to test the waters by entering a new industry, based on analysis they have decided to enter the tablet market to compete with iPad (yes, they're trying to leave beef patties behind for the tech industry... wild and crazy they are). Based on their analysis, the demand curve appears to be elastic; customers are very sensitive to price changes. After a year of gathering data on their firt product release, The shoePad, the company decided to reduce the price of their product from $200 to $100. The objective as to test the market response and their hypothesis that revenue would improve by adjusting the price. The resulting change produced a whopper of results; their theory was correct! Demand for the shoePad was 20,000 units at $200, but with the price reduction to $100 demand trippled to 60,000 units! Revenue was $4 million during their introductory year with the shoePad bearing a $200 price tag, however when the price reduced to $100, revenue skyrocketed to $6 million. Using the formula for demand elasticity; solve for E as follows:
E = [(60,000 – 20,000) / [(60,000 + 20,000)/2]] / [($200 - $100)/[($200 + $100)/2]]
E = (40,000/40,000) / (100/150)
E = 1 / .67
E = 1.49: E > 1, so this product is considered elastic.
What Factors Affect Elasticity?
There are a number of factors that affect the elasticity of demand. A few factors to consider are as follows:
Substitutes: When there are many substitutes the consumer can make a purchasing decision to buy a competitor’s product, creating elastic demand.
Purchasing Power: If a consumer’s personal budget is so large and the low price of a product seems to bear no consequence to their budget, then this will create inelastic demand.
Product Durability: Durable products are those products that can be repaired rather than replaced, prolonging their useful life. Consumers are sensitive to price increases with these products, creating elastic demand.
Product Uses: The more uses a product has, the greater the elasticity of demand. For example, copper has many uses and as price drops, demand increases due to the increase in practical uses at this “lower” price. However, as price increases, substitutes will be used as they are more practical (such as polyethylene pipe products).
Inflation: When inflation occurs, it has been shown that people become more sensitive to pricing, increasing demand elasticity.
Visit Elasticity of Demand Calculator to learn more about elasticity of demand to and to use a calculator that solves these problems.