Price elasticity of demand

The price elasticity of demand reveals how much the quantity demanded of a good or service varies with changes in its price.

In general, there are products that are really sensitive to price changes. In such a way that a simple increase in its price generates a sharp fall in the quantities demanded of this product. Likewise, a small fall in its price will cause a sharp rise in the quantities demanded for it.

On the other hand, it must be said that there are some products, which have a poor change in demand in response to price changes.

Types of price elasticity of demand

When the degree of elasticity is taken into account, five specific types of demand can be differentiated.

• Elastic: This type of elasticity is evident when a small change in price causes a larger change in the quantities demanded. Specifically, it is stated that when the price elasticity of demand for any good is greater than 1, it is recognised that this good has an elastic demand.
• Unitary: This type of elasticity occurs when the variation in price causes a proportionally equal change in demand. It is therefore recognised when the price elasticity of demand for the good is equal to 1.
• Inelastic: This kind of elasticity is evident when a large variation in price has practically no effect on the quantities demanded. Thus, when the elasticity is less than 1, inelastic elasticity is evident.
• Perfectly elastic: This type of elasticity is categorised as the extreme case. In the sense that it occurs when the price elasticity of demand is equal to infinity.
• Perfectly inelastic: This type of elasticity, like perfectly elastic elasticity, is also categorised as an extreme case of demand elasticity. It is said to be inelastic when the elasticity of demand is zero.

Formula for the calculation of the price elasticity of demand

Strictly speaking, the price elasticity of demand is conceptualised as the percentage change in the quantity demanded of a good or service, divided by the percentage change in price. It can thus be expressed in the following formula:

In the formula above, delta Q stands for the absolute change in quantities demanded, and (Q) stands for quantity. At the bottom, delta P represents the absolute change in price and (P) the price.

 The absolute change is applied in view of the fact that the law of demand expresses an inverse relationship between price and quantity, which gives a negative coefficient in the formula. Therefore, the absolute value is taken for the calculation of elasticity operations.

Example

To see the process of calculating the price elasticity of demand, let us assume a possible situation in the milk market.

Let us assume that the price of milk rises from 2.30 to 2.35 dollars. Meanwhile, the quantity of milk demanded is reduced from 900 million litres to 855 million litres as a result of the increase.

Let us then proceed to determine the coefficient of elasticity of demand in this case. To do this, we are going to use the formula previously mentioned, which is as follows:

 Step 1: This step consists of determining the upper part of the formula. That is, the percentage change in the quantities.

We determine the absolute change in quantities. This is obtained by subtracting the final demand from the initial demand: 855 – 900 = -45.

We now divide this value by the initial demand. Thus we have the following:  -45/900 = -0,05. Taken as a percentage value, this equals -0.05 x 100 = -5%.

This -5% then represents the percentage change in the quantities demanded. In other words, we have determined the upper part of the formula.

Step 2: This step consists of determining the lower part of the formula. That is, the percentage change in price.

We determine the absolute change in price, which is obtained by subtracting the final price from the initial price, i.e.: 2.30 – 2.35 = -0.05.

We now divide this value by the initial price. Thus, we have the following: -0,05/2,3 = -0,0217. Taken as a percentage, this is equal to: 0.021 x 100 = -2.17%.

This -2.17% then represents the percentage change in price. In other words, we have determined the lower part of the formula.

Step 3: In this final step we proceed to substitute the values already calculated in the formula for the elasticity of demand. Since both values are negative, to make it clearer, we will put them in positive (the result is the same). Let’s see:

So the demand for this product is elastic, since its coefficient of elasticity is greater than one. A change in price has caused a larger change in quantity demanded. The interpretation indicates that when the price is reduced (or increased) by 1%, the quantity demanded is reduced (or increased) by 2.3%.