Price Elasticity Of Demand

Published Oct 25, 2023

Definition of Price Elasticity of Demand

Price elasticity of demand is a measure that quantifies the responsiveness of the quantity demanded of a good or service to a change in its price. It helps to determine how sensitive consumer demand is to changes in price. Price elasticity of demand can be calculated using the formula:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Example

To illustrate price elasticity of demand, let’s consider the market for gasoline. Assume gasoline prices increase by 20% due to a rise in oil prices. As a result, the quantity demanded of gasoline decreases by 10%. Using the formula, we can calculate the price elasticity of demand:

Price Elasticity of Demand = (-10% / 20%) = -0.5

In this case, the price elasticity of demand for gasoline would be -0.5. This means that a 1% increase in gasoline prices would result in a 0.5% decrease in the quantity demanded of gasoline.

Why Price Elasticity of Demand Matters

Understanding the price elasticity of demand is crucial for businesses and policymakers. It helps businesses to make informed pricing decisions and estimate the impact of price changes on their revenues. For example, if demand for a product is highly elastic (greater than 1), a decrease in price could lead to a proportionally larger increase in quantity demanded, resulting in higher total revenue. On the other hand, if demand is inelastic (less than 1), a decrease in price would lead to a smaller increase in quantity demanded and potentially lower total revenue.

Policymakers also consider price elasticity of demand when implementing taxes or subsidies. If demand for a product is highly inelastic, a tax may not significantly reduce its consumption, and the government would be able to collect substantial tax revenue. However, if demand is elastic, a tax could significantly reduce consumption and may result in lower tax revenues or unintended consequences.

By understanding price elasticity of demand, businesses and policymakers can make more informed decisions about pricing, taxation, and subsidy policies.