Demand Elasticity

What it is:

Demand elasticity is a measure of how sensitive the demand for a product or service is to changes in the price of that product or service. The formula for demand elasticity is:

Elasticity = % Change in Quantity/% Change in Price

How it works (Example):

Let's assume that when gas prices increase by 50%, gas purchases fall by 25%. Using the formula above, we can calculate that the demand elasticity of gasoline is:

Elasticity = -25%/50% = -0.50

Thus, we can say that for every percentage point that gas prices increase, gas demand decreases by half a percentage point.

Demand elasticity is not the same as income elasticity, which is the percentage change in the amount purchased divided by the change in income. When people purchase more of a product (say, Ferraris) when they have higher incomes, that product is said to have positive elasticity. When they purchase less of a good (say, cheap shoes) when they have higher incomes, the good is said to have negative income elasticity.

Why it Matters:

If demand changes a lot when prices change a little, demand elasticity is high. This often is the case for products or services for which there are many alternatives or for which consumers are price sensitive.

The opposite is also true: when there is a small change in demand when prices change a lot, the demand is said to be inelastic. This is often the case for products and services that people consider necessities and will purchase at almost any price. The presence of few good substitutes and the presence of customer loyalty are also factors. At some point, however, there is a price at which demand for any good or service will fall to zero or near zero.

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