What Is Price Elasticity of Demand?
Price elasticity of demand (PED) is a way to measure the change in the demand for a product or service in response to a change in its price.
With most goods, an increase in price will lead to a decrease in demand, and a decrease in price will lead to an increase in demand. When there is a large change in demand after a price change, that good is considered to have elastic demand. On the other hand, if there is only a small change in demand, that good is considered to have relatively inelastic demand.
Price elasticity of demand measures the responsiveness of demand, highlighting whether a good is elastic or inelastic.
How to Calculate Price Elasticity of Demand
Price elasticity of demand is calculated by dividing the percentage change in quantity demanded by the percentage change in price. The value resulting from that calculation indicates the responsiveness of demand.
Price Elasticity of Demand Formula
The formula for price elasticity of demand is:
If you don't have the percentage changes in quantity and price, you can use the following formula instead:
How to TelI if Price Elasticity of Demand Is Elastic or Inelastic
You can tell if price elasticity of demand is elastic or inelastic from the value given by the price elasticity of demand formula. If the value from that equation is:
Price Elasticity of Demand Examples
The calculations above will give you a number that indicates whether demand for a good is elastic or inelastic. If the demand for a good is elastic, the change in demand is greater than the change in price. If it’s inelastic, the change in demand is smaller than the change in price.
There are 100 people who need to get home on New Year’s Eve and the average cost per ride is $20. At this rate, all people are willing to pay that cost to get home.
Uber’s surge pricing raises the average cost to $30 per ride (a price increase of 50%). However, most people don’t live too far from home, so 75 of them decide to walk. This leaves only 25 people who call ubers (a 75% decrease in demand). To calculate price elasticity of demand, you use the formula from above:
Since the equation uses absolute value (omits the negative sign), the price elasticity of demand in this situation would be 1.5. This means that for every 1% increase in price, there is a 1.5% decrease in demand. Since the change in demand is greater than the change in price, we can conclude that demand is relatively elastic.
Once again, there are 100 people who need to get home on New Year’s Eve. The average cost per ride is $20. At this rate, all people are willing to pay this cost.
Assume that Uber’s surge pricing kicks in, raising the average cost to $30 per ride (a price increase of 50%). 25 of them end up calling friends or family instead, leaving only 75 people to call Ubers (a decrease in demand of 25%). To calculate price elasticity of demand, you use the formula from above:
The price elasticity of demand in this situation would be 0.5 or 0.5%. This means that for every 1% increase in price, there is a 0.5% decrease in demand. Since the change in demand is smaller than the change in price, we can conclude that demand is relatively inelastic.
What Does Negative Elasticity Mean?
Generally speaking, demand will decrease when price increases, and demand will increase when price decreases. That means that price elasticity of demand is almost always negative because demand and price have an inverse relationship. Since there is almost always one decreasing variable, the resulting value will be negative.
However, it’s important to note that price elasticity of demand uses absolute value, meaning that it essentially ignores the negative symbol. Since we already know the direction demand will shift, we’re more concerned about the value of the number since it explains whether demand is elastic or inelastic (and how responsive it is to changes in price).
What Is The Difference Between Price Elasticity of Demand and Price Elasticity of Supply?
While price elasticity of demand measures the responsiveness of demand resulting from a change in price, price elasticity of supply measures the change in the supply of a good when there is a change in its price.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Question: How is a stock quote born? The Investing Answer: Have you ever walked into the grocery...Read More →