A Beginner's Guide to Elasticity: Price Elasticity of Demand

Elasticity Is Explained With Specific Reference to Price Elasticity of Demand

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Elasticity is a term used a lot in economics to describe the way one thing changes in a given environment in response to another variable that has a changed value. For example, the quantity of a specific product sold each month changes in response to the manufacturer alters the product's price.  

A more abstract way of putting it that means pretty much the same thing is that elasticity measures the responsiveness (or you could also say "the sensitivity") of one variable in a given environment -- again, consider the monthly sales of a patented pharmaceutical -- to a change in another variable, which in this instance is a change in price.

Often, economists speak of a demand curve, where the relationship between price and demand varies depending upon how much or how little one of the two variables is changed. 

Why the Concept is Meaningful

Consider another world, not the one we live in, where the relationship between price and demand is always a fixed ratio. The ratio could be anything, but suppose for a moment that you have a product that sells X units every month at a price of Y. In this alternative world whenever you double the price (2Y), sales fall by half (X/2) and whenever you halve the price (Y/2), sales double (2X). 

In such a world, there'd be no necessity for the concept of elasticity because the relationship between price and quantity is a permanently fixed ratio. While in the real world economists and others deal with demand curves, here if you expressed it as a simple graph you'd just have a straight line going upward to the right at a 45-degree angle.

Double the price, half the demand; increase it by a quarter and the demand diminishes at the same rate. 

As we know, however, that world is not our world. Let's take a look at a specific instance that demonstrates this and illustrates why the concept of elasticity is meaningful and sometimes vital.

Some Examples of Elasticity and Inelasticity

It's not surprising when a manufacturer substantially increases a product's price, that consumer demand should diminish.

Many common items, such as aspirin, are widely available from any number of sources. In such cases, the product's maker raises the price at its own risk -- if the price rises even a little, some shoppers might stay loyal to the specific brand -- at one time, Bayer nearly had a lock on the U.S. aspirin market -- but many more consumers would probably seek the same product from another manufacturer at the lower price. In such instances, the demand for the product is highly elastic and such instances economists note a high sensitivity of demand.

But in other instances, the demand is not elastic at all. Water, for example, is usually supplied in any given municipality by a single quasi-governmental organization, often along with electricity. When something consumers use daily, such as electricity or water,  has a single source, the demand for the product may continue even as the price rises -- basically, because the consumer has no alternative. 

Interesting 21st Century Complications

Another strange phenomenon in price/demand elasticity in the 21st century has to do with the Internet. The New York Times has noted, for instance, that Amazon often changes prices in ways that are not directly responsive to demand, but rather to the ways consumers order the product -- a product that cost X when initially ordered may be filled at X-plus when reordered, often when the consumer has initiated automatic re-ordering.

The actual demand, presumably, hasn't changed, but the price has. Airlines and other travel sites commonly change the price of a product based on an algorithmic estimation of some future demand, not a demand that actually exists when the price is changed. Some travel sites, USA and others have noted, put a cookie on the consumer's computer when the consumer first inquires about the cost of a product; when the consumer checks again, the cookie raises the price, not in response to a general demand for the product, but in response to a single consumer's expression of interest

These situations do not at all invalidate the principle of price elasticity of demand. If anything, they confirm it, but in interesting and complicated ways.   

In summary: 

  • Price/demand elasticity for common products is generally high.
  • Price/demand elasticity where the good has only a single source or a very limited number of sources is typically low.
  • External situations may create rapid changes in the price elasticity of demand for almost any product with low elasticity.
  • Digital capabilities, such as "demand pricing" on the Internet, can affect price/demand in ways that were unknown in the 20th century.

How to Express Elasticity as a Formula

Elasticity, as an economics concept,can be applied to many different situations, each with its own variables. In this introductory article, we've briefly surveyed the concept of the price elasticity of demand. Here's the formula:

    Price Elasticity of Demand (PEoD) = (% Change in Quantity Demanded/ (% Change in Price)