Price elasticity

Price elasticity of demand

Price elasticity of demand is the proportionate change in the volume of a product that will be bought as a result of a unit change in price. It is:

(change in quantity ÷ total quantity) ÷ (change in price ÷ price)

Price elasticity is almost always negative. Of the two types of exceptions, one is the very rare case of Giffen goods), and the other the Veblen goods which have yet to be proved to exist at all. It is common practice to quote the absolute amount (omit the negative sign).

If the price elasticity is:

  • exactly one, then a small increase or decrease in price will result in the value of sales being unchanged because the change in volume will exactly compensate
  • less than one, then increase in price will increase the value of sales and a decrease will decrease the value of sales — demand is inelastic
  • more than one, then lower prices will mean greater sales in monetary terms — demand is elastic.

Although demand for a good may be inelastic at the level of the total market, in a competitive market prices could still be highly elastic for an individual supplier. Any one firm may find it hard to sell at above the market price, and may gain a lot of sales by undercutting the market price.

Suppliers usually want to maximise their profits, not their sales. While lower prices may increase sales, they will reduce margins, so price elasticity of demand will tend to be significantly greater than one. Cross elasticities may be significant.

Price elasticity of supply

Price elasticity of supply is the effect that the price of a good has on the quantity supplied to the market. Its definition is the same as that of price elasticity of demand except that the quantity is that supplied by suppliers rather than that demanded by consumers.