The Price Elasticity of Demand
In
economics, the demand for a certain good or service is represented by
the demand curve. The demand curve is plotted on a graph with price
labeled on the y-axis and quantity labeled on the x-axis. The resulting
curve is downward-sloping; thus, increases in price result in a fall in
demand for a given product. Just the amount by which demand falls with
an increase in price is measured by the price elasticity of demand; the
price elasticity of demand is measured by the percentage change in
quantity demanded divided by the percentage change in price. So, if
price increases by 10 percent, and demand falls by -0.5 percent, the
price elasticity of demand would be -0.5. However, by convention, price
elasticity is expressed as a positive number. The elasticity would thus
be expressed as 0.5, not -0.5.
Analyzing the Price Elasticity of Demand
After
calculating the price elasticity of demand, one of five results may be
obtained. An elasticity equal to one is said to be unit elastic; that
is, any change in price is matched by a change in quantity demanded. An
elasticity of between zero and one is said to be relatively inelastic,
when large changes in price cause small changes in demand. An elasticity
equal to zero is said to be perfectly inelastic, when a change in price
does not change the quantity demanded. A relatively elastic good is
where elasticity lies between one and infinity, and a small change in
price results in a relatively large change in demand. The last category
is that of a perfectly elastic good, when a minute change of price
results in an infinitely large change in demand.
Applying the Price Elasticity of Demand
The
price elasticity of demand for a certain good or service has
considerable implications for businesses. If an ice cream shop, for
example, were to increase the price of vanilla ice cream by 10 percent,
and if demand fell by 5 percent as a result, management would then know
that the price elasticity of demand for that particular good was
elastic. But if they also increased the price of their top-selling
flavor, chocolate, by the same amount, and if prices remained the same,
then they would have a relatively inelastic product. Thus, elasticities
differ with respect to variety of product in question. Businesses must
therefore make pricing decisions based on these elasticity assumptions.
Impact on Business Management Problems
Price
elasticity of demand affects a business's ability to increase the price
of a product. Elastic goods are more sensitive to increases in price,
while inelastic goods are less sensitive. Assuming that there are no
costs in producing the product, businesses would simply increase the
price of a product until demand falls. Things become more complicated,
however, after introducing costs. Let's say that the cost of vanilla
flavoring increases as a result of short market supply. As profits equal
revenue minus costs, this would lower the ice cream shop's profits. If
costs were close to the price of vanilla ice cream, profits would be
almost zero. As vanilla ice cream is elastic, the shop manager would be
unable to increase the price without damaging demand. Some businesses,
therefore, sell some goods that have little to no profit margin. Their
main profits come from products in higher demand. In this case, the ice
cream shop would increase the price of the more inelastic good,
chocolate ice cream, in order to compensate for the loss in profits.
