What it means
Every business that sets prices is betting on how customers will react. Price elasticity of demand puts a number on that reaction by comparing the percentage change in quantity with the percentage change in price.
The result is usually negative, because higher prices normally reduce the amount bought, so people often quote its absolute value. If the elasticity is greater than 1 in absolute terms, demand is elastic: customers are sensitive to price, and a rise in price reduces total revenue.
If it is below 1, demand is inelastic: customers keep buying, and a price rise increases revenue. An elasticity of exactly 1 is called unit elastic.
Several things determine elasticity. Products with many close substitutes, such as one brand of cereal, tend to be elastic, while essentials such as medicine or fuel for commuters tend to be inelastic.
Time also matters, because people can change habits more easily over months than over days. Finance and pricing teams use the measure to test price changes before making them, and to forecast how revenue and profit will move.
A business with inelastic demand has room to raise prices, while one with elastic demand may gain more by cutting prices and selling more. Elasticity should be looked at alongside costs, because profit depends on margin as well as revenue.
The number is not fixed. It varies along a demand curve and changes with competition, income and fashion, so an estimate from last year may not hold today.
Businesses test with small experiments, such as trying different prices in different regions, to estimate it more reliably. A related idea is cross elasticity, which measures how demand for one product responds to another product's price, and income elasticity, which measures response to changes in income.
Both help in understanding the wider demand picture.
In practice
Real-world examples.
Example
A streaming service raises its monthly fee by 10% and loses 3% of subscribers. Elasticity is -3% / 10% = -0.3, which is inelastic. Revenue rises, so the company keeps the new price. It watches churn each month to confirm that the early result is not a one-off.
Example
A budget airline cuts fares by 20% on a quiet route and passenger numbers rise by 50%. Elasticity is 50% / -20% = -2.5, so demand is elastic. Total revenue increases, even though each ticket sells for less. The airline also earns extra from baggage and snacks, which makes the cut even more worthwhile.
Example
A pharmacy chain raises the price of a branded cold remedy by 8% and sees sales fall by only 2%. The elasticity of -0.25 shows that customers have few alternatives. The category manager decides to test a further small rise. She also checks that competitors have not changed their prices.
Formula
Calculation
Price elasticity of demand = percentage change in quantity demanded / percentage change in price.
A company raises its price from $50 to $55, a rise of ($55 - $50) / $50 = 10%. Monthly sales fall from 2,000 units to 1,700 units, a change of (1,700 - 2,000) / 2,000 = -15%. Elasticity = -15% / 10% = -1.5, so demand is elastic. Revenue before the change was $50 x 2,000 = $100,000 and after it was $55 x 1,700 = $93,500, so revenue fell. Because the elasticity of -1.5 is greater than 1 in absolute terms, a price rise reduces revenue, and a price cut would have increased it. If costs per unit are $30, profit before was ($50 - $30) x 2,000 = $40,000 and after is ($55 - $30) x 1,700 = $42,500, so profit still rose even though revenue fell, because fewer units were produced.Case study
Seen in the real world.
Brightpath Bakeries is a fictional company used here for illustration. It sold a premium loaf at $4.00 and sold 10,000 loaves a week.
The owner raised the price to $4.40, a 10% increase, and sales fell to 9,000 loaves, a 10% decrease. Elasticity was -1.0, so revenue stayed almost level at $39,600 compared with $40,000, but costs fell because fewer loaves were baked.
The illustrative owner concluded that profit had risen even though revenue had not. The lesson was that elasticity needs to be combined with cost data to judge whether a price change is worthwhile.
Watch out
Common mistakes.
- Ignoring the minus sign. Elasticity is normally negative, so compare the absolute value with 1 to judge whether demand is elastic.
- Assuming elasticity is fixed. It changes with competition, time and the size of the price move.
- Looking at revenue alone. A price rise that cuts revenue slightly can still raise profit if costs fall.
Questions
People also ask.
What makes demand inelastic?
Few substitutes, necessity, small cost relative to income and short time to adjust all make demand less sensitive.
How do I estimate it?
Use past price changes and sales data, or run controlled price tests in different markets.
What is the difference between elasticity and sensitivity to price?
They are the same idea in everyday language, but elasticity gives a precise number that you can use in forecasts.
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