Debitoor's accounting dictionary
Price elasticity

Price elasticity - What is price elasticity?

Price elasticity measures the relationship between the supply and demand of a commodity and its price.

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In microeconomic theory, it usually assumed that an increase in price will lead to lower demand and higher supply. Price elasticity measures the extent to which this applies to a specific commodity, and looks at how much the price of a product or service affects supply or demand.

If the price of a good or service easily affects supply or demand, it is described as elastic. Alternatively, if price of a commodity has little impact on supply and demand, it is described as inelastic.

Price elasticity of demand (PED)

‘Price elasticity’ is usually used refer to to the relationship between price and demand. The concept of ‘price elasticity of demand’ measures how much demand for a commodity is affected by its price. There are several methods for calculating price elasticity of demand, but one of the most common measures is the ‘percentage method', which uses the following formula:

Price elasticity of demand = % change in quantity demanded ÷ % change in price

According to laws of demand (whereby an increase in price will result in a decrease in demand, and vice versa), the PED formula will always produce a negative result. When the result of the formula is between 0 and -1, the price of a commodity is said to be inelastic, whereas a result of score of -1 or lower represents inelasticity.

However, because the PED formula always produces a negative result, the minus sign becomes unnecessary - it is therefore ignored. This means that a negative number is converted to a positive number, and a commodity is considered elastic when PED > 1.

Example of measuring PED with the percentage method

The price of a laptop is increased from £500 to £600. This represents a 20% change in price. Typically, 200 laptops are sold per month, but after the increase in price, only 150 laptops are sold. This represents a 25% change in quantity demanded.

The price elasticity of the laptop is 1.25. (-25 ÷ 20 = -1.25, but we overlook the minus sign). Because 1.25 is greater than 1, the laptop price is considered elastic.

What are the causes of price elasticity of demand (PED)?

Price elasticity of demand can be influenced by:

  • Availability of substitutes: if there are many alternatives available, a commodity is likely to have higher elasticity. For example, there are many brands of cleaning products, so consumers are likely to switch to a cheaper alternative if one brand increases their prices by even a small percentage.

  • Necessity: if consumers believe a commodity is essential, it is likely to have lower elasticity. For example, although the British government raised the price of prescription 2018, the public will continue to purchase their prescription because they have no alternative.

  • Brand loyalty: consumers’ attachment to certain brands might override other influential factors. For example, despite iPhones getting more expensive, many iPhone users will stick with the Apple brand when choosing a new phone. iPhones therefore have fairly low elasticity.

  • Cost relative to income: the higher the cost compared to consumers’ income, the more elastic the price will be. For example, rent can represent a big percentage of a person’s income and is therefore highly elasticl; if rent increases by even a small percentage, the renter may need to find a cheaper place to live. Alternatively, everyday items like salt and pepper are inelastic; they take up an extremely small percentage of the average monthly income so an increase in price is likely to go unnoticed.

Price elasticity of supply (PES)

Although price elasticity usually refers to demand, it can also refer to the relationship between the price of a commodity and the willingness of suppliers to produce it. ‘Price elasticity of supply’ measures how the price of a commodity affects the quantity supplied. If supply is elastic, a change in price causes a significant change in the supply of a particular good or service; if supply is inelastic, a change in price might not cause much of a change in the quantity supplied.

Like PED, PES can be calculated using the percentage method, which is calculated with the following formula:

Price elasticity of supply = % change in quantity supplied ÷ % change in price

PES is also measured in a similar way to PED; when PES is > 1, supply is considered elastic.

Examples and causes of price elasticity of supply

Some of the factors influencing price elasticity of supply include:

  • Availability of raw materials: if raw materials are not easily available, supply of certain commodities will be capped regardless of price. For example, gold is considered to be inelastic, as there is a limited amount of the raw material available, regardless of the current market value.

  • Capacity: for commodities limited by a particular size or capacity, price is unlikely to have much impact on the quantity supplied. Concert tickets have a very low elasticity of supply because venues have a limited number of spaces. Increased supply isn’t possible, even if price is changed.

  • Complexity and speed of production: if a commodity requires a complicated or lengthy production process, suppliers are unlikely to be able to respond quickly to changes in price. These commodities would therefore be considered inelastic.

  • Availability in inventories: if a supplier has the materials for a particular product available in storage, they can quickly increase production to supply more of the product; this therefore increases elasticity of supply.

  • Adaptability of supplier: when a supplier can easily adapt their resources or production process to another commodity, PES is increased. For example, fruits, vegetables, and grains are considered extremely elastic; if a product becomes less profitable, farmers can use their existing land and equipment to switch to another crop.

Why is price elasticity important for my small business?

Price elasticity is primarily used by companies to establish and evaluate pricing strategy; understanding whether your goods or services are elastic or inelastic is therefore an important step towards setting your own prices.

If you already have a pricing strategy, price elasticity of demand is an important concept to consider before raising or lowering the price of your goods or services. Raising prices but decreasing demand could increase your profit margin per sale, but could be detrimental to your overall revenues. If you lower prices to increase demand, you will need to assess whether your company has the capacity to handle extra orders, and calculate the costs associated with increasing supply.

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