The Price Elasticity of Demand

The price elasticity of demand is a measure of the extent to which the quantity demanded of a good changes when the price of the good changes and all other influences on buyers’ plans remain the same.

A. Percentage Change in Price

1. The midpoint method uses the average of the initial price and new price in the denominator when calculating a percentage change. Because the average price is the same between two prices regardless of whether the price falls or rises, the percentage change in price calculated by the midpoint method is the same for a price rise and a price fall. 

a. Using the midpoint formula, the percentage change in price equals

B. Percentage Change in Quantity Demanded

Use the midpoint method when calculating the percentage change in quantity.

1. Minus Sign

Because a change in price causes an opposite change in quantity demanded, for the price elasticity of demand we focus on the magnitude of the change by using the absolute value.

C. Elastic and Inelastic Demand

The price elasticity of demand falls into three categories:

1. Elastic demand—when the percentage change in the quantity demanded exceeds the percentage change in price (which means the elasticity is greater than 1).

2. Unit elastic demand—when the percentage change in the quantity demanded equals the percentage change in price (which means the elasticity equals 1).

3. Inelastic demand—when the percentage change in the quantity demanded is less than the percentage change in price (which means the elasticity is less than 1).

4. There are two extreme cases:

a. Perfectly elastic demand—when the quantity demanded changes by a very large percentage in response to an almost zero percentage change in price.

b. Perfectly inelastic demand—when the quantity demanded remains constant as the price changes

D. Influences on the Price Elasticity of Demand

1. Substitution Effect

If good substitutes are readily available, demand is elastic. If good substitutes are hard to find, demand is inelastic.

2. Three factors determine how easy substitutes are to find:

a. Luxury versus necessity—there are few substitutes for necessities (so demand is price inelastic) and there are many substitutes for luxuries (so demand is price elastic).

b. Narrowness of definition—the more narrowly defined the good is, the more elastic its demand. The more broadly defined the good, the less elastic its demand.

c. Time elapsed since price change—the longer the time that has passed since the price change, the more elastic is demand.

3. Income Effects

The larger the proportion of income spent on the good, the more elastic is demand because a price change has a large, noticeable impact on the budget. The smaller the proportion of income spent on the good, the less elastic is demand.