What is Price Elasticity of Demand

There is a direct relationship between price and demand; understanding it can help your ecommerce business grow. You should know if raising or reducing your prices can result in a drastic decrease or increase in the demand for your goods or services.

This is what is known as price elasticity.

In this article, we will cover everything you need to know about this concept in economics, especially on the price elasticity of demand in the Malaysian market.

What is Price Elasticity?

Price elasticity of demand (demand elasticity) is a measurement of the change in the consumption of a product about a change in its price. When the average price of a good rises, it is normal to expect that the average quantity demanded will also fall. But in some cases, the quantity demanded falls more for some products than others.

In economics, it is the relationship between the quantity demanded of a good or service and the price change. In other words, price elasticity of demand is the relationship of consumer response to a change in the price of a product or service.

The degree of change along the linear demand curve relative to the degree of price change will more clearly show the effect of a price change.

Factors Affecting Price Elasticity of Demand

Price elasticity of demand needs to be studied carefully for a business to achieve success in the market. This is because there are different factors affecting the elasticity of a product or service. Understanding the factors controlling elasticity of demand will play a major role in your long-term pricing strategy.

In the next lines, we will review some major factors affecting price elasticities.

The Availability of Close Substitutes

This is one of the most critical factors affecting the price elasticity of demand. Consumers often regard other similar goods that can be substituted for a particular good currently in high demand. Therefore, a product with other reliable substitutes in the market will become more elastic than other products without.

However, inelastic products are so because there are no readily available substitutes. For example, the demand for cooking gas is far more inelastic than the demand for wristwatches or gym equipment.

Necessity or Luxury

The necessity of the good will reduce the price elasticity of demand.

For example, necessary products that fall under food and housing will naturally be more inelastic (even when there’s an apartment supply increase) than luxury products, such as expensive cars or electronic gadgets with more elastic demand. This is because consumers will be more inclined to reduce purchases when the initial price increases.

The Proportion of Income Spent on Commodities

One of the crucial factors affecting the price elasticity is the proportion of a consumer’s income spent on an item. The price elasticity tends to be low when spending on a good is a small proportion of their available income.

Therefore, a change in the price of a good has a significantly lower impact on the consumer’s tendency to consume the good. In contrast, a good that takes up much of the consumer’s income will cause a more elastic demand for the product.

However, high-income consumers will continue to maintain a significantly lower elasticity of demand even as you’re raising prices. 

The Time Frame

This refers to the rate at which consumer demand reacts to the change in price. In other words, this factor considers the time frame from the point of the increase in price to when consumers can find a better substitute for the good while still purchasing the good in question.

Usually, in the short term, buyers cannot find substitutes immediately, so they continue to buy the same product, causing the product’s demand to be inelastic. However, in the long term, consumers may be able to find substitutes or adjust their consumption habits, causing a more elastic demand.

Brand Loyalty

Brand development and brand loyalty can also affect the price elasticity of demand. Consumers who are loyal to a particular brand may be less likely to switch to substitutes, even if prices increase, leading to inelastic demand.

However, there are loopholes here because brand loyalty can wane during recession periods when consumers might opt for cheaper products despite the perceived lower quality. The income level also plays a major role in brand loyalty as it impacts the elasticity of demand. 

The Level of Competition

As a business, you will have competition in the market.

Therefore, consumers will consider your price points and that of your competitors before purchasing, causing your product to be either elastic or inelastic.

This is often tied to cross price elasticity (cross elasticity) – the change in demand for a product, as a result of the price change of another

The Availability of Information

The availability of information about a good or service is another factor influencing price elasticity of demand.

When consumers access more information about a good or service, making knowledgeable purchasing decisions that affect more elastic demand becomes easier.

How to Calculate The Price Elasticity

Estimated price elasticity is how the demand or supply curve of a good or service changes in response to an increase in price. You can calculate elasticity by looking at the percentage change in quantity demanded or supplied for the good or service divided by the percentage change in price. Here it’s important to use absolute values when calculating. This is called the “midpoint method”.

A product that is price elastic will show changes in quantity demanded or supplied for that product.

Price elasticity can be divided into three:

• Price elastic: where price changes significantly influence the supply or demand of a product or service.
  
• Price inelastic: where supply and demand do not correspond to price changes, resulting in the same straight line demand curve.
  
• Price unit elastic: where a price change exhibits proportional responsiveness to the change in both the demand and supply, as they move at the same rate.

To calculate price elasticity, divide the change in demand for a product or service by its corresponding percent change in price. The result will tell you which category your product falls into.

Let’s see this in more detail below:

• An elasticity value of one (one percent price change) means that your product is unit elastic and changes in your price reflect an equal percentage change in supply or demand.

• A value greater than one means that your product is elastic and changes in your price will cause a greater than proportional change in supply or demand.

• A value lower than one means that your product is inelastic and changes in your price will result in a smaller change in the supply or demand for your product.

A good’s price elasticity is far more inelastic if it’s not essential to our daily existence as human beings. Its demand falls more frequently, especially when it’s subject to price change, as opposed to essential goods.  This means that any product that does not respond to changes in price in terms of supply and demand is price inelastic.

For example, a toy game is an elastic good, while cooking gas is inelastic. In general, here we have both price elasticity of demand and price elasticity of supply.

When calculating price elasticity of supply (PES), we measure how responsive the supply of a product or service is when there is a price change. Essentially, the price elasticity of supply is the average percent change in quantity supplied divided by the percent price change.

If there is inelastic supply, an increase in price leads to a change in supply that’s less than the price increase, meaning the PES is less than one. If supply is inelastic, your business mightn’t meet demand or require a longer lead time to produce more products. It could also mean that you need more resources to expand your facilities.

If there is elastic supply, the price change yields a more significant increase in supply, giving the PES “greater than one elasticity”. Knowing PES allows businesses to determine whether a price change will negatively or positively affect the demand for its product or service.

At the end of the day, at the equilibrium point, the price equals the point price quantity supplied, indicating that the market is in a balance between the quantity of goods producers are willing to supply and the quantity consumers are willing to purchase.

How to Interpret The Results

Once you have calculated the elasticity of demand you must understand what the resulting number means. There are ways you can interpret your results, but one of the trusted ways is through understanding the types of price elasticity of demand.

The below information will help you interpret your elasticity coefficient answer:

• Inelastic demand: When you get a coefficient answer less than 1, the product has inelastic demand. Inelastic demand indicates that the product’s demand changes less than the price changes.
  
• Elastic demand: When your PED result exceeds 1, the product has elastic demand. Elastic demand indicates that the product’s demand changes more than the price changes.
  
• Unitary elastic demand: Getting exactly one means the product has unitary elastic demand. Demand is unit elastic when the product’s demand changes in proportion to the unit price changes.
  
• Perfectly inelastic: Exactly 0 means the product is perfectly inelastic. Perfectly inelastic demand indicates that the product’s demand will remain the same throughout the entire demand curve regardless of the price changes. Perfectly inelastic products are usually survival necessities because consumers will continue to buy them regardless of the price.
  

Last but not least, there is another value called perfectly elastic. Infinite (∞) means the product is perfectly elastic. Perfectly elastic demand indicates that the product’s demand will fall to zero if the price increases. Perfectly elastic products typically have a predetermined absolute value.

Examples of Price Elastic and Inelastic Goods

Elasticity is commonly categorized into two types: elastic and inelastic. In the following lines, we will review some notable examples of elastic and inelastic goods.

This is important because as a business owner, you need to be aware of the consumer behavior and you should be able to make decisions about pricing and production.

Elastic Demand Goods

Elastic goods have a high degree of elasticity, meaning that the quantity demanded or supplied is highly responsive to changes in price. Many luxury goods exhibit the same elasticity.

Let’s see examples below:

• Luxury Cars: When luxury car prices increase, people buy fewer because alternatives exist, and the purchase is often discretionary.
  
• Vacation Packages: Higher prices for vacation packages can significantly decrease demand, as consumers can opt for more affordable travel options or postpone their vacations.
  
• Smartphones: With various smartphone options available, consumers will likely be more responsive to price changes, seeking alternatives, or delaying their purchases.
• Designer Clothing: The demand for designer clothing can be elastic, as consumers may choose the lower end of two price points (more budget-friendly options) if prices rise.
  
• Restaurant Meals: Higher prices for dining out may lead people to cook at home or choose less expensive dining alternatives.
  
• Airline Tickets: The relationship between elasticity and ticket prices is notorious. Consumers can be price-sensitive regarding air travel, exploring different carriers, or adjusting travel plans based on ticket prices.
  
• Electronic Gadgets: Demand for gadgets like laptops or tablets can decrease if prices rise, as consumers may postpone or consider more affordable alternatives.
  
• Jewelry: When the price of jewelry increases, consumers might opt for less expensive pieces or delay their purchases.
  
• Sports and Concert Tickets: Higher ticket prices can lead to decreased attendance, as fans may choose to watch events through alternative means or attend less frequently.
  

Another example is organic foods. As organic product price rises, consumers may shift to conventional options, demonstrating elasticity in demand.

Inelastic Demand Goods

Inelastic goods have a low degree of elasticity, indicating that the quantity demanded or supplied is not very responsive to changes in price.

Let’s see some examples of inelastic goods:

• Insulin: People with diabetes often have limited alternatives, so they may continue to purchase insulin even if prices rise.
  
• Prescription Medications: Essential medications may exhibit inelastic demand, as patients may have no choice but to continue purchasing them, regardless of price increases.
  
• Gas: Despite price increases, many people still need to drive for work or daily activities, making gasoline relatively inelastic in the short term.
  
• Utilities (Water, Electricity): Basic utilities are essential, and consumers may continue to use them despite price changes, resulting in inelastic demand.
• Salt: Since salt is a basic necessity, its demand is less affected by price fluctuations, especially in the short term.
  
• Tobacco Products: Despite price hikes, individuals addicted to tobacco may continue purchasing cigarettes, showing inelastic demand.
  
• Internet Services: In today’s digital age, internet access is crucial, making it less responsive to price changes due to its essential nature.
  
• Medical Services: Healthcare services often exhibit inelastic demand, as people prioritize health and may continue seeking medical assistance even with price increases.
  
• Funeral Services: Unfortunately, funeral services are essential in certain situations, leading to inelastic demand despite price variations.
  

Also, don’t forget about the basic food staples (e.g., bread, milk, pepper): These items are necessities, and consumers may continue to purchase them even if prices rise, showcasing inelastic demand.

Importance of Understanding Price Elasticity of Demand

Knowing the price elasticity of demand for goods allows you, as a business owner, to make informed decisions about your pricing strategies. Understanding the price elasticity of demand will provide you with information about consumer price sensitivity.

If you are a manufacturer, it is also essential for you to understand PEDs because they can influence your manufacturing objectives.

Price elasticity can also help you effectively compare pricing methods and perform market research to market your products and services.

You can consider whether your products are elastic or inelastic depending on your industry and the products you sell. This can enable you to create a pricing strategy that best represents your brand.

For example, suppose you run an ecommerce business that sells luxury acrylic nails. In that case, you know that it falls under an elastic good such that a price rise will decrease the quantity demanded. On the other hand, you’ll get an increased quantity demanded if the price drops.

In Malaysia, cell phone services are very competitive and even the slightest change in price could influence consumers to change their plan over to another company.

This information can guide you on increasing or decreasing your price as you study the profile of your target audience. 

High-income consumers will likely afford to purchase your products even with a price increase, but a segment of your target audience that earns between 1,600 MYR and 5,000 MYR is more likely to buy your products when the price falls. 

It is, therefore, beneficial to your business to understand the concept of price elasticity of demand.

Applications of Price Elasticity of Demand in Business

You can apply price elasticity of demand to your business in different ways. Price elasticity can tell you whether or not to increase your prices based on the products you sell and your target market. You can invest more time and effort in pricing your products and services to help you stand out in a highly competitive market.

Price elasticity can also guide you in designing effective advertising campaigns and promotions. For inelastic goods, promotions may focus on value addition rather than price reduction, whereas elastic goods benefit from price discounts.

Also, it can aid in forecasting revenue and predicting revenue changes based on price adjustments. For elastic goods, when price decreases it may lead to increased sales volumes, and could potentially affect total revenue positively. In other cases, it can predict when total revenue falls.

You can apply price elasticity in your market expansion strategy. It can guide your decisions on entering new markets. Flexible pricing strategies may be implemented in regions with more elastic demand to attract a more extensive customer base.

Assessing price elasticity helps businesses anticipate the effects of taxation. Inelastic goods may withstand tax increases, but elastic goods may see a more significant decline in quantity demanded.

If your business runs on subscription models, you can apply price elasticity to determine the elasticity of demand for your service. Pricing adjustments may affect subscriber numbers, influencing decisions on introductory offers or loyalty programs.

Limitations of Price Elasticity of Demand

There are several limitations of price elasticity of demand, and understanding them can help you plan your business strategy. Below are the major limitations of price elasticity of demand.

Price elasticity calculations assume that other factors affecting demand remain constant. Numerous variables like consumer preferences, income, and external economic conditions can change, influencing elasticity. Price elasticity measures often reflect short-term responses. Over the long term, consumers may adjust their habits, preferences, and incomes, altering the elasticity of a product. This long-term view of the changes in price or demand is known as arc price elasticity or arc elasticity.

It can also provide an average response, but individual consumers may exhibit different sensitivities to price changes. This variability makes it challenging to apply elasticity uniformly across an entire market.

Elasticity assumes perfect substitution between goods. In reality, finding substitutes may be complex, especially for unique or specialized products, impacting the accuracy of elasticity predictions. Classifying goods as necessities or luxuries for elasticity analysis oversimplifies consumer behavior. Some products can transition between these categories based on economic conditions, making elasticity predictions more complex.

Elasticity calculations might not capture immediate consumer responses. Time lags in adjusting to price changes can distort the accuracy of an elasticity measure, particularly in industries with slow adaptation.

Elasticity models often assume consumers have perfect information about price changes. Consumers’ expectations, perceptions, and incomplete information can significantly impact their response to price adjustments. Price elasticity focuses on monetary aspects but ignores non-monetary factors influencing demand, such as cultural shifts, social trends, or ethical considerations, which can play a crucial role in consumer behavior.

Last but not least, the assumptions of rational behavior underpinning elasticity models neglect insights from behavioral economics. Human psychology, emotions, and cognitive biases can lead to unpredictable demand responses not captured by traditional elasticity analysis.