Price elasticity

🌱Planted September 22, 2021.
Last tended January 16, 2022.
seedling 🌱
1 minute read ⏱

Price elasticity measures how much the consumer demand for a good changes in response to price changes.

When price changes of a good have a large impact on demand, the demand is considered elastic.

If price changes only slightly impact demand for a good, the demand is considered inelastic.

Changes in consumer demand for a good in response to price changes for that good can be quantified using Price Elasticity of Demand (PED).

Demand for luxury items (like iPhones or premium liquors) and other products with many substitute goods are more likely to be elastic. Why is that? Because consumers have alternatives.

The impact on consumer demand across products in response to price changes for substitute goods can be quantified using Cross-Price Elasticity of Demand (CPED).

Demand for goods like food, water, electricity, and gasoline, don’t respond much to price changes. These types of goods are more likely to be inelastic because consumers have no alternative.

Goods with no alternative tend to be inelastic. Consumers still need them even when the price goes up. These products have a PED < 1 and are considered necessity goods.

Items that aren’t necessities tend to have greater price elasticity. Consumers making economic choices will only buy if the good provides a marginal benefit. Items that consumers only purchase if the price is right have a PED > 1 and are considered luxury goods.

Luxury goods are high quality, but consumers can live without them. They aren’t essential.

One rather unique type of good has an odd relationship with price. When an increase in price causes an increase in demand for a good, it’s considered a Giffen good.

Price elasticity in context

The way a market is defined can have a huge impact on price elasticity within that market. For example, demand for flights between major US cities may be inelastic - the distances are vast and the alternatives are much slower. In Japan’s intercity transit market, high speed trains offer a fast alternative to flying; they are a substitute good for flights. In that market, the demand for flights is elastic.

Price elasticity can also vary based on how long of a period is being analyzed. Day-to-day, demand for gasoline is inelastic; people still need to get to work and do errands. Over several decades more people will adopt greener alternatives like electric vehicles, micromobility, and improved public transit. This will increase the elasticity of consumer demand for gas.

Income elasticity of demand

consumer demand changes in response to price, but how sensitive a consumer is to price can also change. When you land a great new job with double the pay, the cost to eat out at your favorite restaurant doesn’t change, but the frequency you do it might!

The impact that spending power has on demand can be quantified using income elasticity of demand (IED).

Income elasticity of demand is a formula that can be used to calculate how changes in income impact purchasing behavior. The formula for IED is (% change in quantity demanded)/(% change in income).

Much like with Cross-Price Elasticity of Demand (CPED), the sign (positive or negative) of an IED value can be used to classify goods.

Goods that have a positive income elasticity of demand are products that have increased demand when income increases. These are called normal goods.

Some products see decreased demand when income goes up. They have negative income elasticity of demand values. These products are considered inferior goods.

Demand for inferior goods typically decreases because there’s a better product that provides consumers with greater satisfaction - such as higher ply toilet paper.