Introduction

In the microeconomics articles 2-4, we talked about demand, supply and the interaction between them to achieve an equilibrium market price and quantity. We also discussed changes in the determinants of demand and supply which cause shifts in the demand and supply curves, resulting in a new market equilibrium.

In this article and the next, we will discuss other important aspect of demand and supply; their price elasticities.

In the previous articles we talked about the overall market demand and supply for a particular good or service, and assumed curves for individual firms had similar characteristics in a perfect market.

However, in reality the curves for each firm that produces / sells a good or service will differ. This is an important concept to consider when discussing elasticities; firms can look to understand what the demand or supply curve for a good sold by their particular firm looks like compared to the overall market and other firms. Using this, they can decide upon the appropriate strategy for the firm. As we go through the below, this should hopefully become clearer.

In this article, where we refer to a good we also mean a service.

What is price elasticity of demand and how is it measured?

The price elasticity of demand is the responsiveness of quantity demanded to a change in price.

When price goes up, quantity demanded goes down. However, the amount by which quantity demanded falls when price goes up depends on the individual demand curve for each good, and can also differ for each firm; this is its price elasticity.

Price elasticity of demand is measured between two price points on a demand curve. A difference in elasticities is shown on the two demand curves below, D1 and D2.

On the demand curve with a steeper incline (D1) the change in price has a smaller effect on the quantity demanded than the curve with a shallow incline (D2). We say that, in relative terms, D1 is more price inelastic and D2 is more price elastic.

The way we determine whether demand for a good is price elastic or price inelastic in absolute terms between two points is as follows:

1. Elastic - demand for a good is price elastic if the quantity demanded moves proportionately more to a change in price in percentage terms. For example, if the price for a good increases by 1%, but the quantity demanded decreases by 5%, we say it is price elastic;‍
2. Inelastic - demand for a good is price inelastic if the quantity demanded moves proportionately less to a change in price in percentage terms. For example, if the price for a good increases by 1%, but the quantity demanded only decreases by 0.5%, we say it is price inelastic;‍
3. Unit elasticity - demand for a good is unit elastic if the quantity demanded moves proportionately the same to a change in price in percentage terms.

Why is price elasticity of demand important for a firm?

Up to now we have drawn demand curves as straight. However, in reality, they are likely to be curved. Their steepness or shallowness (i.e. their price elasticity) will vary at different price points. Further, the demand curve for each firm, even for the same good, will differ.

This is because, in reality, perfect markets do not exist, the ceteris paribus assumption does not hold true, and different factors affect different firms. For example, a firm's location could impact what its particular demand curve looks like versus the rest of the market. For example, a service station on the motorway may have a less price elastic demand curve for fuel, bottles of water, and other items compared to other firms that sell such goods elsewhere; it can therefore charge more for those items without suffering from a disproportionate reduction in quantity demanded.

A firm should therefore know whether its own demand curve for the good/s it sells is price elastic or inelastic between its current price and a new prospective price, because a change in price could affect the firm's revenue.

Inelastic

If the demand is price inelastic between the current price and new price, a new lower price will result in a proportionately lower increase in quantity demanded and revenue.

Alternatively, if the new price is higher than the current price, this will result in a proportionately lower decrease in quantity demanded and revenue.

See P1 to P2 and Q1 to Q2 above.

A firm may therefore be incentivised to make changes to increase price and decrease supply in these circumstances (because the price increase will outstrip the quantity decrease).

Elastic

If the demand is price elastic between the current price and prospective price, a new lower price will result in a proportionately larger increase in quantity demanded and revenue.

Alternatively, if the new price is higher than the current price, this will result in a proportionately larger decrease in quantity demanded and revenue.

See P2 to P3 and Q2 to Q3 above.

A firm may therefore be incentivised to make changes to decrease price and increase supply in these circumstances (because the price decrease will be outstripped by the increase in quantity demanded).

Unit elasticity

If demand has unit elasticity between the current price and a new price, higher or lower, there will be no change in revenue because quantity demanded moves proportionately the same as price.

A firm can maximise its revenue by increasing its supply to the level at which the demand curve turns to unit elasticity.

A word of warning on revenue

However, revenue is not everything.

A firm will also need to consider whether it can produce a good at a certain price in light of its production costs, which will impact its profit.

There may be little point in producing a vast quantity of goods at a price where no profits are made (although some business strategies do call for this).

Determinants of Price Elasticity

We discussed the determinants of demand in our article on demand. These determinants impact the position of the demand curve, as well as its shape (steep, shallow, curved, straight etc.).

The determinants which affect price elasticity in particular are:

1. ‍Number and closeness of substitutes - if a good has many substitutes which are very similar to it, the demand for it is likely to be very elastic. This is because, if its price rises, consumers will be able to switch to one of the substitutes. The opposite applies if there are a limited number of alternatives. Further, the prices of those substitutes is also relevant. Take the motorway service station example - there may be a limited number of alternatives at the service station, and all alternatives will also have an increased price. Accordingly, the demand curve for the relevant good and all alternatives will be relatively price inelastic (compared to non-motorway service station shops);
2. Proportion of income spent on a good - if a large proportion of consumers' income is spent on a good, they are likely to switch if the price rises, and it will therefore be price elastic. If only a small proportion of income is spent on a good, consumers are less likely to switch if the price rises;
3. Taste - goods will differ, and consumers may have different tastes. For example, clothing at a high-end store will be different to that in a low-end store, and the stores will be targeting different markets. If a good has a loyal brand following, is in trend, or otherwise is preferred by consumers, its demand is likely to be price inelastic.

The elasticities in the demand for goods may also vary over a given the time period. For example, a good which was previously price inelastic may become more price elastic over time as other producers become incentivised to produce substitute goods and take advantage of the higher prices.

Other determinants of demand may also affect its price elasticity. Have a look at the determinants of demand discussed and think about the impact they could have on price elasticity.

Conclusion

You should now understand the concepts of price elasticity of demand and why it is important for a firm to understand the price elasticity for its own goods - for the market generally, but also for the firm specifically. In summary:

• Price elasticity of demand is the responsiveness of quantity demanded to a change in price;
• If demand is price inelastic, a change in price will result in a proportionately smaller change in quantity demanded. If demand is price elastic, a change in price will result in a proportionately larger change in quality demanded. If demand is unit elastic, a change in price will have proportionately the same impact on quantity demanded;
• Firms can maximise revenue by changing varying to the point that it is unit elastic;
• The determinants of demand impact price elasticity, including 1) number and closeness of substitutes; 2) proportion of income spent on a good; and 3) taste (amongst others).

Think about the goods that you use every day and assess their price elasticity of demand with reference to the determinants of demand. Think about how price elasticity of demand might differ between firms which sell the same good and why this could be the case (note the motorway service station example we gave above).

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