What is Price Elasticity of Demand?
Price elasticity of demand (PED) measures how sensitive consumers are to price changes. It's the percentage change in quantity demanded divided by the percentage change in price — a key tool for setting pricing strategy and predicting revenue.
PED = (% Change in Quantity Demanded) / (% Change in Price). If |PED| > 1, demand is elastic (sensitive to price). If |PED| < 1, demand is inelastic (relatively insensitive).
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Step-by-step worked examples
A coffee shop raises prices from $3 to $3.60 (20% increase). Sales drop from 200 to 160 cups (20% decrease). Calculate PED.
% Change in Q = (160 - 200) / 200 = -20% % Change in P = (3.60 - 3.00) / 3.00 = +20% PED = -20% / +20% = -1.0 (|PED| = 1.0 — unit elastic)
A luxury watch increases price from $5,000 to $6,000 (20% increase). Demand falls from 50 to 20 units (60% decrease). What is PED?
% Change in Q = (20 - 50) / 50 = -60% % Change in P = (6,000 - 5,000) / 5,000 = +20% PED = -60% / +20% = -3.0 (|PED| = 3.0 — highly elastic; luxury goods are price-sensitive)
A pharmacy raises insulin prices from $50 to $75 per vial (50% increase). Demand drops only 5% (because patients need it). Calculate PED.
% Change in Q = -5% % Change in P = (75 - 50) / 50 = +50% PED = -5% / +50% = -0.1 (|PED| = 0.1 — highly inelastic; necessities are price-insensitive)
Flashcards
Quick quiz
Q1.A 10% price increase causes a 15% fall in quantity. What is |PED|?
Q2.Which good typically has the most elastic demand?
Q3.A bread bakery lowers prices by 20% and sees a 5% rise in sales. Demand is…
Q4.Inelastic demand means a price increase will…
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Common mistakes
Higher prices always decrease revenue. — Correct: With inelastic demand, higher prices often increase revenue because quantity drop is small.
All luxury goods have elastic demand. — Correct: Some luxury items (Rolex watches) have strong brand loyalty — less price-sensitive than generic competitors.
PED is positive. — Correct: PED is negative (price up → quantity down). We use the absolute value |PED| to compare elasticity.
Necessities always have zero elasticity. — Correct: Necessities are inelastic (|PED| < 1) but not zero — demand does respond somewhat to extreme price changes.
FAQ
Why do companies need to understand price elasticity?
To optimize pricing: elastic goods need competitive pricing; inelastic goods can support higher prices and margins.
How does elasticity change over time?
Long-term elasticity is usually higher than short-term because consumers have time to find substitutes or adjust behavior.
What is cross-price elasticity?
A measure of how demand for one good changes when the price of a substitute (e.g., Coke vs. Pepsi) changes.
Can PED be positive?
Rarely — most goods show negative PED (price up → quantity down). Giffen goods (inferior goods where demand rises with price) are exceptions.