Law of demand tells us that if the price of a good declines then the consumer will buy more of this product. However, it doesn’t mention the quantity of good which will be bought.
The responsiveness (or sensitivity) of demanders to a price change is called product’s price elasticity of demand. For some items it can be very high – for example a new Ferrari, price change of this good can cause very large changes in quantity demanded. Economists say that the demand for these type of products is relative elastic or simply elastic.
For other items change in price doesn’t affect so much quantity bought (an example can be salt, sugar). The demand for such products is relatively inelastic or simply inelastic.
Price Elasticity Coefficient and Formula
In economics price elasticity or inelasticity of demand is denoted by Ed, and it’s calculated by following formula:
Also Ed may be calculated by following formula:
Use of Percentage
Economist use percentage rather that absolute amounts because it’s easier to identify if demand is elastic or not. Also, by using percentage we can correctly compare consumers’ responsiveness to change in price of different items.
We know that price and quantity demanded are inverse related. Thus Ed will always be a negative number. As an example, let’s assume that prices decline, so quantity demanded will increase, which means that the numerator in our formula will positive, but the denominator negative, so Ed will be negative. So economists ignore this minus sign and show only absolute value.
Interpretation of Ed
The Demand is elastic if a specific percentage change in price produces a larger percentage change in quantity demanded. Then Ed>1.
Demand is called inelastic if a specific percentage change in price produces a smaller percentage change in quantity demanded. In this case Ed<1.
The case that separates Elastic and Inelastic Demand occurs when percentage change in price is the same as percentage change in quantity demanded and this situation is called unit elasticity. In this case Ed=0.
When it’s said that demand is inelastic it isn’t meant that consumers are completely unresponsive to a price change. In the case that price change results in no percentage change in quantity demanded, economists say that demand is perfectly inelastic. The price elasticity coefficient is zero because there is no response (change in quantity) to a change in price. Examples of items that may produce perfectly inelastic demand are insulin (for diabetics), heroin (for addicts). A line parallel to the vertical axis represents perfectly inelastic demand graphically.
Conversely, when it’s said that the demand is elastic, it isn’t meant that the demanders are completely responsive for a price change. In this extreme case, when a small reduction in price causes buyers to buy all goods from zero to all that they can obtain, the elasticity coefficient is infinite; economists call this type of demand perfectly elastic. A line parallel to horizontal axis represents perfectly elastic demand.
This formula estimates elasticity at the midpoint of the relevant price range. The midpoint formula for is stated as follows:
Take care; use it when you get that the demand for the same numbers is elastic for one direction and inelastic for the opposite one.
A very useful table for elasticity of demand that almost all economists should remember: