Price Elasticity of Demand
Also known as: elasticity, own-price elasticity.
How strongly the quantity bought responds to a price change: the percentage change in quantity divided by the percentage change in price.
Synthetic dataExamples on this page use synthetic data created for illustration.
Definition
Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. A value of −2 means a 1% price rise goes with about a 2% fall in quantity, but observed price changes alone rarely identify it, because other things change at the same time.
In plain terms
Demand is elastic when the elasticity is below −1 (quantity reacts more than price) and inelastic when it is between −1 and 0. It depends on how easily buyers can substitute, on the kind of product, and on the time horizon.
Estimating it from sales records is harder than the formula suggests. Prices fall during promotions, holidays and clearance, when demand is changing for other reasons. A naive ratio mixes the price effect with those other effects. This is the general problem of Confounding.
Example
A price falls from 20 to 18 (−10%) and units sold rise from 100 to 125 (+25%).
| Reading | Calculation | Elasticity |
|---|---|---|
| Naive | +25% ÷ −10% | −2.5 |
| If the cut coincided with a seasonal peak that would have lifted sales 15% anyway | (125 / 115 − 1) = +8.7%, ÷ −10% | about −0.87 |
The first reading says demand is strongly elastic; the second, inelastic. The sales data alone cannot tell which is right without information about what else changed.
Common misunderstandings
- “Elasticity is a fixed property of the product.” It varies with price level, season, competitors and time horizon.
- “Sales rose after a price cut, so demand is elastic.” Sales may have been rising for another reason.
- “The simple ratio is exact for large changes.” It is an approximation for small changes; other definitions exist for large ones.
References
- Hal R. Varian. Intermediate Microeconomics: A Modern Approach . W. W. Norton, 2014. ISBN 978-0393123968.
- Judea Pearl. Causality: Models, Reasoning, and Inference . Cambridge University Press, 2009. ISBN 978-0521895606.