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📊 What is Price Elasticity of Demand?

Price Elasticity of Demand (PED) measures how responsive the quantity demanded of a product is to a change in its price. It tells you: "If I change my price by 10%, how much will demand change?"

Key Point: PED helps businesses make smart pricing decisions. Should you raise prices to increase revenue, or lower them to boost sales? The answer depends on whether your product is elastic (sensitive to price changes) or inelastic (not very sensitive).

The PED Formula

PED = (% Change in Quantity Demanded) / (% Change in Price)
Using Midpoint Method (more accurate):
PED = [(Q2 - Q1) / ((Q2 + Q1)/2)] / [(P2 - P1) / ((P2 + P1)/2)]
Where:
Q1 = Original quantity demanded
Q2 = New quantity demanded
P1 = Original price
P2 = New price

Simple Example

A coffee shop raises price from $4 to $5. Sales drop from 200 to 160 cups per day.

% Change in Quantity = (160 - 200) / ((160 + 200)/2) = -40 / 180 = -22.2%
% Change in Price = (5 - 4) / ((5 + 4)/2) = 1 / 4.5 = 22.2%
PED = -22.2% / 22.2% = -1.0
PED = 1.0 (using absolute value)

Interpretation: PED of 1.0 means demand is unit elastic. A 1% price increase causes exactly 1% decrease in quantity demanded.

Interpreting PED Values

PED Value Classification What It Means Example Products
PED > 1 Elastic Demand very sensitive to price Luxury cars, designer clothing, restaurant meals
PED = 1 Unit Elastic Demand changes proportionally Mid-range consumer goods
PED < 1 Inelastic Demand not very sensitive Petrol, electricity, basic groceries, medicine
PED = 0 Perfectly Inelastic Demand unchanged regardless of price Life-saving drugs, insulin (rare in reality)
PED = ∞ Perfectly Elastic Any price increase kills all demand Perfect competition markets (theoretical)

Why PED Matters for Business

Pricing Strategy:

  • Elastic products (PED > 1): Lower prices to increase revenue (volume gains beat price loss)
  • Inelastic products (PED < 1): Raise prices to increase revenue (price gains beat volume loss)

Revenue Impact Example:

Elastic Product (PED = 2.0):

Current: $50 price × 1,000 units = $50,000 revenue
Raise price 10% to $55
Demand falls 20% (PED of 2.0) to 800 units
New revenue: $55 × 800 = $44,000
Result: Lost $6,000! Wrong move.

Inelastic Product (PED = 0.5):

Current: $50 price × 1,000 units = $50,000 revenue
Raise price 10% to $55
Demand falls only 5% (PED of 0.5) to 950 units
New revenue: $55 × 950 = $52,250
Result: Gained $2,250! Good move.
💡 The Revenue Rule

For Elastic Products (PED > 1): Price ↑ → Revenue ↓ and Price ↓ → Revenue ↑
For Inelastic Products (PED < 1): Price ↑ → Revenue ↑ and Price ↓ → Revenue ↓
For Unit Elastic (PED = 1): Price changes don't affect total revenue

Factors That Affect Elasticity

1. Availability of Substitutes

More substitutes = more elastic demand. If Coca-Cola raises prices, you can switch to Pepsi easily.

  • Specific brands (Coke): Very elastic (many alternatives)
  • Product categories (soft drinks): Moderately elastic
  • Necessities with no substitutes (electricity): Inelastic

2. Necessity vs Luxury

Necessities are inelastic (you need them). Luxuries are elastic (you want them but can do without).

  • Bread, milk, petrol: Inelastic
  • Restaurant meals, holidays, jewelry: Elastic

3. Proportion of Income

Items that cost a small % of income are inelastic. Big purchases are elastic.

  • Salt, matches, toothpicks: Inelastic (too cheap to care)
  • Cars, houses, appliances: Elastic (major purchase decisions)

4. Time Horizon

Demand becomes more elastic over time as people find alternatives.

  • Short-term: Petrol is inelastic (must fill up today)
  • Long-term: Petrol is more elastic (can buy fuel-efficient car, move closer to work)

5. Brand Loyalty

Strong brands have more inelastic demand. People pay premium prices.

  • Apple products: Relatively inelastic (loyal customers)
  • Generic products: Very elastic (price-sensitive buyers)

Common PED Values by Product Type

Product Category Typical PED Elasticity Type
Salt 0.1 Highly inelastic
Petrol (short-term) 0.2-0.3 Inelastic
Electricity 0.5 Inelastic
Coffee 0.7 Moderately inelastic
Housing (owner-occupied) 1.0 Unit elastic
Restaurant meals 1.6 Elastic
Air travel (leisure) 1.5-2.0 Elastic
Luxury cars 2.5 Very elastic
⚠️ Important Notes

PED is always expressed as positive value (absolute value) for easier interpretation, even though technically it's negative (price up, quantity down).

PED varies along the demand curve. At high prices, demand is usually more elastic. At low prices, more inelastic.

PED is different from price elasticity of supply (PES), which measures seller responsiveness, not buyer responsiveness.

🔢 Calculating Price Elasticity of Demand

Example 1: Coffee Shop Price Change

Scenario: Local cafe changes coffee price

Data:

Original price (P1): $4.50
New price (P2): $5.00
Original quantity (Q1): 300 cups/day
New quantity (Q2): 270 cups/day

Step 1: Calculate % Change in Quantity (Midpoint Method)

% ΔQ = (Q2 - Q1) / ((Q2 + Q1)/2) × 100
% ΔQ = (270 - 300) / ((270 + 300)/2) × 100
% ΔQ = -30 / 285 × 100
% ΔQ = -10.53%

Step 2: Calculate % Change in Price

% ΔP = (P2 - P1) / ((P2 + P1)/2) × 100
% ΔP = (5.00 - 4.50) / ((5.00 + 4.50)/2) × 100
% ΔP = 0.50 / 4.75 × 100
% ΔP = 10.53%

Step 3: Calculate PED

PED = |% ΔQ / % ΔP|
PED = |-10.53% / 10.53%|
PED = 1.0

Interpretation: Coffee is unit elastic at this price point. A 10.53% price increase caused exactly 10.53% decrease in sales.

Revenue Impact:

Old revenue: $4.50 × 300 = $1,350/day
New revenue: $5.00 × 270 = $1,350/day
Change: $0 (unit elastic means revenue unchanged)

Example 2: Electronics Store Sale

Scenario: TV price drops during sale

Data:

Original price: $1,200
Sale price: $900
Original sales: 20 units/month
Sale period sales: 45 units/month

Calculation:

% ΔQ = (45 - 20) / ((45 + 20)/2) × 100 = 76.92%
% ΔP = (900 - 1200) / ((900 + 1200)/2) × 100 = -28.57%
PED = |76.92% / -28.57%|
PED = 2.69 (Elastic)

Interpretation: TVs are very elastic. A 28.57% price cut increased demand by 76.92%.

Revenue Impact:

Old revenue: $1,200 × 20 = $24,000
Sale revenue: $900 × 45 = $40,500
Increase: $16,500 (+68.75%)
Strategy: For elastic products, lowering prices increases total revenue. The volume gain (125% more units) outweighs the price loss (25% lower price).

Example 3: Petrol Price Increase

Scenario: Petrol station raises prices

Data:

Price rises from $2.20 to $2.50 per liter
Weekly sales drop from 50,000L to 48,000L

Calculation:

% ΔQ = (48,000 - 50,000) / 49,000 × 100 = -4.08%
% ΔP = (2.50 - 2.20) / 2.35 × 100 = 12.77%
PED = |-4.08% / 12.77%|
PED = 0.32 (Inelastic)

Interpretation: Petrol demand is inelastic. People need to drive, so a 12.77% price increase only reduces demand by 4.08%.

Revenue Impact:

Old revenue: $2.20 × 50,000 = $110,000
New revenue: $2.50 × 48,000 = $120,000
Increase: $10,000 (+9.1%)
Strategy: For inelastic products, raising prices increases total revenue. The price gain (13.6% higher) outweighs the volume loss (4% fewer liters).

Using PED for Pricing Decisions

Decision Framework:

Your PED To Increase Revenue Why
PED > 1 (Elastic) Lower prices Volume increase beats price decrease
PED < 1 (Inelastic) Raise prices Price increase beats volume decrease
PED = 1 (Unit) Either (revenue stays same) Changes cancel out

Estimating PED Without Data

If you don't have sales data, estimate PED based on product characteristics:

High PED (Elastic > 1.5) if product has:

  • Many close substitutes
  • Luxury/non-essential nature
  • High cost relative to income
  • Highly competitive market
  • Easy to delay purchase

Low PED (Inelastic < 0.5) if product has:

  • Few or no substitutes
  • Necessity/essential nature
  • Low cost relative to income
  • Strong brand loyalty or addiction
  • Immediate need (can't delay)

Testing Price Changes Safely

A/B Testing Method:

1. Select two similar customer groups
2. Keep price same for Group A (control)
3. Change price for Group B (test)
4. Compare demand changes
5. Calculate PED from results

Small Step Method:

1. Make small price change (5-10%)
2. Monitor demand for 2-4 weeks
3. Calculate PED
4. If profitable, continue; if not, revert
⚠️ Common Mistakes

Ignoring competitors: Your PED changes if competitors also change prices
Wrong time period: Measure demand after market adjusts (not day 1)
External factors: Season, economy, trends affect demand independently of price
Not using midpoint method: Simple % method gives different results for increases vs decreases

🌍 Real-World Price Elasticity Examples

1
Streaming Service Price Increase

Netflix NZ raises subscription price

The Situation:

Old price: $14.99/month
New price: $16.99/month (13.3% increase)
Subscribers before: 850,000
Subscribers after: 810,000

PED Calculation:

% ΔQ = (810k - 850k) / 830k × 100 = -4.82%
% ΔP = (16.99 - 14.99) / 15.99 × 100 = 12.51%
PED = |-4.82% / 12.51%|
PED = 0.39 (Inelastic)

Revenue Impact:

Metric Before After Change
Subscribers 850,000 810,000 -40,000 (-4.7%)
Monthly revenue $12.74M $13.76M +$1.02M (+8.0%)
Annual revenue $152.9M $165.1M +$12.2M
Outcome: Despite losing 40,000 subscribers, Netflix increased revenue by $12.2M annually. This works because demand is inelastic (PED = 0.39). Customers with established viewing habits and family sharing don't easily cancel.

Why Inelastic?

  • Content library lock-in (favorite shows)
  • Shared accounts (multiple users per subscription)
  • Habit formation (part of daily routine)
  • Relative affordability ($17/month vs $20+ for cinema)
  • Switching costs (learning new interface, losing watchlist)
2
Airline Ticket Pricing

Air NZ adjusts domestic flight prices

Business vs Leisure Travelers:

Business Travelers (Wellington-Auckland):

Price increase: $180 → $220 (22% increase)
Weekly bookings drop: 1,200 → 1,140 (5% decrease)
PED = 5% / 22% = 0.23 (Very inelastic)

Leisure Travelers (Auckland-Queenstown):

Price increase: $150 → $190 (26.7% increase)
Weekly bookings drop: 800 → 600 (25% decrease)
PED = 25% / 26.7% = 0.94 (Nearly unit elastic)

Revenue Impact:

Segment Old Revenue New Revenue Change
Business $216,000 $250,800 +$34,800 (+16%)
Leisure $120,000 $114,000 -$6,000 (-5%)
Strategy: Airlines use price discrimination. Business travelers (inelastic, must travel for meetings) get charged more. Leisure travelers (elastic, can choose not to go) get discounts and sales. This maximizes revenue from each segment.

Why Different Elasticities?

Factor Business Leisure
Necessity Must attend meeting Optional holiday
Who pays Company pays Personal money
Flexibility Fixed dates Can reschedule
Substitutes Limited (need direct flight) Many (drive, different destination)
3
Supermarket Bread Pricing

Countdown tests bread price changes

Premium vs Budget Bread:

Premium Artisan Bread:

Price: $5.50 → $6.50
Daily sales: 200 → 140 loaves
% ΔQ = -30%, % ΔP = 18.2%
PED = 1.65 (Elastic)

Budget White Bread:

Price: $2.00 → $2.30
Daily sales: 1,000 → 950 loaves
% ΔQ = -5.1%, % ΔP = 14.3%
PED = 0.36 (Inelastic)

Revenue Results:

Product Old Revenue New Revenue Decision
Premium bread $1,100 $910 Revert price (lost $190/day)
Budget bread $2,000 $2,185 Keep price (gained $185/day)
💡 Lesson Learned

Premium products are luxuries (elastic). Budget staples are necessities (inelastic). Different pricing strategies needed for different segments, even within the same product category.

4
Gym Membership Price Testing

Les Mills gym tests membership pricing

Market Research Results:

Option A: Lower Price

Price drop: $65 → $49/month
Memberships increase: 400 → 580
% ΔQ = +45%, % ΔP = -24.6%
PED = 1.83 (Elastic)
Revenue: $26,000 → $28,420 (+9.3%)

Option B: Raise Price

Price increase: $65 → $75/month
Memberships decrease: 400 → 360
% ΔQ = -10%, % ΔP = 14.3%
PED = 0.70 (Inelastic but close to 1)
Revenue: $26,000 → $27,000 (+3.8%)

Decision Analysis:

Consideration Lower Price Raise Price
Revenue gain $2,420 (+9.3%) $1,000 (+3.8%)
Members 580 (+45%) 360 (-10%)
Capacity strain High (crowding) Low (less crowded)
Wear & tear Higher costs Lower costs
Per-member profit Lower margin Higher margin
Final Decision: Gym chose to raise price to $75. Although lower revenue gain ($1,000 vs $2,420), they avoid crowding, reduce equipment wear, and maintain premium positioning. Sometimes the highest revenue isn't the best strategy when capacity is limited.

🎯 Test Your Knowledge

Complete this 10-question quiz on Price Elasticity of Demand

1. What does PED measure?
How much profit you make
How responsive demand is to price changes
How much to charge customers
How many units to produce
2. If PED = 2.5, the product is:
Inelastic
Elastic
Unit elastic
Perfectly inelastic
3. For an elastic product (PED > 1), to increase revenue you should:
Raise prices
Lower prices
Keep prices the same
Stop selling the product
4. Which product is most likely to be inelastic?
Designer handbags
Restaurant meals
Insulin for diabetics
Luxury cars
5. Price rises 20%, quantity demanded falls 10%. What is PED?
0.5 (inelastic)
2.0 (elastic)
10 (very elastic)
20 (perfectly elastic)
6. Products with many substitutes tend to have:
Inelastic demand
Elastic demand
Zero elasticity
Negative elasticity
7. For an inelastic product (PED < 1), raising prices will:
Decrease revenue
Increase revenue
Not affect revenue
Eliminate demand
8. Why is petrol typically inelastic in the short term?
It's very cheap
Few immediate substitutes, people need to drive
It's a luxury item
Strong brand loyalty
9. If PED = 1.0 and you raise price by 10%, revenue will:
Increase 10%
Decrease 10%
Stay approximately the same
Double
10. Over time, demand generally becomes:
More elastic (people find alternatives)
More inelastic
Stays exactly the same
Becomes zero

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