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Price Elasticity of Demand Definition
The ratio of change in the quantity of product that is demanded or the product purchased to the change in price is called as Price Elasticity of Demand. Its formula in terms of economics is as follows
PED = (dQ/Q) / (dP/P)
Economists use Price Elasticity to interpret how the real economy works. They get to know about how the supply or demand changes. For example, the price of some goods does not change by changing the supply or demand of those goods. So they are termed as inelastic. Let us take an example to understand inelastic goods. People want to travel or move around the world to accomplish their tasks. For this purpose, they have to buy gasoline. If the price of oil is increased, then the people will buy the amount of gas in the same quantity.
Whereas if we talk about inelastic goods, then we see very noticeable changes in the price of such goods because of the demand or supply of those goods changes. Now let’s consider the formula and examine how the demand side of the equation is affected by varying the price elasticity of demand. You can see the difference in the price elasticity of supply as well.
A Little More on Price Elasticity of Demand
If the quantity demanded shows a very noticeable change by changing the price of that quantity then it is known as elastic quantity. It means that the quantity is stretched very much from its mean position or preliminary point. Similarly, if the quantity exhibits a very small or minor change in reaction to its price, such a quantity is known as inelastic quantity. It shows that the quantity is not much fluctuated from its previous point.
If the buyer substitutes one product with another product whose price is increasing very fast, the demand for the product will decrease in the same manner. Let’s make it easier to understand. If the people rate coffee and tea equally, and the price of coffee increases, then it would be quite easier for people to choose tea instead of coffee. Because they like coffee and tea equally. So, they will buy tea instead of coffee, then the demand for coffee will fall automatically. This is because both are a very good replacement for each other.
If you have an option either to buy a product or wait until its price goes down, then, of course, you will wait and use the old one that you already have unless the old product is damaged. For instance, if you have an old washing machine and it works perfectly but you want to buy a new one when you go to the market and check the price of a new machine. If the price is too high, you will obviously change your mind and wait until the price falls. So, the quantity will fall when its price becomes high.
But if we take a look into less discretionary goods i.e. the goods in which we do not have the option to buy or not. The quantity demanded of such goods will not fall as much as it falls for the more discretionary goods. We can say, the less discretionary a good is, the less its quantity demanded will decrease. For example, the buyers “pay for the privilege” means they pay a large amount for a small house, or addictive products or they require add-on products. Add-on products are those which have some extra features and additional charges are applied to buy such products. It includes tobacco, alcohol and many other add-on products.
Sin taxes are applied to such products. Lost tax revenues on the sold products generally increased by the higher taxes on the products still sold. Inkjet printer cartridges and college textbooks are examples of add-on products. These goods are very important to buy. They can’t be forgone or neglected as they are not discretionary items. They do not have any replacement. For example, only HP printers can use HP ink.
Just like demand and supply, time is also very important. Due to changes in price, demand also changes. If a product is sold on a certain price, its demand response is variable. It may change as the season changes.
Examples of Price Elasticity of Demand
It is commonly a rule of thumb that if the quantity of an item demanded or bought fluctuates more than the variations in the price, then the item or product is considered elastic. (The price is increased by +five percent, but the demand is decreased by -ten percent. On the other hand, if the quantity of an item demanded or bought is the same as the price of that item then it is considered as Unit elasticity.(ten percent/ ten percent is equal to one). If the quantity bought or demanded changes lower than its price, it is said to as inelastic (-five percent demanded a +ten percent variation in price).
Let’s calculate the elasticity of demand. Let the price of an apple is decreased by 6 percent from USD 1.99 a bushel to USD 1.87 a bushel. Then you see that the customers or purchasers will purchase more apples. Their purchase is increased by 20 percent.
Elasticity of apples = 0.20/0.06 = 3.33
In terms of demand, it shows that the apples are elastic.
- References for Price Elasticity of Demand
Academic Research on Price Elasticity of Demand
The impact of food prices on consumption: a systematic review of research on the price elasticity of demand for food. This paper explains the common phenomena of price change and its impact on the demand for the products. The authors examined 160 approaches on the PED for main food types and changes in estimates. For food items and nonalcoholic items, the range of price elasticity remained as 0.27-0.81. The author evaluates the price impacts on the basis of substitutes and price feedback in populations at risk.
Price elasticity of demand for crude oil: estimates for 23 countries, Cooper, J. C. (2003). This study applies a Multiple Regression Theory as an extension of the NPA model (Nerlove Partial Adjustment). It is used to assess the PEDs of crude oil in twenty-three countries for short term as well as long term. Its international demand is fairly insensitive to price variations.
• Evidence of a shift in the short-run price elasticity of gasoline demand, Hughes, J. E., Knittel, C. R., & Sperling, D. (2006). This paper evaluates the effects of PED on gasoline. The present demand elasticity is different from the old one. This is because of the structural and behavioural changes in the prices of gasoline. The authors make a comparison of its price elasticity and income elasticity from 1975-1980 and 2001-2006. There is a great difference in the short term elasticities while a minor difference in the long term elasticities.
The price elasticity of demand for common stock, Loderer, C., Cooney, J. W., & Van Drunen, L. D. (1991). The Journal of Finance, 46(2), 621-651. This paper is based on the PED for the common stock of a person corporation. Though it is assumed that the demand is PE (Perfectly Elastic), it is little. The regulated companies announce the offers of primary stock that reduces their stock prices. Its after-effects have been discussed thoroughly.
Using full duality to show that simultaneously additive direct and indirect utilities implies unitary price elasticity of demand, Samuelson, P. A. (1965). Econometrica: Journal of the Econometric Society, 781-796. This paper states that the IUF (Indirect Utility Function) is an idea that provides the highest value of an individual’s ordinal utility within the limitations of the income and prices. The author explains with the help of a numerical example and the results match with the Cobb Douglas Model or pure Bernoulli Marshall case.
• The price elasticity of demand for whole life insurance, Babbel, D. F. (1985). The Journal of Finance, 40(1), 225-239. This research presents an RPI (Real Price Index) for the whole life insurance in the US from 1953-1979. The new purchases are negatively in relation to the variations in the cost index. However, its strong PED does not make sure that the insurance companies show a high price competition.
• On the price elasticity of demand for patents, Rassenfosse, G. D., & Potterie, B. V. P. D. L. (2012). Oxford Bulletin of Economics and Statistics, 74(1), 58-77. This paper analyses the effect of the patent fee on the Patent Demand. The dataset of the patent offices of the United States, EPO (European) and Japan has been taken since 1980. The results show that fee has severely gone down at the European Patent Office over the 90s. The PED of patents is almost-0.30.
The dynamics of price elasticity of demand in the presence of reference price effects, Fibich, G., Gavious, A., & Lowengart, O. (2005). Journal of the Academy of Marketing Science, 33(1), 66-78. The writers formulate the expression for the PED with the impacts of the reference price. It has to be noticed as soon as the price changes. So, the price elasticity of this immediate term is more than the one for the long term. The authors have given quantitative definitions of these economic terms. They use parameters of discrete memory and AIT (Average Interpurchase Time).
Consumers’ price elasticity of demand modeling with economic effects on electricity markets using an agent-based model, Thimmapuram, P. R., & Kim, J. (2013). IEEE Transactions on Smart Grid, 4(1), 390-397. A technology using which the customers can show PED in a smart grid atmosphere is called AMI or Automated Metering Infrastructure. The authors use EMCAS (Electricity Market Complex Adaptive System) to simulate the reformed electricity markets and to find the effect of customers PED on the performance of the market. The findings are shared with respect to its application in the Korean Power System.
Price elasticity of demand for term life insurance and adverse selection, Pauly, M. V., Withers, K. H., Subramanian-Viswana, K., Lemaire, J., & Hershey, J. C. (2003). National bureau of economic research. This research is a statistical calculation of the demand elasticities of price and risk in terms of life insurance. It shows that the elasticity according to the variations in premiums is normally higher as compared to the elasticity according to variations in risk. Likewise, the elasticity ranging from -0.3 – -0.5 is relatively low. It has an adverse effect on life insurance.
On the theoretical relationship between systematic risk and price elasticity of demand, Conine Jr, T. E. (1983). Journal of Business Finance & Accounting, 10(2), 173-182. The objective of this paper is to show a theoretical bridge in PED and procedural risk for the output of a company. The findings are that its key determinants are PED, the certainty equal to the parameter of random demand, variable cost, covariances and the market cash flow.