EFA (5): Price elasticity of demand

Imagine you have a product that is not selling as well as it did in the past (this shouldn't be hard at the moment). You are thinking about changing the price to increase your total revenue (or "turnover").

You are not sure, however, whether you should put the price up or down.

A key factor in this decision is the price elasticity of demand for your product. This is the subject of the fifth item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

In most cases, the demand for a product rises when the price falls and vice versa (others things being equal). The price elasticity of demand measures how responsive demand is to price changes. It is calculated by the percentage change in demand divided by the percentage change in price.

Let's take a simple example.

Imagine that you lower your price by ten per cent and that the demand for your product rises by exactly ten per cent. In this case, your product has an elasticity of one or "unit elasticity". Your turnover from the product will remain (more or less) the same.

If demand rises by more than ten per cent, the price elasticity is greater than one, and the demand for your product is said to be "elastic". Your turnover would rise in this situation.

If, on the other hand, demand rises by less than ten percent, the price elasticity is less than one, and demand is said to be "inelastic". Your turnover will fall in this case.

In an extreme situation where demand for a product is not at all responsive to price, we say that demand is "perfectly inelastic". This would be the case when you have no choice as to whether you buy the product, whatever the price — for example, a life-saving drug.

At the other extreme, a "perfectly elastic" good is one for which demand changes infinitely in response to a small price change. For example, a price rise would lead to nobody buying the good at all. This might be the situation if you have a number of sellers of an identical product and one tries to charge more than the others.

In general, demand is more elastic when (a) the product is not essential; (b) there are many competitors selling the product; (c) there are possible substitutes for the product; (d) we consider a longer time period.

For example, the demand for oil (and petrol) tends to be relatively inelastic when prices rise in the short term, but more elastic over a longer period, as people change to other types of fuel or buy more economical cars.

So, should you put your price up or down? Er, sorry, can't tell you. Estimating the price elasticity of demand for a particular product is very complicated. Unfortunately, you can't conduct a controlled experiment and keep all other factors (incomes, tastes, etc.) constant.

In practice, you have to test the market — and try to discover how elastic your customers are.