Elasticity of Demand

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Definition of Elasticity of Demand:

The elasticity of demand measures the relationship between a price change and the resulting change in the quantity demanded for a good or service. The term is more accurately referred to as the "price elasticity of demand."

Detailed Explanation:

Pricing is one of the most significant challenges for most businesses. Given the law of demand, we know that if a company increases its price, it will lose sales. Would the reduction in sales be offset by the increase in revenues generated by the higher price?  Understanding a good or service’s elasticity of demand is useful in reaching pricing decisions. Economists use the elasticity of demand to measure a product or service’s sensitivity to price changes. Some products may have a demand that is very vulnerable to changes in price. Other products may see a small drop in the quantity sold after a price change. Necessities, such as gasoline or electrical power, are less sensitive to price increases than luxuries, such as dinner at a fine restaurant or travel to foreign countries. When the price of gasoline increases, people will continue to purchase gas because they must commute to their jobs, shop for groceries, or maintain their social lives. The law of demand dictates that consumers will seek ways to purchase less gas at higher prices, but the decrease in purchases may be slight. Perhaps people will carpool or use mass transportation. For all but the highest prices of each product, these goods have an inelastic demand because the quantity demanded is less vulnerable to price changes than other goods, such as luxury items.

Watch as two budding entrepreneurs quickly learn about the elasticity of demand when revenues fall after increasing the price of a cup of hot chocolate.

The formula for the price elasticity of demand is:

An elasticity of demand exceeding one means that a small increase in price will result in a larger change in the quantity demanded. For example, if the quantity demanded decreased 15% following a 10% increase in price, the price elasticity of demand would equal 1.5. Businesses may want to reconsider increasing their price if they have an elastic price elasticity of demand because their revenues would decrease. On the other hand, total revenues would increase if a company increases the price of a product with an inelastic price elasticity of demand. In these cases, the price elasticity of demand is less than one.

Dig Deeper With These Free Lessons:

Price Elasticity of Demand – How Consumers Respond to Price Changes
Demand – The Consumer's Perspective
Changes in Demand – When Consumer Tastes Change
Supply and Demand – Producers and Consumers Reach Agreement
Who Really Pays An Excise Tax

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