Lesson preview · Price elasticity of demand
Price elasticity of demand: measuring it and what drives it
~8 min · Free to read
Imagine two price rises on the same street. The town’s only bus company puts up the price of a monthly pass by 10%, and it sells 4% fewer passes. A café puts up the price of its muffins by 10%, and it sells 30% fewer muffins.
The price rises by the same percentage in both cases, but buyers react differently. Most riders keep buying the pass, because they still have to get to school or work. Many muffin buyers simply go to the bakery next door.
Key Term
Price elasticity of demand
Price elasticity of demand (PED) measures how strongly buyers react to a change in a good’s price. It divides the percentage change in the amount people buy (the quantity demanded) by the percentage change in price.
Quantity goes on top and price on the bottom. Work out each percentage change as (new − old) ÷ old × 100.
For the bus pass, PED = −4% ÷ 10% = −0.4. For the muffins, PED = −30% ÷ 10% = −3. Read −0.4 as: for every 1% the price rises, the quantity demanded falls by 0.4%.
PED is negative because a higher price means a smaller quantity demanded (the law of demand). Always write the minus sign. To judge how strongly buyers react, look at its size and ignore the sign.
Key Term
Elastic, inelastic or unit elastic
- Elastic (size bigger than 1): quantity changes by a bigger percentage than price. Muffin demand, at −3, is elastic.
- Inelastic (size smaller than 1): quantity changes by a smaller percentage than price. Bus pass demand, at −0.4, is inelastic.
- Unit elastic (size exactly 1, so PED = −1): both change by the same percentage.
Two extremes mark the limits. With perfectly inelastic demand (PED = 0), buyers take the same amount at any price. With perfectly elastic demand, the smallest price rise loses every buyer. Market demand for real goods sits in between. One small wheat farm among thousands faces almost perfectly elastic demand.
Key Term
What makes demand elastic
- Substitutes. These are other goods that do the same job. The more there are, and the closer they are, the more elastic demand is. A street may have five places selling muffins but one bus route.
- Necessity. People keep buying what they need, such as medicine, so demand is inelastic. A holiday abroad can wait, so its demand is more elastic.
- Share of income. Salt is so cheap that a 10% rise goes unnoticed. A 10% rise on a 2,000-dollar holiday costs 200 dollars, and people notice.
- Time. Given more time, buyers find other options, so demand becomes more elastic. A driver can’t change car overnight, but can by next year.
- How widely the market is defined. Demand for petrol in general is inelastic. Demand for petrol at one station is elastic, because drivers can fill up across the road.
From the midpoints, as on the card, PED is about −0.43. From the old values, as in the formula above, it is −4% ÷ 10% = −0.4. Either way, demand for the pass is inelastic: riders have few substitutes for the town’s only bus.
Trap · Common Misconception
"A steep demand curve means inelastic demand"
Slope compares changes in units; elasticity compares percentage changes. Along a straight line, slope stays the same but elasticity changes.
Take a straight demand line where every 1-dollar cut adds 10 sales. At 8 dollars, 20 sell. A cut to 7 dollars is a 12.5% price cut, and sales rise 50% to 30: PED = −4, elastic. At 3 dollars, 70 sell. A cut to 2 dollars is a 33% price cut, and sales rise 14% to 80: PED is about −0.43, inelastic. Same slope, different elasticity, so you can’t judge elasticity by steepness alone.
Steepness helps only when two demand curves pass through the same point: there, the steeper one is less elastic.
Trap · Common Misconception
"Inelastic means buyers don't react"
Inelastic means buyers react less than the price changes, not that they don’t react. Bus pass sales still fell by 4%. Only perfectly inelastic demand shows no reaction at all.
Real example: car fuel. A 2004 review of studies, mostly from North America and Europe, used data from 1929 to the 1990s. It asked what happened when fuel got 10% dearer after allowing for inflation, and stayed that way. Within a year, drivers bought about 2.5% less fuel on average: a PED of about −0.25. After about five years, they bought about 6% less: about −0.6.
At first, people drove a little less and in ways that saved fuel. Later, they also switched to cars that use less fuel, so demand grew more elastic.
Evidence: robust that the long-run fall is bigger, mixed on sizes. Some later studies found much smaller short-run falls.
Check yourself · no marks
A shop cuts the price of a phone case from 20 to 16 dollars. Weekly sales rise from 100 to 130. What is the PED, and is demand elastic or inelastic?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
The price of bread rises by 10%, and the quantity of bread demanded falls by 3%. What is the price elasticity of demand, and what does it say about demand for bread?
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