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## Price elasticity of demand

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"Price elasticity" redirects here. It is not to be confused with Price elasticity
of supply.
Price elasticity of demand (PED or Ed) is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a
change in its price, ceteris paribus. More precisely, it gives the percentage
change in quantity demanded in response to a one percent change in price (ceteris
paribus).

Price elasticities are almost always negative, although analysts tend to ignore the
sign even though this can lead to ambiguity. Only goods which do not conform to the
law of demand, such as Veblen and Giffen goods, have a positive PED. In general,
the demand for a good is said to be inelastic (or relatively inelastic) when the
PED is less than one (in absolute value): that is, changes in price have a
relatively small effect on the quantity of the good demanded. The demand for a good
is said to be elastic (or relatively elastic) when its PED is greater than one (in
absolute value): that is, changes in price have a relatively large effect on the
quantity of a good demanded. Demand for a good is:

## {\displaystyle e_{\langle p\rangle }={\frac {\mathrm {d} Q/Q}{\mathrm {d} P/P}}}

e_{{\langle p\rangle }}={\frac {{\mathrm {d}}Q/Q}{{\mathrm {d}}P/P}}
Revenue is maximized when price is set so that the PED is exactly one. The PED of a
good can also be used to predict the incidence (or "burden") of a tax on that good.
Various research methods are used to determine price elasticity, including test
markets, analysis of historical sales data and conjoint analysis.

Contents [hide]
1 Definition
2 Point-price elasticity of demand
3 Arc elasticity
4 History
5 Determinants
6 Relation to marginal revenue
7 Effect on total revenue
8 Effect on tax incidence
9 Optimal pricing
9.1 Constant elasticity and optimal pricing
9.2 Non-constant elasticity and optimal pricing
9.3 Limitations of revenue-maximizing and profit-maximizing pricing strategies
10 Selected price elasticities
11 See also
12 Notes
13 References
14 External links
Definition
The variation in demand in response to a variation in price is called the price
elasticity of demand. It may also be defined as the ratio of the percentage change
in demand to the percentage change in price of particular commodity. The formula
for the coefficient of price elasticity of demand for a good is:

## {\displaystyle e_{\langle p\rangle }={\frac {\mathrm {d} Q/Q}{\mathrm {d} P/P}}}

e_{{\langle p\rangle }}={\frac {{\mathrm {d}}Q/Q}{{\mathrm {d}}P/P}}
The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the "law of
demand". For example, if the price increases by 5% and quantity demanded
decreases by 5%, then the elasticity at the initial price and quantity = -5%/5% =
-1. The only classes of goods which have a PED of greater than 0 are Veblen and
Giffen goods. Although the PED is negative for the vast majority of goods and
services, economists often refer to price elasticity of demand as a positive value
(i.e., in absolute value terms).

## This measure of elasticity is sometimes referred to as the own-price elasticity of

demand for a good, i.e., the elasticity of demand with respect to the good's own
price, in order to distinguish it from the elasticity of demand for that good with
respect to the change in the price of some other good, i.e., a complementary or
substitute good. The latter type of elasticity measure is called a cross-price
elasticity of demand.

As the difference between the two prices or quantities increases, the accuracy of
the PED given by the formula above decreases for a combination of two reasons.
First, the PED for a good is not necessarily constant; as explained below, PED can
vary at different points along the demand curve, due to its percentage nature.
 Elasticity is not the same thing as the slope of the demand curve, which is
dependent on the units used for both price and quantity. Second, percentage
changes are not symmetric; instead, the percentage change between any two values
depends on which one is chosen as the starting value and which as the ending value.
For example, if quantity demanded increases from 10 units to 15 units, the
percentage change is 50%, i.e., (15 - 10) 10 (converted to a percentage). But if
quantity demanded decreases from 15 units to 10 units, the percentage change is
-33.3%, i.e., (10 - 15) 15.

## Two alternative elasticity measures avoid or minimise these shortcomings of the

basic elasticity formula: point-price elasticity and arc elasticity.

## Point-price elasticity of demand

The point elasticity of demand method is used to determine change in demand within
the same demand curve, basically a very small amount of change in demand is
measured through point elasticity. One way to avoid the accuracy problem described
above is to minimize the difference between the starting and ending prices and
quantities. This is the approach taken in the definition of point-price elasticity,
which uses differential calculus to calculate the elasticity for an infinitesimal
change in price and quantity at any given point on the demand curve:

## {\displaystyle E_{d}={\frac {P}{Q_{d}}}\times {\frac {\mathrm {d} Q_{d}}{\mathrm

{d} P}}} E_{d}={\frac {P}{Q_{d}}}\times {\frac {{\mathrm {d}}Q_{d}}{{\mathrm
{d}}P}}
In other words, it is equal to the absolute value of the first derivative of
quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided
by its quantity (Qd). However, the point-price elasticity can be computed only
if the formula for the demand function, {\displaystyle Q_{d}=f(P)} Q_{d}=f(P), is
known so its derivative with respect to price, {\displaystyle {dQ_{d}/dP}}
{dQ_{d}/dP}, can be determined.

## In terms of partial-differential calculus, point-price elasticity of demand can be

defined as follows: let {\displaystyle \displaystyle x(p,w)} \displaystyle
x(p,w) be the demand of goods {\displaystyle x_{1},x_{2},\dots ,x_{L}}
x_{1},x_{2},\dots ,x_{L} as a function of parameters price and wealth, and let
{\displaystyle \displaystyle x_{l}(p,w)} \displaystyle x_{l}(p,w) be the demand for
good {\displaystyle \displaystyle l} \displaystyle l. The elasticity of demand for
good {\displaystyle \displaystyle x_{l}(p,w)} \displaystyle x_{l}(p,w) with respect
to price {\displaystyle p_{k}} p_{k} is

## {\displaystyle E_{x_{l},p_{k}}={\frac {\partial x_{l}(p,w)}{\partial p_{k}}}\cdot

{\frac {p_{k}}{x_{l}(p,w)}}={\frac {\partial \log x_{l}(p,w)}{\partial \log
p_{k}}}} E_{{x_{l},p_{k}}}={\frac {\partial x_{l}(p,w)}{\partial p_{k}}}\cdot
{\frac {p_{k}}{x_{l}(p,w)}}={\frac {\partial \log x_{l}(p,w)}{\partial \log
p_{k}}}
Arc elasticity
Main article: arc elasticity
A second solution to the asymmetry problem of having a PED dependent on which of
the two given points on a demand curve is chosen as the "original" point will and
which as the "new" one is to compute the percentage change in P and Q relative to
the average of the two prices and the average of the two quantities, rather than
just the change relative to one point or the other. Loosely speaking, this gives an
"average" elasticity for the section of the actual demand curvei.e., the arc of
the curvebetween the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity
is defined mathematically as:

## {\displaystyle E_{d}={\frac {\frac {P_{1}+P_{2}}{2}}{\frac {Q_{d_{1}}+Q_{d_{2}}}

{2}}}\times {\frac {\Delta Q_{d}}{\Delta P}}={\frac {P_{1}+P_{2}}{Q_{d_{1}}
+Q_{d_{2}}}}\times {\frac {\Delta Q_{d}}{\Delta P}}} E_{d}={\frac {{\frac
{P_{1}+P_{2}}{2}}}{{\frac {Q_{{d_{1}}}+Q_{{d_{2}}}}{2}}}}\times {\frac {\Delta
Q_{d}}{\Delta P}}={\frac {P_{1}+P_{2}}{Q_{{d_{1}}}+Q_{{d_{2}}}}}\times {\frac
{\Delta Q_{d}}{\Delta P}}
This method for computing the price elasticity is also known as the "midpoints
formula", because the average price and average quantity are the coordinates of the
midpoint of the straight line between the two given points. This formula is
an application of the midpoint method. However, because this formula implicitly
assumes the section of the demand curve between those points is linear, the greater
the curvature of the actual demand curve is over that range, the worse this
approximation of its elasticity will be.

History

The illustration that accompanied Marshall's original definition of PED, the ratio
of PT to Pt
Together with the concept of an economic "elasticity" coefficient, Alfred Marshall
is credited with defining PED ("elasticity of demand") in his book Principles of
Economics, published in 1890. He described it thus: "And we may say generally:
the elasticity (or responsiveness) of demand in a market is great or small
according as the amount demanded increases much or little for a given fall in
price, and diminishes much or little for a given rise in price". He reasons
this since "the only universal law as to a person's desire for a commodity is that
it diminishes... but this diminution may be slow or rapid. If it is slow... a small
fall in price will cause a comparatively large increase in his purchases. But if it
is rapid, a small fall in price will cause only a very small increase in his
purchases. In the former case... the elasticity of his wants, we may say, is great.
In the latter case... the elasticity of his demand is small." Mathematically,
the Marshallian PED was based on a point-price definition, using differential
calculus to calculate elasticities.

Determinants
The overriding factor in determining PED is the willingness and ability of
consumers after a price change to postpone immediate consumption decisions
concerning the good and to search for substitutes ("wait and look"). A number
of factors can thus affect the elasticity of demand for a good:

## Availability of substitute goods

The more and closer the substitutes available, the higher the elasticity is likely
to be, as people can easily switch from one good to another if an even minor price
change is made; There is a strong substitution effect. If no close
substitutes are available, the substitution effect will be small and the demand
inelastic.
Breadth of definition of a good
The broader the definition of a good (or service), the lower the elasticity. For
example, Company X's fish and chips would tend to have a relatively high elasticity
of demand if a significant number of substitutes are available, whereas food in
general would have an extremely low elasticity of demand because no substitutes
exist.
Percentage of income
The higher the percentage of the consumer's income that the product's price
represents, the higher the elasticity tends to be, as people will pay more
attention when purchasing the good because of its cost; The income effect
is substantial. When the goods represent only a negligible portion of the
budget the income effect will be insignificant and demand inelastic,
Necessity
The more necessary a good is, the lower the elasticity, as people will attempt to
buy it no matter the price, such as the case of insulin for those who need it.

Duration
For most goods, the longer a price change holds, the higher the elasticity is
likely to be, as more and more consumers find they have the time and inclination to
search for substitutes. When fuel prices increase suddenly, for instance,
consumers may still fill up their empty tanks in the short run, but when prices
remain high over several years, more consumers will reduce their demand for fuel by
switching to carpooling or public transportation, investing in vehicles with
greater fuel economy or taking other measures. This does not hold for consumer
durables such as the cars themselves, however; eventually, it may become necessary
for consumers to replace their present cars, so one would expect demand to be less
elastic.
Brand loyalty
An attachment to a certain brandeither out of tradition or because of proprietary
barrierscan override sensitivity to price changes, resulting in more inelastic
demand.
Who pays
Where the purchaser does not directly pay for the good they consume, such as with
corporate expense accounts, demand is likely to be more inelastic.
Relation to marginal revenue
The following equation holds:

## {\displaystyle R'=P\,\left(1+{\dfrac {1}{E_{d}}}\right)} R'=P\,\left(1+{\dfrac {1}

{E_{d}}}\right)

where
R' is the marginal revenue
P is the price
Proof:
TR = Total Revenue
90
{\displaystyle R'={\dfrac {\partial TR}{\partial Q}}={\dfrac {\partial }{\partial
Q}}(P\,Q)=P+Q\,{\dfrac {\partial P}{\partial Q}}} R'={\dfrac {\partial TR}
{\partial Q}}={\dfrac {\partial }{\partial Q}}(P\,Q)=P+Q\,{\dfrac {\partial P}
{\partial Q}}

## {\displaystyle E_{d}={\dfrac {\partial Q}{\partial P}}\cdot {\dfrac {P}

{Q}}\Rightarrow E_{d}\cdot {\dfrac {Q}{P}}={\dfrac {\partial Q}{\partial
P}}\Rightarrow {\dfrac {P}{E_{d}\cdot Q}}={\dfrac {\partial P}{\partial Q}}}
{\displaystyle E_{d}={\dfrac {\partial Q}{\partial P}}\cdot {\dfrac {P}
{Q}}\Rightarrow E_{d}\cdot {\dfrac {Q}{P}}={\dfrac {\partial Q}{\partial
P}}\Rightarrow {\dfrac {P}{E_{d}\cdot Q}}={\dfrac {\partial P}{\partial Q}}}

## {\displaystyle R'=P+Q\cdot {\dfrac {P}{E_{d}\cdot Q}}=P\,\left(1+{\dfrac {1}

{E_{d}}}\right)} {\displaystyle R'=P+Q\cdot {\dfrac {P}{E_{d}\cdot Q}}=P\,\left(1+
{\dfrac {1}{E_{d}}}\right)}

On a graph with both a demand curve and a marginal revenue curve, demand will be
elastic at all quantities where marginal revenue is positive. Demand is unit
elastic at the quantity where marginal revenue is zero. Demand is inelastic at
every quantity where marginal revenue is negative.

## Effect on total revenue

See also: Total revenue test

A set of graphs shows the relationship between demand and total revenue (TR) for a
linear demand curve. As price decreases in the elastic range, TR increases, but in
the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1.
A firm considering a price change must know what effect the change in price will
have on total revenue. Revenue is simply the product of unit price times quantity:

## {\displaystyle {\mbox{Revenue}}=PQ_{d}} {\mbox{Revenue}}=PQ_{d}

Generally any change in price will have two effects:

## The price effect

For inelastic goods, an increase in unit price will tend to increase revenue, while
a decrease in price will tend to decrease revenue. (The effect is reversed for
elastic goods.)
The quantity effect
An increase in unit price will tend to lead to fewer units sold, while a decrease
in unit price will tend to lead to more units sold.
For inelastic goods, because of the inverse nature of the relationship between
price and quantity demanded (i.e., the law of demand), the two effects affect total
revenue in opposite directions. But in determining whether to increase or decrease
prices, a firm needs to know what the net effect will be. Elasticity provides the
answer: The percentage change in total revenue is approximately equal to the
percentage change in quantity demanded plus the percentage change in price. (One
change will be positive, the other negative.) The percentage change in quantity
is related to the percentage change in price by elasticity: hence the percentage
change in revenue can be calculated by knowing the elasticity and the percentage
change in price alone.

As a result, the relationship between PED and total revenue can be described for
any good:

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0),
changes in the price do not affect the quantity demanded for the good; raising
prices will always cause total revenue to increase. Goods necessary to survival can
be classified here; a rational person will be willing to pay anything for a good if
the alternative is death. For example, a person in the desert weak and dying of
thirst would easily give all the money in his wallet, no matter how much, for a
bottle of water if he would otherwise die. His demand is not contingent on the
price.
When the price elasticity of demand for a good is relatively inelastic (-1 < Ed <
0), the percentage change in quantity demanded is smaller than that in price.
Hence, when the price is raised, the total revenue increases, and vice versa.
When the price elasticity of demand for a good is unit (or unitary) elastic (Ed =
-1), the percentage change in quantity demanded is equal to that in price, so a
change in price will not affect total revenue.
When the price elasticity of demand for a good is relatively elastic ( -? < Ed <
-1), the percentage change in quantity demanded is greater than that in price.
Hence, when the price is raised, the total revenue falls, and vice versa.
When the price elasticity of demand for a good is perfectly elastic (Ed is - ?),
any increase in the price, no matter how small, will cause the quantity demanded
for the good to drop to zero. Hence, when the price is raised, the total revenue
falls to zero. This situation is typical for goods that have their value defined by
law (such as fiat currency); if a 5 dollar bill were sold for anything more than 5
dollars, nobody would buy it, so demand is zero.
Hence, as the accompanying diagram shows, total revenue is maximized at the
combination of price and quantity demanded where the elasticity of demand is
unitary.

## It is important to realize that price-elasticity of demand is not necessarily

constant over all price ranges. The linear demand curve in the accompanying diagram
illustrates that changes in price also change the elasticity: the price elasticity
is different at every point on the curve.

## Effect on tax incidence

When demand is more inelastic than supply, consumers will bear a greater proportion
of the tax burden than producers will.
Main article: tax incidence
PEDs, in combination with price elasticity of supply (PES), can be used to assess
where the incidence (or "burden") of a per-unit tax is falling or to predict where
it will fall if the tax is imposed. For example, when demand is perfectly
inelastic, by definition consumers have no alternative to purchasing the good or
service if the price increases, so the quantity demanded would remain constant.
Hence, suppliers can increase the price by the full amount of the tax, and the
consumer would end up paying the entirety. In the opposite case, when demand is
perfectly elastic, by definition consumers have an infinite ability to switch to
alternatives if the price increases, so they would stop buying the good or service
in question completelyquantity demanded would fall to zero. As a result, firms
cannot pass on any part of the tax by raising prices, so they would be forced to
pay all of it themselves.

## In practice, demand is likely to be only relatively elastic or relatively

inelastic, that is, somewhere between the extreme cases of perfect elasticity or
inelasticity. More generally, then, the higher the elasticity of demand compared to
PES, the heavier the burden on producers; conversely, the more inelastic the demand
compared to PES, the heavier the burden on consumers. The general principle is that
the party (i.e., consumers or producers) that has fewer opportunities to avoid the
tax by switching to alternatives will bear the greater proportion of the tax
burden. In the end the whole tax burden is carried by individual households
since they are the ultimate owners of the means of production that the firm
utilises (see Circular flow of income).

PED and PES can also have an effect on the deadweight loss associated with a tax
regime. When PED, PES or both are inelastic, the deadweight loss is lower than a
comparable scenario with higher elasticity.

Optimal pricing
Among the most common applications of price elasticity is to determine prices that
maximize revenue or profit.

## Constant elasticity and optimal pricing

If one point elasticity is used to model demand changes over a finite range of
prices, elasticity is implicitly assumed constant with respect to price over the
finite price range. The equation defining price elasticity for one product can be
rewritten (omitting secondary variables) as a linear equation.

where

## {\displaystyle LQ=\ln(Q),LP=\ln(P),E} LQ=\ln(Q),LP=\ln(P),E is the elasticity, and

{\displaystyle K} K is a constant.
Similarly, the equations for cross elasticity for {\displaystyle n} n products can
be written as a set of {\displaystyle n} n simultaneous linear equations.

LP^{k}
where

## {\displaystyle l} l and {\displaystyle k=1,\dotsc

,n,LQ_{l}=\ln(Q_{l}),LP^{l}=\ln(P^{l})} k=1,\dotsc
,n,LQ_{l}=\ln(Q_{l}),LP^{l}=\ln(P^{l}), and {\displaystyle K_{l}} K_{l} are
constants; and appearance of a letter index as both an upper index and a lower
index in the same term implies summation over that index.
This form of the equations shows that point elasticities assumed constant over a
price range cannot determine what prices generate maximum values of
{\displaystyle \ln(Q)} \ln(Q); similarly they cannot predict prices that generate
maximum {\displaystyle Q} Q or maximum revenue.

## Constant elasticities can predict optimal pricing only by computing point

elasticities at several points, to determine the price at which point elasticity
equals -1 (or, for multiple products, the set of prices at which the point
elasticity matrix is the negative identity matrix).

## Non-constant elasticity and optimal pricing

If the definition of price elasticity is extended to yield a quadratic relationship
between demand units ( {\displaystyle Q} Q) and price, then it is possible to
compute prices that maximize {\displaystyle \ln(Q)} \ln(Q), {\displaystyle Q} Q,
and revenue. The fundamental equation for one product becomes

## {\displaystyle LQ=K+E_{1}\times LP+E_{2}\times LP^{2}} LQ=K+E_{1}\times

LP+E_{2}\times LP^{2}
and the corresponding equation for several products becomes

## {\displaystyle LQ_{l}=K_{l}+E1_{l,k}\times LP^{k}+E2_{l,k}\times (LP^{k})^{2}}

LQ_{l}=K_{l}+E1_{{l,k}}\times LP^{k}+E2_{{l,k}}\times (LP^{k})^{2}
Excel models are available that compute constant elasticity, and use non-constant
elasticity to estimate prices that optimize revenue or profit for one product
or several products.

## Limitations of revenue-maximizing and profit-maximizing pricing strategies

In most situations, revenue-maximizing prices are not profit-maximizing prices. For
example, if variable costs per unit are nonzero (which they almost always are),
then a more complex computation of a similar kind yields prices that generate
optimal profits.

## In some situations, profit-maximizing prices are not an optimal strategy. For

example, where scale economies are large (as they often are), capturing market
share may be the key to long-term dominance of a market, so maximizing revenue or
profit may not be the optimal strategy.

## Selected price elasticities

Various research methods are used to calculate price elasticities in real life,
including analysis of historic sales data, both public and private, and use of
present-day surveys of customers' preferences to build up test markets capable of
modelling such changes. Alternatively, conjoint analysis (a ranking of users'
preferences which can then be statistically analysed) may be used. Approximate
estimates of price elasticity can be calculated from the income elasticity of
demand, under conditions of preference independence. This approach has been
emprirically validated using bundles of goods (e.g. food, healthcare, education,
recreation, etc.).

Though PEDs for most demand schedules vary depending on price, they can be modeled
assuming constant elasticity. Using this method, the PEDs for various
goodsintended to act as examples of the theory described aboveare as follows. For
suggestions on why these goods and services may have the PED shown, see the above
section on determinants of price elasticity.

Cigarettes (US)
-0.3 to -0.6 (General)
-0.6 to -0.7 (Youth)
Alcoholic beverages (US)
-0.3 or -0.7 to -0.9 as of 1972 (Beer)
-1.0 (Wine)
-1.5 (Spirits)
Airline travel (US)
-0.3 (First Class)
-0.9 (Discount)
-1.5 (for Pleasure Travelers)
Livestock
-0.5 to -0.6 (Broiler Chickens)
Oil (World)
-0.4
Car fuel
-0.09 (Short run)
-0.31 (Long run)
Medicine (US)
-0.31 (Medical insurance)
-0.03 to -0.06 (Pediatric Visits)
Patents
-0.30 to -0.50
Rice
-0.47 (Austria)
-0.8 (Bangladesh)
-0.8 (China)
-0.25 (Japan)
-0.55 (US)
Cinema visits (US)
-0.87 (General)
Live Performing Arts (Theater, etc.)
-0.4 to -0.9
Transport
-0.20 (Bus travel US)
-2.8 (Ford compact automobile)
Cannabis (US)
-0.655
Soft drinks
-0.8 to -1.0 (general)
-3.8 (Coca-Cola)
-4.4 (Mountain Dew)
Steel
-0.2 to -0.3
Telecommunications
-0.405 (Mobile)
-0.434 (Broadband)
Eggs
-0.1 (US: Household only)
-0.35 (Canada)
-0.55 (South Africa)
Golf
-0.3 to -0.7
See also
Arc elasticity
Cross elasticity of demand
Income elasticity of demand
Price elasticity of supply
Supply and demand
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Jump up ^ Brownell, Kelly D.; Farley, Thomas; Willett, Walter C. et al. (2009).
^ Jump up to: a b Ayers; Collinge (2003). p.120.
^ Jump up to: a b Barnett and Crandall in Duetsch (1993), p.147
Jump up ^ "Valuing the Effect of Regulation on New Services in Telecommunications"
(PDF). Jerry A. Hausman. Retrieved 29 September 2016.
Jump up ^ "Price and Income Elasticity of Demand for Broadband Subscriptions: A
Cross-Sectional Model of OECD Countries" (PDF). SPC Network. Retrieved 29 September
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External links
A Lesson on Elasticity in Four Parts, Youtube, Jodi Beggs
Price Elasticity Models and Optimization
Price elasticity of demand : Practical Applications
Approx. PED of Various Products (U.S.)
Approx. PED of Various Home-Consumed Foods (U.K.)
Categories: Elasticity (economics)DemandPricing
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