Example of Price Elasticity

Definition

Price elasticity is a measure of how much the quantity of a product demanded changes when the price of the product changes, first introduced by Alfred Marshall in 1890.

How It Works

The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. This measure can be used to determine whether a product is elastic or inelastic, with elastic products having a price elasticity greater than 1 and inelastic products having a price elasticity less than 1. According to Ricardo's comparative advantage model, 1817, countries should export goods for which they have a lower opportunity cost, which is often related to the price elasticity of demand for those goods. For example, Boeing produces ~800 aircraft annually (Boeing annual report), and the demand for aircraft is generally inelastic, with a price elasticity of around 0.5, meaning that a 10% increase in price would lead to a 5% decrease in quantity demanded.

The price elasticity of demand is influenced by several factors, including the availability of substitutes, the necessity of the product, and the income level of the consumer. Products with many close substitutes, such as coffee, tend to have a higher price elasticity of demand, as consumers can easily switch to a different brand or product if the price increases. In contrast, products with few substitutes, such as insulin, tend to have a lower price elasticity of demand, as consumers are less sensitive to price changes. The law of diminishing marginal utility, first introduced by Carl Menger in 1871, also plays a role in determining the price elasticity of demand, as consumers tend to derive less additional utility from each additional unit of a product consumed.

The price elasticity of supply is also an important concept, as it measures how much the quantity of a product supplied changes when the price of the product changes. This measure can be used to determine whether a product is supply elastic or supply inelastic, with supply elastic products having a price elasticity greater than 1 and supply inelastic products having a price elasticity less than 1. According to the Heckscher-Ohlin model, 1933, countries should export goods that are intensive in the factors of production that are abundant in the country, which is often related to the price elasticity of supply for those goods.

Key Components

• Substitutes: The availability of close substitutes for a product increases its price elasticity of demand, as consumers can easily switch to a different brand or product if the price increases.
• Necessity: The necessity of a product decreases its price elasticity of demand, as consumers are less sensitive to price changes for essential goods.
• Income level: The income level of the consumer affects the price elasticity of demand, as higher-income consumers tend to be less sensitive to price changes.
• Time period: The time period over which the price change occurs affects the price elasticity of demand, as consumers may be more sensitive to price changes in the short run than in the long run.
• Market structure: The market structure, such as monopoly or perfect competition, affects the price elasticity of demand, as firms with market power may be able to charge higher prices without losing demand.

Common Misconceptions

• Myth: Price elasticity is the same as price sensitivity — Fact: Price elasticity is a measure of how much the quantity of a product demanded changes when the price of the product changes, while price sensitivity is a broader concept that refers to the degree to which consumers respond to price changes, with evidence from the World Trade Organization showing that price elasticity is a key factor in determining the impact of trade policies on consumer behavior.
• Myth: All products have a price elasticity of demand greater than 1 — Fact: Many products, such as tobacco, have a price elasticity of demand less than 1, meaning that a price increase would lead to an increase in revenue for the firm.
• Myth: Price elasticity is only relevant for consumer goods — Fact: Price elasticity is also relevant for capital goods, such as aircraft, as firms must consider the price elasticity of demand when making investment decisions.

In Practice

The price elasticity of demand is a critical concept in business strategy, as firms must consider the potential impact of price changes on demand. For example, Coca-Cola, which produces ~1.9 billion servings of beverages daily (Coca-Cola annual report), must consider the price elasticity of demand when setting prices for its products. If Coca-Cola were to increase the price of its beverages by 10%, it would likely lead to a decrease in demand, as consumers could switch to other brands or products. However, if Coca-Cola were to increase the price of its beverages in a market with few substitutes, such as a monopoly market, it may be able to increase revenue despite the decrease in demand.