What Is Price Elasticity?

Definition

Price elasticity is a measure of how responsive the quantity demanded of a good or service is to changes in its price, first introduced by Alfred Marshall in 1890.

How It Works

The price elasticity of demand is calculated as the percentage change in quantity demanded in response to a one percent change in price. This relationship is often illustrated using the demand curve, which shows the quantity of a good or service that consumers are willing to buy at different price levels. For example, a study of the demand for cigarettes in the United States found that a 10% increase in price led to a 4% decrease in consumption (Chaloupka, 2002), indicating that the demand for cigarettes is relatively inelastic.

The price elasticity of demand is influenced by several factors, including the availability of substitutes, the necessity of the good or service, and the proportion of income spent on the good or service. According to Ricardo's comparative advantage model, 1817, countries will specialize in producing goods for which they have a comparative advantage, and the price elasticity of demand will play a crucial role in determining the pattern of trade. For instance, the demand for oil is relatively inelastic, as there are few substitutes for oil in the short run, and a small increase in price leads to a small decrease in consumption.

The cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good or service to changes in the price of another good or service. This relationship is important in understanding the effects of price changes on the demand for related goods or services. For example, the cross-price elasticity of demand between Coca-Cola and Pepsi is high, as the two products are close substitutes, and a price increase for one product will lead to an increase in demand for the other product.

Key Components

• Income elasticity of demand: measures how responsive the quantity demanded of a good or service is to changes in income, and an increase in income elasticity of demand indicates that the good or service is a normal good.
• Cross-price elasticity of demand: measures the responsiveness of the quantity demanded of one good or service to changes in the price of another good or service, and a high cross-price elasticity of demand indicates that the two goods or services are close substitutes.
• Price elasticity of supply: measures how responsive the quantity supplied of a good or service is to changes in its price, and an increase in price elasticity of supply indicates that the supply of the good or service is more responsive to price changes.
• Advertising elasticity of demand: measures how responsive the quantity demanded of a good or service is to changes in advertising expenditure, and an increase in advertising elasticity of demand indicates that advertising is effective in increasing demand.
• Distribution channels: the way in which a good or service is delivered to the consumer, and changes in distribution channels can affect the price elasticity of demand, for example, online shopping has increased the price elasticity of demand for many goods.

Common Misconceptions

Myth: Price elasticity of demand is always constant — Fact: Price elasticity of demand can vary depending on the price level and the availability of substitutes, for example, the demand for a good may be elastic at high prices and inelastic at low prices.

Myth: A high price elasticity of demand always indicates that the good or service is a luxury good — Fact: A high price elasticity of demand can also indicate that the good or service has close substitutes, for example, the demand for Coca-Cola is highly elastic because Pepsi is a close substitute.

Myth: Price elasticity of supply is always high for agricultural products — Fact: The price elasticity of supply for agricultural products can be low in the short run due to the time it takes to adjust production, for example, the supply of wheat is relatively inelastic in the short run because it takes several months to harvest a new crop.

Myth: Advertising has no effect on price elasticity of demand — Fact: Advertising can increase the price elasticity of demand by making consumers more aware of substitutes and increasing the responsiveness of demand to price changes, for example, advertising can increase the demand for a good by making consumers more aware of its benefits.

In Practice

In 2019, Boeing produces ~800 aircraft annually (Boeing annual report), and the company faces a relatively inelastic demand for its aircraft, as there are few substitutes for commercial aircraft and the demand is driven by the growth of air travel. However, the demand for business jets is more elastic, as companies can choose to travel by commercial aircraft or other modes of transportation. According to a report by the Teal Group, the demand for business jets is highly elastic, with a price elasticity of demand of -2.5, indicating that a 10% increase in price will lead to a 25% decrease in demand. This highlights the importance of understanding price elasticity of demand in the aircraft industry, where small changes in price can have significant effects on demand.