As a marketing professional, it is essential to understand how to calculate price elasticity of demand of a product. If the price of the product is too high, then sales will be low. At the same time, if the price is too low, the company will face losses. The concept of price elasticity of demand can provide solutions to such problems.
The price elasticity of demand is a powerful tool that allows you to identify how the consumers react to the change of a product’s price. This concept will allow you to plan the pricing strategy of your business and help you maximize your revenue and sales.
This article will teach you what is price elasticity of demand, the formula for calculating it. The article will also provide a step-by-step guide on how you can calculate the price elasticity of demand along with examples and brief explanations of what different values price elasticity of profit means to help you understand the concept better.
Price Elasticity of Demand Formula
The formula for calculating price elasticity of demand (PED) is derived by dividing the percentage change in the quantity of demand of a product by the percentage change in its price.
The formula can be expressed as,
PED = (% Change in Quantity of Demand) ÷ (% Change in Price)
The price elasticity of demand equation can be further elaborated into the following,
PED = {(D1 – D0) ÷ (D1 + D0)} ÷ {(P1 – P0) ÷ (P1 + P0)}
Where,
D0 = Initial Quantity of Demand
P0 = Initial Price of the Product
D1 = Final Quantity of Demand
P1 = Final Price of the Product
The second equation is known as the “Midpoint Formula” calculating the price elasticity of demand.
What is Price Elasticity Of Demand?
In economics, the elasticity of demand is a metric that reflects how any change in the pricing of a good affects its demand among consumers. To put it in simple words, it is a method to identify the consumers’ responsiveness in the event of price fluctuation of any products.
The term “Elasticity” bears huge significance in economics. If the demand for a product changes greatly with any change in its price, then the product is considered as “Elastic”. On the other hand, if there is little to no change in demand for a product even if its price changes, then the product is considered “Inelastic”.
The products that are considered “Inelastic” are typically those that we consider necessary goods. For example, medicines, gasoline, etc. Even if the prices of such products increase, the demand for these products will experience little to no change at all.
On the other hand, luxury products are usually considered “Elastic” as when the price of such products increases, the demand for these goods falls drastically. If the price decreases, the demand soars.
The concept of price elasticity of demand is especially helpful to those who work in the marketing department. Their job is to create inelastic demand for the goods they promote. And this concept helps them to identify the differences in their products from other similar types of products that are available in the market and make pricing decisions accordingly.
How To Calculate Price Elasticity Of Demand?
To compute the price elasticity of demand, use the following steps:
Step 1: First, determine the initial quantity of demand and price of the product which are denoted by D0 and P0 respectively.
Step 2: Next, find out the final quantity of demand and price of the product which are represented by D1 and P1 respectively.
Step 3: In this step, work out the denominator of the midpoint formula for elastic demand which represents the percentage change in the price of the product.
Step 4: After finding out the denominator of the midpoint formula for price elasticity of demand, work out the numerator of the formula. The numerator represents the percentage change in the quantity of demand.
Step 4: Lastly, divide the value obtained in “Step 4” by the value obtained in “Step 3” to get the price elasticity of demand for the product.
Practical Examples
To better understand how to calculate the price elasticity of demand, take a look at the following examples:
Example 1
Let’s start with a simple problem. Consider a hypothetical situation where a 45% increase in petrol price has resulted in a decrease in its purchase by 22%. Now, find out the price elasticity of demand for petrol in this example.
From the above example, we can see that the percentage change in the quantity of demand for petrol is -22%. Here, the value of percentage change in the quantity of demand is negative because the demand has declined since the price hike of petrol.
And the change in price is going to be +45%. Here, the value is positive because the price of petrol increased in this example.
So, the price elasticity of demand for this example is going to be,
PED = (% Change in Quantity of Demand) ÷ (% Change in Price)
= (-22%) ÷ (+45%)
= (-0.22) ÷ (.45)
= -0.489
Therefore, the price elasticity of demand for petrol is -0.489.
Example 2
In this example, let’s assume a famous smartphone brand sells its flagship smartphone at $575 per unit. The monthly sales report of that company shows that consumers bought 200,000 units of that smartphone in November. The company offered a $75 discount on that smartphone model in the following month which resulted in an increase in sales to 220,000 units. Find out the price elasticity of demand for this smartphone model.
Given,
The Initial Quantity of Demand or D0 = 200,000 Units,
The Final Quantity of Demand or D1 = 220,000 Units,
Initial Price or P0 = $575, and
Final Price or P1 = ($575 – $75) = $500
So, the price elasticity of demand is going to be,
PED = {(D1 – D0) ÷ (D1 + D0)} ÷ {(P1 – P0) ÷ (P1 + P0)}
= {(220,000 – 200,000) ÷ (220,000 + 200,000)} ÷ {($500 – $575) ÷ ($500 + $575)}
= (0.0476) ÷ (-0.0698)
= -0.682
Therefore, the price elasticity of demand is -0.682.
How to Interpret Price Elasticity of Demand
The value of price elasticity of demand can be positive, zero, and even negative. To understand what different values of price elasticity of demand means, take a look at the terms given below:
Elastic Demand
If the value of the price elasticity of demand for a product is greater than one, that means demand for this product is elastic. So, if the price of the product experiences any changes, the demand for that product will change significantly. Typically, luxury products are considered to have elastic demand.
Whenever a product has elastic demand that indicates if the price of the product increases, the revenue will decrease. And in the event of a price cut in such a product will result in a rise in revenue.
Inelastic Demand
A product is considered to have an inelastic demand if its price elasticity of demand is less than one. It indicates that even if the product’s price fluctuates, the quantity of demand for that product will experience little to no change. Necessary goods like gasoline, salt, etc. are considered to have inelastic demand.
If a product has inelastic demand, an increase in its price will increase revenue. And if the price decreases, it will result in a decline in revenue.
Unitary Elastic Demand
If the price elasticity of demand of a product is exactly equal to one, that means the product has unitary elastic demand. The term “Unitary Elastic Demand” implies the demand for the product will change proportionately with the price change.
When some product has this type of demand, if the price of the product increases or decreases, the revenue will change proportionately.
Perfectly Elastic Demand
If the price elasticity of demand for a product turns out to be infinite (∞), this implies the demand for the product is perfectly elastic. What this means is the demand for this type of product will fall all the way to zero if the price increases even a bit.
If the price decreases, the quantity of demand for that product reaches infinity.
Perfectly Inelastic Demand
When the price elasticity of demand for a product is exactly zero that means the product has a perfectly inelastic demand. This indicates no matter how much the price of the product fluctuates; the demand will remain unchanged.
The survival necessities are considered to have perfectly inelastic demand. That’s because no matter how high or how low the price is, consumers will keep on buying them. And in the event of a price cut on such products will result in a significant decrease in revenue.
Conclusion
If a company doesn’t know about the price elasticity of demand for their product, this can badly hurt its revenue and sales numbers. If the company sells its products at a lower price, the company might face losses as well.
At the same time, if the price is too high, consumers are not going to buy them. Knowing how to calculate price elasticity of demand helps companies with product pricing decisions and predicting revenue and sales.
