Module II·Article III·~10 min read
Price Elasticity of Demand
Business in a Competitive Environment
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Price Elasticity of Demand
What is price elasticity of demand (PED)?
The law of demand tells us that when the price rises, demand decreases. But by how much does it decrease? This question is critically important for business: if a company raises its price by 10%, will it lose 5% of its customers or 50%? The answer determines whether a price increase will bring more profit or less.
Price elasticity of demand (PED) measures the degree of reaction of the quantity demanded to a change in price. Formally:
PED = (% change in quantity demanded) / (% change in price)
PED is always negative (law of demand: price increases → demand decreases), but for convenience the absolute value (modulus) is usually used.
Interpretation of PED values
- |PED| > 1 → demand is elastic — the percentage change in demand is greater than the percentage change in price. Consumers respond strongly to price changes.
- |PED| < 1 → demand is inelastic — the percentage change in demand is less than the percentage change in price. Consumers respond weakly to price changes.
- |PED| = 1 → demand is unit elastic — percentage changes in demand and price are equal.
- |PED| = 0 → demand is perfectly inelastic — the quantity demanded does not change when the price changes (vertical demand curve). Examples: life-essential medicines (insulin for diabetics).
- |PED| = ∞ → demand is perfectly elastic — at the slightest increase in price, demand drops to zero (horizontal demand curve). Examples: goods in a perfectly competitive market (wheat from an individual farmer).
Calculation of PED: detailed examples
Example 1: Coffee shop
The coffee shop raised the price of a latte from 250 to 300 rubles. Before the increase, it sold 200 cups per day; after — 160 cups.
- % change in price = ((300 - 250) / 250) × 100% = +20%
- % change in demand = ((160 - 200) / 200) × 100% = -20%
- PED = -20% / +20% = -1.0 (unit elasticity)
What does this mean for revenue? Before the increase: 250 × 200 = 50,000 rub./day. After: 300 × 160 = 48,000 rub./day. Revenue has almost not changed (slightly decreased). With unit elasticity, the price change practically does not affect total revenue.
Example 2: Gasoline
The price of gasoline rose from 50 to 60 rubles per liter (+20%). Consumption fell from 100,000 to 95,000 liters per day (-5%).
- PED = -5% / +20% = -0.25 (inelastic demand)
Demand for gasoline is inelastic because drivers have few short-term alternatives: they cannot instantly switch to an electric car or public transport. However, in the long run, gasoline demand is more elastic: people gradually buy more fuel-efficient cars, move closer to work, or use public transport.
Example 3: Business-class airline tickets
An airline lowered the price of a business-class ticket Moscow—London from 200,000 to 160,000 rubles (-20%). The number of tickets sold increased from 50 to 80 per month (+60%).
- PED = +60% / -20% = -3.0 (highly elastic demand)
Revenue before: 200,000 × 50 = 10,000,000 rub. After: 160,000 × 80 = 12,800,000 rub. Revenue increased by 28%! With elastic demand, lowering the price increases total revenue — this is a key conclusion for business.
PED and total revenue: the golden rule for business
The relationship between elasticity and revenue is one of the most practically significant propositions in economic theory:
| Demand | Price Increase | Price Decrease |
|---|---|---|
| Elastic (|PED| > 1) | Revenue falls | Revenue rises |
| Inelastic (|PED| < 1) | Revenue rises | Revenue falls |
| Unit elasticity (|PED| = 1) | Revenue does not change | Revenue does not change |
Why does this work this way? With elastic demand, a 10% price increase leads to a loss of more than 10% of customers — the loss of clients “outweighs” the price increase. With inelastic demand, a 10% price increase leads to a loss of less than 10% of customers — the price increase “outweighs” the loss of clients.
Strategic application: If you sell a product with inelastic demand (gasoline, medicines, cigarettes), it is profitable for you to raise the price — revenue will increase. If your product is elastic (entertainment, restaurant meals, economy class airline tickets), it may be more profitable to lower the price in order to attract more buyers and increase revenue.
Factors determining PED
Why is demand for some products elastic, while for others it is not? Four key factors:
1. Availability of substitutes. The more substitutes, the more elastic the demand. Demand for a specific brand of water (Evian) is highly elastic — there are dozens of alternatives. Demand for water in general is inelastic (there are no substitutes).
2. Share in the budget. The larger the share of the consumer’s budget taken by the goods, the more elastic the demand. A 50% increase in the price of salt will practically not change demand (salt expenditures are a fraction of the budget). A 50% increase in the price of housing will dramatically reduce demand (rent can be 30–40% of the budget).
3. Time. In the short term, demand is less elastic: consumers need time to find substitutes and change habits. In the long term, demand is more elastic. Example: after the sharp rise in gasoline prices in the 1970s, consumption hardly changed in the first months, but over the next 10 years car manufacturers developed more efficient engines, and consumption decreased significantly.
4. Necessity vs. luxury. Demand for necessities (bread, milk, basic medicine) is inelastic — people buy them regardless of price. Demand for luxury items (yachts, designer clothing, gourmet restaurants) is elastic — when price rises, consumers easily refuse them.
Other types of elasticity
Income elasticity of demand (YED)
YED = (% change in demand) / (% change in income)
YED helps classify products:
- YED > 0 → normal good (demand increases with income)
- 0 < YED < 1 → necessity (demand increases, but slower than income). Example: bread (YED ≈ 0.2), basic clothing
- YED > 1 → luxury good (demand grows faster than income). Example: restaurant meals (YED ≈ 1.5), international travel (YED ≈ 2.0)
- YED < 0 → inferior good — demand falls as income rises. Example: instant noodles (YED ≈ -0.5), bus rides
Business application: Companies selling luxury goods must be prepared for significant drops in sales during recessions (incomes fall → demand for luxury drops even more). Companies selling necessities are more resilient during economic downturns. This is why Walmart shares (discounters) are usually more stable during crises than LVMH shares (luxury brands).
Cross elasticity of demand (XED)
XED = (% change in demand for good A) / (% change in price of good B)
- XED > 0 → substitutes: price increase of B → demand increase for A. Example: Coca-Cola and Pepsi (XED ≈ +0.7)
- XED < 0 → complements: price increase of B → demand decrease for A. Example: printers and cartridges (XED ≈ -0.4)
- XED = 0 → goods are unrelated: price change in B does not affect demand of A. Example: bananas and cars
Business application: Knowing XED helps firms anticipate the consequences of competitors’ pricing decisions. If Pepsi reduces its price by 15%, Coca-Cola can estimate that its demand will drop by about 10% (XED ≈ 0.7 × 15% ≈ 10.5%), and prepare a response.
Price elasticity of supply (PES)
PES = (% change in quantity supplied) / (% change in price)
PES is always positive (law of supply). It shows how quickly producers can respond to price changes.
- PES > 1 → supply is elastic — producers quickly ramp up output. Typical for goods with available raw materials, simple technology, free capacities.
- PES < 1 → supply is inelastic — producers react slowly. Typical for goods with limited resources, complex production processes, or long production cycles.
Examples:
- Software production: PES is very high (millions of copies can be “produced” in seconds — copying cost is near zero)
- High-quality wine production: PES is low (vineyards are limited, wine must be aged for years)
- Housing in central Moscow: PES is extremely low (land is limited, construction takes years, regulatory restrictions)
Application of elasticity in business strategy
Price discrimination
Many companies use knowledge of differences in demand elasticity between groups of consumers for price discrimination — selling the same product at different prices to different buyers.
Example: airline tickets. Business travelers have inelastic demand (they need to fly at specific times, there are few alternatives, expenses are paid by the company). Tourists have elastic demand (they can change dates, choose another destination, or refuse the trip altogether). Therefore, airlines set high prices for tickets bought at the last moment (business travelers), and low prices for tickets bought in advance (tourists). One and the same flight can cost 5,000 rubles (if bought three months in advance) and 50,000 rubles (if bought in a day).
Tax policy
Governments use PED knowledge when choosing products to tax. Excise taxes on goods with inelastic demand (alcohol, tobacco, gasoline) generate significant revenue, because consumption hardly decreases when the price rises due to the tax. If the government imposed the same excise on a product with elastic demand (for example, ice cream), consumption would sharply decrease, and tax revenues would be minimal.
Practical exercises
Exercise 1: Calculating PED
Question: The price of a product fell from £20 to £16. As a result, the quantity demanded grew from 50 to 70 units. (a) Calculate the percentage change in quantity demanded (b) Calculate the percentage change in price (c) Calculate PED (percentage method) (d) Determine whether demand is elastic
Solution: (a) % change in Qd = ((70 - 50) / 50) × 100% = (+40%)
(b) % change in P = ((16 - 20) / 20) × 100% = (-20%)
(c) PED = % change in Qd / % change in P = +40% / (-20%) = -2.0
(d) |PED| = 2.0 > 1, so demand is elastic. The percentage change in demand (40%) is greater than the percentage change in price (20%). Consumers react strongly to the price change of this product — likely it has accessible substitutes.
Exercise 2: Elasticity and revenue
Question: Using data from Exercise 1: (a) Calculate total revenue before and after the price change (b) Determine whether the price reduction increased or decreased total revenue (c) Explain why this happened
Solution: (a) TR before = £20 × 50 = £1,000. TR after = £16 × 70 = £1,120.
(b) The price reduction increased total revenue by £120 (from £1,000 to £1,120, up by 12%).
(c) This occurred because demand is elastic (|PED| = 2.0 > 1). With elastic demand, the percentage increase in sales quantity (40%) exceeds the percentage decrease in price (20%). In other words, the firm lost £4 on each sold unit, but attracted 20 additional buyers. The gain from increased sales volume outweighed the loss from the price reduction.
Practical rule for business: if demand for your product is elastic, lowering the price will increase total revenue. If inelastic — lowering the price will reduce revenue. This is the “golden rule” of pricing.
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