Elasticity of demand

When you raise the price of most items, people will buy less of them. For example, when one airline raises its price, air passengers may switch to a rival airline.

When you lower the price of most items, people will buy more of them. For example, the falling price of computers has meant that increasing numbers of families and businesses have bought them.

Common sense tells us that when prices change, so too will the quantities bought. However, businesses need to have more precise information than this - they need to have a clear measure of how the quantity demanded will change as a result of a price change.

Price elasticity of demand

A very useful measure of the relationship between price and quantity demanded is 'price elasticity of demand'. Price elasticity of demand is a measure of the percentage change in the quantity of a good demanded divided by the percentage change in its price.

We can show this in a simple formula:

Price elasticity demand = percentage change in quantity demanded divided by percentage change in the price of the goods

If a good fell in price by 50(e.g. from £1 to 50p) and the quantity demanded increased by 100(e.g. from 1000 to 2000), we could say that the elasticity of demand is 2:

If a good fell in price by 50(e.g. from £1 to 50p) and the quantity demanded increased by 25(e.g. from 1000 to 1250), we could say that the elasticity of demand is one half.

From a business point of view it is important to understand what will happen to demand if you raise or lower price. There are clearly many advantages to be gained if people buy a lot more of our goods when (as a producer) we lower price.

In business we use the term 'elastic demand' to describe a position where the quantity demanded changes by a bigger percentage than the price change.

We use the term 'inelastic demand' where the demand change is a smaller percentage than the price change.

It makes sense to lower the price of goods from the previous price if demand is elastic and it is relatively cheap to expand production.

It makes sense to raise the price of goods from the previous price if demand is inelastic.