Price Elasticity of Demand: Concept and Applications

I was delaying my purchase of shoes for weeks. There were other priorities to allocate my resources. One day, while driving, my eyes caught a board highlighting words of “Special Discount” at a local shoe store. I stopped my car and went to the store. I came out with a new pair of shoes.

What happened to other priorities?

They are still important, but the decision of the seller to decrease price has led me to go for the purchase immediately. The fundamental law of demand guides us that change in price results towards a shift in demand for the product.

How much price needs to be changed to maximize our revenue?

price elasticity of demand

The basic law of demand does not help us to answer this question. On the other hand, it is essential for a business manager to know the exact or the most probable change in our revenue. It is more important for public managers to know which policies help them to increase or decrease demand for certain goods and services.

The economists love to interpret this phenomenon with the term of ‘price elasticity of demand’ and denote as Ed to differentiate from ‘price elasticity of supply’. They neither measure change of price in currency nor change of quantity demanded in weighs. They use different methods to calculate elasticity of demand including percentage, total expenditure and graphic. But the most popular, i.e. percentage method uses ‘percentage’ of change to calculate elasticity of demand.

The elasticity of demand does not have a unit value. In other words, it is a unit but without a value.

Applications of Price Elasticity of Demand

This model has a robust scope of applications in business as well as public sectors. However, the baseline of all such application is knowledge of the amount of change in price which can impact demand of quantity to maximize the benefit. For example:

1-   It is important for public managers as well as the agriculture business to decide what kind of crops shall help their revenue. A hybrid seed may produce a surplus to decrease the demand as well as the price of the product. If everyone goes for it, the government would have to change its agriculture policies accordingly to maintain healthy competition.

 2-   Every government cries against smoking. The public managers restrict the public places to stop it. Almost every pack of cigarette contains some symbol or photo to make smoking distasteful for the viewers. But the maximum impact is brought by huge taxation. The public managers see the inelasticity in demand for cigarettes, so they find it useful to raise huge taxes. Some people (…perhaps smokers?) claim that half of the educational institutions and hospital utilities are running on the taxes on the use of tobacco. Otherwise, Singapore can successfully ban the use of chew gum inside the country.

3-   Many governments fix prices of essential products to make them accessible to the weakest section of the society. It is another argument whether it is useful or not but it is clear that price elasticity of demand can help us to decide what is more beneficial for the business as well as the consumers.

4-   Measurement of price elasticity of demand helps the public managers to fix minimum wages to make it beneficial for the both as well as the labor.

5-   We have been observing long queues at gas stations due to limited natural supply, unplanned gas based drive on roads and freedom to install CNG gas stations anywhere. The price elasticity of demand and supply might have worked for the situation. But ultimate the August court of the country had to intervene.

 6-   The Excise department can raise more revenue by selling ‘vanity number plates’ to the consumers.

 7-   The price elasticity of demand helps the monopolist most to fix prices of the products which are inelastic or relatively inelastic to maximize his profits.

 8-   The price elasticity of demand also helps us to see what substitutes can reduce demand of a competitive product.

Wikipedia summarizes some more applications:

“Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms’ investment decisions.

Effect of international trade and terms of trade

Analysis of consumption and saving behavior

Analysis of advertising on consumer demand for particular goods”