2.3 Price Elasticity of Demand

What elasticity measures

Price elasticity of demand (PED) measures how sensitive quantity demanded is to a change in price: %ΔQd ÷ %ΔP. If |PED| > 1, demand is elastic (quantity responds strongly); if |PED| < 1, demand is inelastic; if |PED| = 1, demand is unit elastic. Because price and quantity move oppositely, PED is technically negative, but we usually discuss its absolute value.

Determinants of elasticity

Demand is more elastic when goods have more substitutes, are luxuries (not necessities), take up a larger share of income, or are measured over a longer time horizon (more time to adjust). Necessities, goods with few substitutes, and short time frames tend to have inelastic demand.

Elasticity and total revenue

Elasticity links price changes to total revenue (TR = P×Q). If demand is elastic, a price increase lowers TR (quantity falls more than proportionally); a price decrease raises TR. If demand is inelastic, a price increase raises TR; a price decrease lowers TR. At unit elastic demand, TR is maximized and unaffected by small price changes.

Key terms

Price elasticity of demand (PED)

The percentage change in quantity demanded divided by the percentage change in price; measures responsiveness of quantity to price.

Elastic demand

|PED| > 1; quantity demanded changes more than proportionally to a price change.

Inelastic demand

|PED| < 1; quantity demanded changes less than proportionally to a price change.

Determinants of elasticity

Availability of substitutes, necessity vs. luxury, share of income spent, and time horizon.

Elasticity & total revenue rule

Elastic: price and revenue move opposite directions. Inelastic: price and revenue move same direction. Unit elastic: revenue is maximized.

Try an AP-style question

What is the price elasticity of demand?

1. 0.4, elastic
2. 0.4, inelastic
3. 2.5, inelastic
4. 2.5, elastic