What Is Price Elasticty of Demand?
12 Apr 2006 in Regulatory Economics, Glossary
What does it mean when someone says demand is price "elastic" or
"inelastic"? Why should I care?
Like all other scholarly fields, economics have their
own jargon.
"Price elasticity" refers to how an individual buyer (or
a marketful of buyers) responds to changes in prices.
The Law of Demand governs this relationship. The quantity
demanded
is higher with low prices and lower with high prices. This is just
common sense, but of course economists must convert all common
sense notions into abstruse language. Wikipedia has a relatively
simple but pedantic exposition that illustrates why people
hate economics.
The table below defines in words and math the four interesting
categories of price elasticity. (A similar story can be told
about supply
elasticity.)
| Price Elasticity (E) | ||
| Perfectly inelastic | The quantity demanded is totally unresponsive to any change in price | E = 0 |
| Inelastic | The quantity demanded
increases less than 1% for a 1% decrease in price. or
The quantity demanded decreases less than 1% for a 1% increase in price. |
0 < E < 1 |
| The quantity demanded decreases exactly 1% for a 1% increase in price. | E = 1 | |
| Elastic | The quantity demanded
increases more than 1% for a 1% decrease in price. or
The quantity demanded decreases more than 1% for a 1% increase in price. |
E > 1 |
| Infinitely elastic | The quantity demanded goes to zero if price increases. | E = infinity |
Whether demand is said to be elastic or inelastic does not reveal whether the market is competitive or uncompetitive. Plenty of goods are sold in very competitive markets where demand is highly inelastic--meaning that even large increases in price have little short-term effect on quantities demanded. Examples Neutral Source is especially familiar with range from the mundane(e.g., gasoline) to the sublime (e.g., limited production fine wine).
Price elasticity matters a lot in regulatory economics. Economists use this information to estimate how alternative regulatory standards or designs are likely to affect market prices and quantities. These estimates are the building blocks for benefit-cost analysis--the primary analytic tool used for describing regulatory impacts.