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Measurement of Price Elasticity

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Last updated date: 14th Jul 2024
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What is the Price Elasticity of Demand?

The price elasticity of demand is a calculation of the degree of change in a commodity's demand with respect to the price change of that commodity. The price elasticity of demand, in other words, is the rate of change in the quantity requested in response to the price change. It is sometimes denoted by Ep or PED. To understand the meaning of elasticity of demand, it is important to learn the methods of measuring the quantity.

Here, we will study the relative elasticity of demand types: price elasticity of demand, price elasticity formula, the elasticity of demand and supply, point elasticity of demand, etc.

Methods of Measuring Price Elasticity of Demand

Basically, there are four ways by which we can calculate the price elasticity of demand, and these are:

• Percentage method

• Total outlay method

• Point method

• Arc method

Percentage Method- Price Elasticity Demand

The Percentage method is one of the widely used methods for calculating demand price elasticities, where price elasticity is calculated in terms of the rate of the percentage change in the quantity requested to the percentage change in price.

The price elasticity of demand can, according to this approach, be mathematically expressed as -

PED = % change in quantity demanded / % change in price, where

$\text{change in quantity demanded} = \frac{\text{new quantity (Q2)} - \text{initial quantity (Q1)}} {\text{initial quantity (Q1)} \times 100}$

$\text{change in price} = \frac{\text{new price ( P2)} -\text{initial price ( P1)}} {\text {initial price ( P1)} \times 100}$

Therefore, $PED=\frac{\Delta Q}{\Delta P}\times \frac{P1}{Q1}$

For example, when the price of a commodity was Rs 10 per unit, the market demand for that commodity was 50 units a day. When the price of the product dropped to Rs 8, demand increased to 60 units. The price elasticity of demand can here be evaluated as -

PED =%change in quantity demanded/ % change in price, where

$\frac{Q2-\frac{Q1}{Q1}}{p2-\frac{p1}{p1}}\times100$

= $\frac{60-\frac{50}{50}\times100}{8-\frac{10}{10}\times100}$

= $\frac{20}{-20}$

= -1

In comparison to supply price elasticity, demand price elasticity is often a negative number since the quantity requested and the product share price are inversely related. This implies that the higher the price, the lower the demand, and the lower the price, the greater the product demand.

Total Outlay Method

Professor Alfred Marshall developed the total outlay method, also known as the overall cost method of calculating price demand elasticity. The price elasticity of demand can, according to this approach, be calculated by comparing the total expenditure on the commodity before and after the price adjustment.

We can get one of three results when comparing the expenditure. They are the

Request elasticity would be greater than the unity of (Ep > 1)

If total expenditure rises with a decrease in price and decreases with a rise in price, the value of the PED is greater than 1. Here, price rises, and overall spending or outlays shift in the opposite direction.

The elasticity of demand will be equal to unity (Ep = 1)

If, in response to a rise in the price of the commodity, the overall expenditure on the commodity remains unchanged, the value of the PED would be equal to 1.

The elasticity of demand will be less than unity (Ep < 1)

The value of PED would be less than 1 if total spending decreases with a decline in price and rises with a rise in price. Here, commodity prices and overall spending are going in the same direction.

When the information from the above table is plotted in the graph, we get a graph like the one shown below.

On the X-axis, gross outlay or cost is calculated in the graph while the price on the Y-axis is measured. The transfer from point A to point B demonstrates elastic demand in the figure, as we can see that overall spending has risen with price decreases.

As total expenditure has remained unchanged with the change in price, the shift from point B to point C demonstrates unitary elastic demand. Likewise, as overall expenditure, as well as price, has decreased, the shift from point C to point D indicates inelastic demand.

Price Elasticity on a Linear Demand Curve

If the demand curve is linear in nature, the PED is determined simply by applying the above expression, i.e.

$PED = \frac{\text{lower segment of the demand curve}}{ \text{upper segment of the demand curve}}$

MN is a linear demand curve in the figure and P is the midpoint of the curve.

Therefore, at point P,

$PED = \frac{\text{lower segment of the demand curve}}{ \text{upper segment of the demand curve}}$

Price Elasticity on a Non-linear Demand Curve

If the demand curve is non-linear or convex in nature, then at the point where the PED is to be determined, a tangent line is drawn. Then again, PED is measured as

$PED = \frac{\text{lower segment of the demand curve}}{ \text{upper segment of the demand curve}}$

FAQs on Measurement of Price Elasticity

1. Define Price Elasticity of Demand and Write Down the Methods of Measuring Price Elasticity of Demand.

The price elasticity of demand is a calculation of the degree of change in a commodity's demand from the price change of that commodity.

The price elasticity of demand, in other words, is the rate of change in the quantity requested in response to the price change. It is sometimes referred to by Ep or PED as 'price elasticity and is denoted.

Methods of Measuring Price Elasticity of Demand

Basically, there are four ways that we can calculate the price elasticity of demand. Such approaches are -

1. Percentage method

2. Total outlay method

3. Point method

4. Arc method

2. Write the Salient Features of Price Elasticity.

Key features of Price elasticity are as follows.

• Price elasticity tests the reaction to a change in the price of the quantity requested or supplied by a good. It is measured as the percentage change in the amount requested or supplied, separated by the percentage change in price.

• Elasticity can be described as an elastic or very responsive unit that is not very responsive, elastic, or inelastic.

• Elastic demand or supply curves suggest that the quantity ordered or supplied reacts in a greater than a proportional way to price changes.

• An inelastic demand or supply curve is one that induces a smaller percentage change in the quantity requested or supplied by a given percentage change in price.

• Unitary elasticity implies that the price shift of a given percentage contributes to an equivalent percentage change in the amount ordered or supplied.

3. What is the price elasticity of demand?

The price elasticity of demand for a good is a measure of how price affects the quantity demanded. When prices increase, demand for most of the goods decreases, but it decreases more in the case of some goods. The price elasticity is the percentage of change in the quantity required when the price goes up by one percent while all other factors remain constant. If the elasticity is 2, it signifies that a 1% increase in price results in a 2% decrease in quantity demanded. Other elasticities are used to determine how the quantity needed changes as a result of other factors.

Except in exceptional circumstances, price elasticities are negative. When a good is described to have an elasticity of 2, it almost invariably indicates that it has a formal elasticity of -2.  The term "more elastic" refers to a good's elasticity being of greater magnitude, regardless of the sign. Positive elasticity products, such as Veblen and Giffen goods, are uncommon exceptions to the law of demand. When the elasticity of demand for a good is less than one in absolute value, it is said to be inelastic: changes in price have a relatively modest effect on the quantity required. When the elasticity of demand for a good is greater than one, it is considered to be elastic. A good with an elasticity of 2 has elastic demand because quantity decreases twice as much as the price rises; a good with an elasticity of -0.5 has inelastic demand because quantity decreases half as much as the price rises.

4. What is meant by arc elasticity?

Hugh Dalton was the first to introduce arc elasticity. It's comparable to a standard elasticity problem, except with the addition of the index number issue. The change of percentage in P and Q in relation to the average of the two prices and the average of the two quantities, rather than just the change in relation to one point or the other, is another answer to the asymmetry problem of having an elasticity dependent on which of the two given points on a demand curve is picked as the "original" point and which as the "new" one. This produces an "average" elasticity for the real demand curve between the two points—i.e., the arc of the curve. As a result, the arc elasticity, in this case in relation to the price of the commodity, is known.

As the average price and average quantity are the coordinates of the midpoint of the straight line between the two provided locations, this method of estimating price elasticity is also known as the "midpoints formula." The midpoint approach is applied in this formula. The greater the curvature of the actual demand curve throughout that range, however, the worse this approximation of its elasticity will be because this calculation implicitly assumes the segment of the demand curve in between those points is linear.

5. How did the concept of price elasticity originate?

Alfred Marshall is credited with defining "elasticity of demand" in Principles of Economics, published in 1890, along with the concept of an economic "elasticity" coefficient. Only four years after inventing the notion of elasticity, Alfred Marshall invented the price elasticity of demand. To get the equation for price elasticity of demand, he employed Cournot's basic demand curve creation method. Price elasticity of demand is defined as follows: In general, the elasticity (or responsiveness) of demand in a market is big or little, depending on how much or little the amount sought grows or reduces for a given fall in price, and how much or little it diminishes for a given rise in price. He justifies this by stating that the sole universal law governing a person's demand for an item is that it declines over time, but this diminishment may be gradual or rapid.

If it is slow, a tiny price drop will result in a disproportionately huge increase in his purchases. However, if it happens quickly, a tiny price drop will only result in a small rise in his purchases. In the first situation, we may remark that his desires are extremely malleable. In the second scenario. His demand has a low degree of flexibility. The Marshallian PED was based on a point-price definition, with elasticities calculated using differential calculus.

6. What are the two determinants of price elasticity?

Two of the determinants of price elasticity are:

Goods that can be Substituted

The higher the elasticity, the more and closer the substitutes are available, because individuals may quickly transfer from one good to another if the price changes even slightly. A strong substitution impact exists. If there are no close substitutes, the substitution effect will be limited, and demand will be inelastic.

The Scope of a Good Definition

The lower the elasticity, the broader the scope of a good (or service). For example, if a large number of substitutes are available, Company X's fish and chips will have a very high elasticity of demand, whereas food, in general, will have a very low elasticity of demand because substitutes do not exist.

7. What is the quantity effect with regards to price elasticity?

A higher unit price tends to result in fewer units being sold, whereas a lower unit price tends to result in more units being sold.

Because of the inverse nature of the relationship between price and quantity demanded inelastic items, the two effects have opposing effects on total revenue. However, before deciding whether to raise or lower prices, a company must first determine the net effect. The change in total revenue is roughly equal to the change in the quantity required plus the change in price. To know more, visit the Vedantu app and website.