2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16
The first law of economics states that there is an inverse relationship between the demand for a product and its price. However, this is too general a statement. It is equally important for economists to measure the degree of consumer response to a changing price, because in different markets, with the same change in the cost of a product, the quantity that a consumer wants to purchase changes in different ways.
The concept of price elasticity
To measure the sensitivity of demand, or the response of a change in the quantity demanded to a change in the cost of a good, an indicator called "price elasticity" is used. In other words, elasticity is the ratio of the percentage change in demand to the percentage change in the cost of a good.
The quantitative measure is called the "elasticity coefficient", which makes it clear by what percentage the quantity demanded will change after a change in the price of a good by one percent. Due to the inverse relationship between the cost of goods and the magnitude of demand for it, the elasticity coefficient always takes a value less than zero. Howeverfor comparison purposes, economists ignore the minus, using the absolute value of the coefficient.
Interpretation of elasticity coefficient
The value that price elasticity acquires in each individual case allows economists to judge the degree of elasticity of demand for the product under study. Depending on this, the following groups of goods are distinguished:
- Goods for which demand is elastic. Their coefficient of elasticity takes a value greater than one. In this case, there is a sensitive reaction of buyers to a change in the value of the goods, as a result of which the demand changes to a greater extent than the cost. In such a situation, a change in the cost of goods entails a change in the total proceeds from its sale in the opposite direction.
- Goods with inelastic demand. The price elasticity calculated for them takes a value less than one. If the price of goods with inelastic demand decreases, the increase in demand is not enough to compensate for the fall in revenue, as a result, following the price, sales revenue falls.
- Products with price elasticity equal to one. The price and quantity demanded in this case change in the same way, as a result, neither a decrease nor an increase in value changes the proceeds from the sale.
Methods for calculating elasticity
The elasticity coefficient can be calculated in two ways:
- When calculating the arc elasticity, two points are taken into account, between which and is measuredelasticity value.
- Point price elasticity of demand represents the change in quantity demanded for an infinitesimal change in price. The fact is that the demand curve has a convex shape. All this leads to the fact that the price elasticity at each point of the chart takes on different values.
Defining price elasticity is sometimes hard to understand, but it's a must for any company. When making decisions about pricing, organizations should be guided by the elasticity of demand for a product so that a change in revenue following a change in cost is not unexpected.
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