What is Price Elasticity Of Demand?

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Price elasticity of demand is a measurement of the change in the consumption of a product in relation to a change in its price. Expressed mathematically, it is:Economists use price elasticity to understand how supply and demand for a product change when its price changes. Like demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity of supply refers to the relationship between change in supply and change in price. It’s calculated by dividing the percentage change in quantity supplied by the percentage change in price. Together, the two elasticities combine to determine what goods are produced at what prices.

Definition

Price elasticity of demand measures how the quantity demanded of a product changes in response to a change in price. It is expressed mathematically as: Price Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Price.

Origin

The concept of price elasticity of demand originated in the 19th century economic studies, first systematized by Alfred Marshall in his book 'Principles of Economics'. Marshall used the elasticity concept to help economists understand market dynamics and consumer behavior.

Categories and Features

Price elasticity of demand can be categorized into several types: perfectly inelastic (elasticity coefficient is 0), where demand does not change with price; unitary elasticity (elasticity coefficient is 1), where demand changes proportionally with price; elastic demand (elasticity coefficient greater than 1), where demand changes more than the price change; and inelastic demand (elasticity coefficient less than 1), where demand changes less than the price change. Elastic demand is often seen in luxury goods markets, while inelastic demand is common in essential goods markets.

Case Studies

A typical case is Apple's pricing strategy during new product launches. Apple often sets high initial prices, leveraging brand loyalty and product innovation to maintain demand, resulting in low price elasticity of demand despite high prices. Another example is the oil market, where oil, as a necessity, has low price elasticity of demand, meaning demand changes little even if prices rise.

Common Issues

Investors often misunderstand price elasticity of demand, assuming all goods' demand will significantly change with price changes. In reality, price elasticity of demand varies by product type and market conditions. Another common issue is ignoring the time factor, as short-term and long-term demand elasticity may differ.

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Oversupply

Oversupply, also known as excess supply, occurs when the quantity of a good or service available in the market exceeds the quantity demanded by consumers. This situation typically results in a decrease in the price of the good or service, as suppliers reduce prices to clear excess inventory or minimize losses.

Law Of Supply And Demand

The Law of Supply and Demand is a fundamental economic principle that describes the relationship between the availability of a product (supply) and the desire for that product (demand). Specifically:Law of Supply: All else being equal, an increase in the price of a good will result in an increase in the quantity supplied. Conversely, a decrease in the price will result in a decrease in the quantity supplied. This occurs because higher prices can lead to higher profits, attracting more producers to the market.Law of Demand: All else being equal, an increase in the price of a good will result in a decrease in the quantity demanded. Conversely, a decrease in the price will result in an increase in the quantity demanded. This happens because higher prices reduce consumers' purchasing power or willingness to buy.

Supply Curve

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Law Of Supply

The Law of Supply states that, all else being equal, an increase in the price of a good or service will result in an increase in the quantity supplied, and a decrease in the price will result in a decrease in the quantity supplied. This principle reflects producers' response to price signals, where higher prices typically lead to higher profits, thereby incentivizing producers to supply more.

Supply Shock

A supply shock refers to a sudden and unexpected event that causes a significant change in the supply of a good or service. These shocks can be positive (increasing supply) or negative (decreasing supply) and are typically caused by external factors such as natural disasters, technological innovations, changes in government policies, or international trade events. Supply shocks can have substantial impacts on market prices and overall economic activity.