Wednesday, August 18, 2010

What is Price Elasticity?

I saw this term used on and couldn't remember the exact definition from when I took Econ way back when, so I thought I'd look it up and share it. There are at least two different types of elasticity. Price Elasticity of Demand and Price Elasticity of Supply. They are basically the same thing but for two different variables.

Price Elasticity is simply a measure of how much the Supply or Demand changes with a change in price.

Let's do an example with Price Elasticity of Demand. Say a candy bar is $1 and the demand for it is 100 units and the price is raised to $1.01 and this causes the demand to decrease to 90 units. We can come up with a number that represents how much this difference in price is affecting the demand.

The equation is (P/Q) * (∆Q/∆P) or ∆Q%/∆P%. For our example, let's use the first equation. P = Price = 1.01, Q = Quantity = 90, ∆Q = 90 - 100 = -10, ∆P = 1.01 - 1.00 = .01. Therefore, PED (Price Elasticity of Demand) = 1.01/90 * -10/.01 = -11.22

Note that since the value is negative, it indicates an inverse relationship. Basically, as price increases, the demand decreases. That's usually how it happens, but sometimes you could have weird cases where the fact that it's becoming more expensive makes it more in demand. Perhaps this could happen with an IPO of stock or a rare diamond.