What is price elasticity? Definition and meaning

Price Elasticity is a measure of how consumers react to the prices of products and services. Normally demand declines when prices rise, but depending on the product/service and the market, how consumers react to a price change can vary.

There are two types of price elasticities:

  • Price elasticity of demand: also known as PED or Ed, is a measure in economics to show how demand responds to a change in the price of a product or service.
  • Price elasticity of supply: also called PES or Es, is a measure that shows how the quantity of supply is affected by a change in the price of a good or service.

Moreover, consumer preferences and seasonal trends can significantly influence demand, adding complexity to how price changes affect market behavior.

Price elasticity image
In this image, demand for products A and B changes to a greater extent than alterations in price. Products D, E, and F have smaller demand changes than alterations in price. With product C, demand and prices change by the same proportion. Product A is a non-essential good (such as a weekend in a spa), product F is an essential good (such as milk or bread), while product C might be a Coke (people would turn to Pepsi if Coke’s price rose).

The OECD (Organisation for Economic Co-operation and Development) offers the following definition:

“The price elasticity in demand is defined as the percentage change in quantity demanded divided by the percentage change in price.”

“Since the demand curve is normally downward sloping, the price elasticity of demand is usually a negative number. However, the negative sign is often omitted.”

Do not confuse the term with income elasticity of demand. Income elasticity of demand measures how demand for a product or service changes when people’s incomes change.

Price elastic vs inelastic

When demand or supply for something changes considerably after a price change, the product or service is very price elastic.

If, however, there is no change in demand or supply, or very little change, it is price inelastic.

This article focuses more on the price elasticity of demand. When there is good price elasticity, it means that the change in demand is greater than the change in price.

Price elasticity - three products
Demand for one can of diet coke is elastic because there are other cheap alternatives available. Even if milk prices go up, people will continue buying it, especially if they have children. A spa treatment is a non-essential luxury item. They are the first things we cut back on when either prices go up or our disposable income shrinks.

  • Example

Let’s suppose that the price of a Coke rises by 10%, and demand subsequently falls by 10%. Demand for Coke is price elastic.

Most goods have high price elasticity, unlike basic staple foods. If the price of bread rises 10% in London, demand for bread does not fall by anywhere near that amount; if at all. Bread is price-inelastic.

Price elasticity of staple goods in high-poverty areas, however, are different. In high-poverty areas, they follow the demand-price relationship of Giffen goods.

  • No substitute products

Several factors determine price elasticity. For example, if there are no substitute products, demand tends to be inelastic. In such cases, suppliers have some power over price.

  • Many substitute products

When there are many substitute products in existence, however, demand is usually elastic. Then suppliers have virtually no control over price.

Price elasticity is mostly inverse

Price elasticities nearly always have an inverse relationship, i.e., when the price goes up demand declines.

Only products and services that do not conform to the law of demand have a positive PED. Giffen or Veblen goods are excellent examples.

  • Veblen Goods

Veblen goods are luxury goods; demand for them rises when prices go up. Consumers buy Veblen goods to impress their neighbors, family, and friends.

They are status symbol-enhancing goods. Swiss watches, sports cars, jewelry, and designer handbags, for example, are Veblen goods.

  • Giffen Goods

These goods also defy the economic laws of price and demand, but for a completely different reason. Giffen goods are very basic products which low-income households rely on.

Examples of Giffen goods are rice in China, bread in Europe and North America, and tortillas in Mexico.

If the price of tortillas rises in Mexico, poor people will cut back on more expensive foods. They will reduce their meat consumption and consume more tortillas. Demand for Giffen goods rises when prices go up.

The price elasticity for most goods and services is inverse, i.e., demand falls when prices rise. However, it is positive for Giffen and Veblen goods, i.e., demand rises when prices go up.

Conversely, for luxury services such as first-class air travel or five-star hotel accommodations, price elasticity can also be affected by perceived value, where higher prices may signal superior quality and exclusivity to consumers.

Furthermore, increased access to market information and price comparison tools has heightened consumers’ sensitivity to price changes, thereby potentially increasing the price elasticity of demand for a wide range of products.

Alfred Marshall - coined term price elasticity
Alfred Marshall, known as the ‘Father of economists’ of his time, coined the term ‘price elasticity’ in 1890. (Image: Wikipedia)

Calculating price elasticity

Calculating the price elasticity of a good or service is straightforward. We take the percentage change in demand and divide it by the percentage change of price.

Let’s say the price of a smartphone brand rises by 10%, resulting in a 10% decline in demand. We do the following calculation:

-10% (demand change) ÷ 10% (price change) = -1
The PED is -1 (minus one)

Price elasticity may vary from minus one to plus one. Most products and services range from minus one to zero. Giffen or Veblen goods, on the other hand, range from zero to plus one.

Alfred Marshall

Economic historians say that Alfred Marshall (1842-1924), a British economist, coined the term ‘elasticity of demand’ in his 1890 book – Principles of Economics.

Marshall Wrote:

“And we may say generally:— the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price … the only universal law as to a person’s desire for a commodity is that it diminishes… but this diminution may be slow or rapid.”

“If it is slow… a small fall in price will cause a comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause only a very small increase in his purchases. In the former case… the elasticity of his wants, we may say, is great. In the latter case… the elasticity of his demand is small.”

Compound nouns containing “elasticity”

There are many compound nouns containing the word “elasticity,” such as “price elasticity.” A compound noun is a term that consists of two or more words. Let’s take a look at some, their meanings, and how we can use them in a sentence:

  • Cross-price elasticity

A measure of how the quantity demanded of one good responds to a change in the price of another good.
Example: “Businesses often assess cross-price elasticity to understand the relationship between complementary or substitute products in the market.”

  • Income elasticity

Indicates how the demand for a good changes in response to changes in consumers’ income levels.
Example: “Luxury car dealers monitor income elasticity to predict how sales might fluctuate with shifting economic tides.”

  • Advertising elasticity

Reflects the sensitivity of the demand for a product to changes in advertising expenditure.
Example: “The marketing team evaluated the advertising elasticity to determine the effectiveness of the recent campaign.”

  • Long-run elasticity

Measures the responsiveness of demand or supply to price changes over a longer period.
Example: “Economists are more interested in long-run elasticity to gauge how fuel prices will affect travel behavior over the next decade.”

  • Short-run elasticity

Evaluates the immediate response of demand or supply to changes in price, usually within a year.
Example: “The short-run elasticity of seasonal fruits often shows significant fluctuations due to temporary market conditions.”

  • Brand elasticity

Assesses how sensitive consumers are to changes in the price of a specific brand’s product.
Example: “The brand elasticity for the new smartphone model was surprisingly low, indicating strong brand loyalty among consumers.”

  • Engel elasticity

Measures how the demand for a good changes as household income changes, named after the statistician Ernst Engel.
Example: “The Engel elasticity of luxury vacations tends to be quite high, as they are one of the first expenses households cut back on during economic downturns.”

Three Videos

These three YouTube videos come from our sister channel, Marketing Business Network. They explain what the terms “Price Elasticity”, “Giffen Goods”, and “Veblen Goods” mean using easy-to-understand language and examples:

  • What is Price Elasticity?

  • What are Giffen Goods?

  • What are Veblen Goods?