Price Elasticity of Demand

Answer 1

When the price of something you're used to paying for increases do you buy less of it? Or if the price suddenly drops do you buy more of it? Economists call this effect the price elasticity of demand. They use a formula to determine just how price elastic the demand for certain goods are.

What about that premium coffee you buy on your way to work? What if the price suddenly jumped from $3.00 to $4.50? That's an increase of 50%. Well, you might rightly consider buying your coffee from the drive-up at the fast food place or purchasing your own coffee at the grocery store and brewing it in a travel mug for your commute. The demand for such "luxury" coffee can be considered price elastic.

On the other hand, think about this in terms of gasoline. If you're like most Americans you drive a car in order to get to work and run errands. When the price of gas goes up do you stop buying as much gas? Maybe a little bit, but most likely, you continue driving the same number of miles you drove before because you have to. Consequently, you end up purchasing the same number of gallons of gasoline you did last week, even if the price has jumped by 50%. That's because fuel is traditionally price inelastic. The changes in the price do not alter demand by very much in the short run.

Factors that affect the price elasticity of demand are the availability of alternative goods or services, levels of discretionary income, and timeframe. As we saw in the example of the coffee, where an alternative source offers a substitute for the "luxury" good demand is price elastic. However, with gasoline there are no good short-term alternatives, so the demand stays relatively flat while prices fluctuate.

Your level of discretionary income is also an important factor. If your income level rises or drops, you may find your own reaction to certain goods and services moving in concert. Things you were unwilling to give up before become much easier to do without when your income falls.

Also, the timeframe plays an important role in price elasticity of demand. Imagine that gas prices rise, as in the example above, but instead of dropping back down again they stay elevated for years at a time. This would cause people to seriously reconsider their reliance on a personal automobile. We'd see people start to ride bicycles more, or an increase in carpooling, or greater acceptance of public transportation. While the demand for a good may be price inelastic in the short run, it may well become elastic in the long run.

Answer 2

How much do you pay for a widget? What if the price for that widget were to go up? Would you buy less of it? Sometimes when prices go up we learn how to do without and other times we just can’t (or refuse to) and we end up paying the higher price.

Prices for goods do change over time. We all know that. But a characteristic of prices you may not have considered is how they affect demand. Generally, when prices for a good go up demand will fall. But this movement is not always constant across socioeconomic strata, nor do goods all move to the same degree with each dollar of price increase. The measure of how much demand changes due solely to changes in prices of goods is what economists call “price elasticity of demand”. That’s a mouthful, and sometimes they abbreviate it as PED.

As I said, not every good behaves the same way, or is as elastic as others. We’ve all seen the rising fuel costs in recent years. How much has that affected our fuel consumption? My guess is that it hasn’t changed it that much. That’s because fuel demand tends to be very price inelastic in the short run. You still need to get to work and get back home, after all.

PED may not play a big role in your decision making at the pump. But what happens when the price of a visit to the movie theater goes up? The demand for theater tickets tend to be considerably more price elastic, meaning demand is much more sensitive to rising costs. And it makes sense, especially in our digital age that people are less willing to spend on seeing a movie in a theater with each marginal dollar of admission price increase. You can stream movies live on your computer, rent them at a vending machine, or have them mailed to your home for pennies on the dollar versus theater admission.

Medical services tend to be inelastic; unless you’re looking at elective cosmetic surgery. In reality we all make adjustments to our wishlists as prices go up, but some things we just need to have. As with many things in Personal Finance, your priorities and values will ultimately drive your decision making.