Price elasticity of demand
How strongly buyers respond to a price change, what makes demand elastic or inelastic, and how to measure it with the midpoint method.
FinanceA company's marketAbout 6 min: 3 reading, 3 practiceUpdated
General education, not financial advice.
- Calculate a price elasticity of demand with the midpoint method
- Name what makes demand more or less elastic
- Describe income, cross-price and supply elasticities
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 1 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 5
What it is
The law of demand tells us the direction buyers respond to a price change. Elasticity measures how much.
Price elasticity of demand = percentage change in quantity demanded ÷ percentage change in price.
It is usually given as a positive number. Mankiw's example: if a 10% rise in the price of ice cream makes you buy 20% less, your elasticity is 20 ÷ 10 = 2.
- Elastic demand: elasticity above 1. Quantity moves proportionately more than price.
- Inelastic demand: elasticity below 1. Quantity moves proportionately less.
- Unit elastic: exactly 1.
- At the extremes, perfectly inelastic demand (elasticity 0) is a vertical curve; perfectly elastic demand (infinite) is horizontal.
As a rule of thumb, through a given point, the flatter the demand curve, the more elastic demand is.
The midpoint method. A rise from 4 to 6 is a 50% rise, but a fall from 6 to 4 is a 33% fall: the answer depends on the starting point. The midpoint method divides each change by the average of the two values, so the answer is the same in either direction. From 4 to 6: (6 − 4) ÷ 5 × 100 = 40%.
Quick check
Tap an answer to check it.
The price rises 10% and the quantity demanded falls 5%. What is the elasticity, and is demand elastic?
- That divides the price change by the quantity change; divide the other way round
Show answer
0.5: inelastic. 5 ÷ 10 = 0.5, which is below 1.
Why it matters
What makes demand elastic? Mankiw's rules of thumb:
- Close substitutes make demand more elastic: butter (margarine is a close substitute) more than eggs.
- Necessities have less elastic demand than luxuries: doctor's visits against sailboats. What counts as a necessity depends on the buyer's preferences, not the good itself.
- Narrowly defined markets are more elastic: "vanilla ice cream" has close substitutes; "food" does not.
- Longer time horizons make demand more elastic. Mankiw cites studies finding that a 10% rise in petrol prices cuts use by about 2.5% after a year and about 6% after five years, as people switch cars and change habits.
Other elasticities:
- Income elasticity of demand = % change in quantity ÷ % change in income. Positive for normal goods, negative for inferior goods. Necessities such as food have small income elasticities; luxuries large ones.
- Cross-price elasticity of demand = % change in quantity of good 1 ÷ % change in the price of good 2. Positive for substitutes, negative for complements.
- Price elasticity of supply = % change in quantity supplied ÷ % change in price. It depends on how easily sellers can change output: beachfront land is inelastic; manufactured goods such as books and cars are more elastic. Supply is usually more elastic in the long run.
Text description
Two demand curves pass through the same point: a price of 4 and a quantity of 100. The steep curve is inelastic: when the price rises to 5, the quantity falls only to 90. The flatter, dashed curve is elastic: the same rise in price cuts the quantity to 70. Through a given point, the flatter the curve, the more elastic the demand.
Worked example
Mankiw's supply example uses the midpoint method: milk rises from 2.85 to 3.15 a gallon, and dairy farmers raise output from 9,000 to 11,000 gallons a month.
- % change in price: (3.15 − 2.85) ÷ 3.00 × 100 = 10%.
- % change in quantity: (11,000 − 9,000) ÷ 10,000 × 100 = 20%.
- Price elasticity of supply: 20 ÷ 10 = 2. Supply is elastic.
Try a demand example of your own (the defaults are from Mankiw's inelastic-demand figure):
Common mistake
Confusing elasticity with slope. The slope measures the change in units; elasticity measures it in percentages. Along a straight-line demand curve the slope is the same everywhere, but elasticity is not: demand is more elastic where the price is high and the quantity low.
Key terms
- elasticity
- a measure of how much quantity responds to a change in one of its determinants
- price elasticity of demand
- % change in quantity demanded ÷ % change in price
- elastic
- elasticity greater than 1
- inelastic
- elasticity less than 1
- midpoint method
- calculating a percentage change by dividing by the average of the start and end values
- income elasticity of demand
- % change in quantity demanded ÷ % change in income
- cross-price elasticity of demand
- % change in quantity of one good ÷ % change in the price of another
- price elasticity of supply
- % change in quantity supplied ÷ % change in price
Practise the key terms
Tap a card to turn it over. 8 cards.
| Front | Back |
|---|---|
| elasticity | a measure of how much quantity responds to a change in one of its determinants |
| price elasticity of demand | % change in quantity demanded ÷ % change in price |
| elastic | elasticity greater than 1 |
| inelastic | elasticity less than 1 |
| midpoint method | calculating a percentage change by dividing by the average of the start and end values |
| income elasticity of demand | % change in quantity demanded ÷ % change in income |
| cross-price elasticity of demand | % change in quantity of one good ÷ % change in the price of another |
| price elasticity of supply | % change in quantity supplied ÷ % change in price |
Practice
Work it through
The price of a bus ticket rises from 2.00 to 3.00, and daily journeys fall from 1,100 to 900. Use the midpoint method.
- (3 − 2) ÷ 2.5 × 100
- 200 ÷ 1,000 × 100
- 20 ÷ 40
Quick quiz
Tap an answer to check it.
In the last exercise, is demand for bus journeys elastic or inelastic?
- Elastic demand has an elasticity above 1
Show answer
Inelastic: 0.5 is below 1. Journeys fell proportionately less than the fare rose.
Which good would you expect to have the more elastic demand?
- Broadly defined markets have fewer close substitutes
Show answer
One brand of breakfast cereal. Narrowly defined markets have close substitutes, so demand is more elastic.
A good's income elasticity is −0.4. What kind of good is it?
- A luxury has a large positive income elasticity
Show answer
An inferior good. Demand falls as income rises.
Sort it
Which group does this belong to?
Petrol over five years
Buyers have time to adjustShow answer
More elastic demand. Buyers have time to adjust
Petrol over one month
Little time to change habitsShow answer
Less elastic demand. Little time to change habits
A luxury holiday
Luxuries are more elasticShow answer
More elastic demand. Luxuries are more elastic
Insulin for a diabetic
A necessity without close substitutesShow answer
Less elastic demand. A necessity without close substitutes
One brand of bottled water
Many close substitutesShow answer
More elastic demand. Many close substitutes
In short
- Elasticity = % change in quantity ÷ % change in price (or income, or another good's price).
- Above 1 is elastic, below 1 inelastic.
- The midpoint method gives the same answer whichever way the price moves.
- Substitutes, luxuries, narrow markets and long horizons make demand more elastic.
Mastery check
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Check yourself
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By the midpoint method, what is the percentage change from 4 to 6?
Show answer
40% (2 ÷ 5 × 100).
Is the cross-price elasticity of two substitutes positive or negative?
Show answer
Positive: a rise in one good's price raises the quantity demanded of the other.
In Mankiw's milk example, what is the price elasticity of supply?
Show answer
2 (20% ÷ 10%).
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 5.
- On this site: Demand and what shifts it and Elasticity and total revenue.
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