Price Elasticity of Demand

Play Price Elasticity Challenge →

What Is Price Elasticity of Demand?

Price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Because the two move in opposite directions, the raw value is negative, so economists usually discuss its absolute value. Demand is elastic when that value exceeds 1, inelastic when it falls between 0 and 1, and unit elastic when it equals 1. A perfectly inelastic demand is drawn as a vertical line with an elasticity of 0. Economists often use the midpoint, or arc, method so the result is the same whether price rises or falls.

Why It Matters

Price elasticity of demand is one of the most practical tools in economics because it predicts how buyers react to price changes. Its magnitude depends on several determinants: the availability of close substitutes, whether the good is a necessity or a luxury, the share of a buyer's budget it consumes, and the time horizon, since demand grows more elastic over time. Elasticity drives the total-revenue test, because raising price increases revenue when demand is inelastic but decreases it when demand is elastic. It also determines who bears a tax: the more inelastic side of the market shoulders the larger share of the burden. Firms, governments, and analysts all rely on elasticity to forecast the consequences of price changes.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank: