This question lingers in the mind of every business professional. To gain a better understanding of this problem, you need to learn about the price elasticity of demand.
Here is the formula for elasticity:
Price elasticity of demand = (% change in quantity demanded) / (% change in price)
As you can see from the equation for the price elasticity of demand, it measures the relative responsiveness of quantity demanded to a change in price.
When a product has a price elasticity of demand that is greater than 1, economists say that the product's demand is price elastic. For example, if a 10% reduction in price results in a 20% gain in quantity demanded, then the price elasticity of demand is 2 (20% / 10%) and thus deemed as price elastic.
When a product has a price elasticity of demand that is less than 1, economists say that the product's demand is price inelastic. A product that is price inelastic has a demand that is not sensitive to price changes. Take salt for example. Salt is a cheap but also an essential good. As the price of salt increases, people do not tend decrease their consumption of salt.
When a product has a price elasticity of demand that is equal to 1, economists classify the product's demand as unitary price elasticity. In this case, any percent change in price is accompanied with an equal percent change in quantity demanded.
Determinants of the Price Elasticity of Demand
There are three important factors that determine the price elasticity of demand:
Number of substitute products: As a rule of thumb, the more substitutes there are for a product, the more price elastic the demand for the product is. Take gasoline for example. Gasoline is a very inelastic product mainly because, at this point, there are simply no good substitutes for gasoline.
- Portion of budget spent on product: The less the consumer spent on the product, the more inelastic the product is. Again, let's take salt for example. In the United State, very few people care enough to even check how much salt is selling per pound since it represents such a small portion of an average American's budget. Expensive items, such as washing machines, are generally more price elastic since consumers are more willing to wait for a better bargain or search for alternatives.
- Time period considered: The shorter the time period considered, the more inelastic the demand will be. In the short-run, consumers do not have enough time to respond to price changes. For example, in the short-run, people may find it hard to avoid paying high gasoline prices. However, if high gasoline prices persist, people will have enough time to respond by developing alternative energy, which will ease demand for gasoline.