Price elasticity of demand refers to the way prices change in relationship to the demand, or the way demand changes in relationship to pricing. Price elasticity can also reference the amount of money each individual consumer is willing to pay for something. People with lower incomes tend to have lower price elasticity, because they have less money to spend. A person with a higher income is thought to have higher price elasticity, since he can afford to spend more. In both cases, ability to pay is negotiated by the intrinsic value of what is being sold. If the thing being sold is in high demand, even a consumer with low price elasticity is usually willing to pay higher prices.
Elasticity implies stretch and flexibility. The price flexibility or the elasticity of demand will change based on each item. Changing nature of both price and demand are affected by a number of factors.
Generally, goods or services offered at a lower price lead to a demand for greater quantity. If you can get socks on sale you might buy several pairs or several packages, instead of just a pair. This means that though the seller offers the socks at a lower price, he usually ends up making more money, because demand for the product has increased. However if the price is set too low, the retailer may lose money by selling too many pairs of socks at a reduced rate.
Price elasticity of demand evaluates how change in price influences demand. In certain circumstances, demand remains inelastic, despite higher prices. This is true of a number of medications that are available to treat certain conditions, where there is no substitute. Demand remains constant in spite of high prices.
It’s also true of fuel consumption, where few substitutes exist. In 2006, when gasoline prices skyrocketed, demand for gasoline was only slightly affected. Some people were able to use less gas for their cars, or to purchase cars that were hybrids, but these were in short supply. Since few alternatives existed, people continued to buy gasoline, and demand was thus considered inelastic. Price didn’t significantly alter demand. Other utilities, like water, often are highly inelastic in price because they have no substitute to which a consumer can turn.
Price elasticity of demand also explains that price becomes more elastic, when higher prices may turn away most consumers who can choose to buy something else that is less expensive. When a good or service has numerous substitutes, prices are more elastic and will change with demand. In fact, availability of substitution is often a better predictor of price elasticity than is demand. Amount of competition, numerous companies offering the same items, can also affect price flexibility of demand. Usually, competition in the marketplace keeps prices lower and more flexible. Generic equivalents of certain items have lowered the demand for brand name items, thus lowering their price.
In economics, complex formulas show how the price elasticity of demand can be either profitable or detrimental to the seller. These formulas describe how good or bad price elasticity of demand functions. Examples of good (for the seller) price elasticity of demand include inelastic pricing. In this example, a small drop in demand is made up for by higher prices. A unit price elasticity that raises demand can also be profitable for a company. On the other hand, bad price elasticity occurs when quantity demand increases, but does not make up for discounted price, causing a drop in company profits.
A perfectly elastic price is equally detrimental. Raised price in the good eliminates demand completely. The most profitable arrangement in pricing is when demand is perfectly inelastic, as with the medicine and utilities cited above. Despite rise in price, demand does not decrease, resulting in the highest profits for a company.