Price Elasticity of Demand
How strongly quantity demanded responds to price, and why it decides who bears a tax and whether price cuts raise revenue.
Price elasticity of demand measures how strongly the quantity demanded responds to a change in price. It is defined as the percentage change in quantity demanded divided by the percentage change in price. Because demand normally falls when price rises, the raw value is negative; economists usually work with its absolute value. The midpoint method computes percentage changes relative to the average of the old and new values, which makes the elasticity independent of direction.
Values are classified by magnitude. Demand is elastic when the absolute elasticity exceeds 1, meaning quantity responds more than proportionally; inelastic when it is below 1; unit elastic exactly at 1; perfectly inelastic at 0, as approximated by life-saving insulin for a patient; and perfectly elastic at infinity, as approximated by a farmer selling identical wheat at the going market price. Four factors drive elasticity: the availability of substitutes, whether the good is a necessity or a luxury, the share of the budget it absorbs, and the time horizon — demand for gasoline is inelastic in the short run but noticeably more elastic over years as people change vehicles and habits.
Elasticity directly determines how revenue responds to price changes:
| Elasticity | Price cut | Price rise |
|---|---|---|
| Elastic (>1) | Revenue rises | Revenue falls |
| Unit elastic (=1) | Revenue unchanged | Revenue unchanged |
| Inelastic (<1) | Revenue falls | Revenue rises |
The logic: a price cut raises quantity but lowers the price per unit; if quantity grows proportionally more than price falls, total revenue (price × quantity) rises. This is why firms in elastic markets compete on price aggressively while firms selling necessities can raise prices without losing much volume.
Elasticity also determines who bears a tax. When a government taxes a good, the burden is shared between buyers and sellers according to relative elasticities: the side that is less elastic — that cannot easily change behavior — pays most of the tax. Cigarette taxes, for instance, fall largely on consumers because demand is inelastic, while a tax on a good with highly elastic demand falls mostly on producers. The same logic explains why governments tax goods with inelastic demand when they want reliable revenue.
Two related measures complete the toolkit. Cross-price elasticity compares the response of demand for one good to the price of another: positive for substitutes, negative for complements. Income elasticity compares demand to income: positive for normal goods, negative for inferior goods. Together with price elasticity they make up the standard vocabulary for describing how markets respond to change — the vocabulary used throughout supply and demand analysis.