Price inelasticity of demand

What Is Price Inelasticity of Demand?

Price inelasticity of demand refers to a situation in which the quantity demanded of a good or service changes little, if at all, in response to a change in its price. In simpler terms, consumers continue to purchase roughly the same amount of a product even if its price increases or decreases. This concept is a fundamental aspect of economics, particularly within the field of microeconomics and the study of consumer-behavior.

When demand is price inelastic, it indicates that consumers are not highly sensitive or responsive to price fluctuations. This often occurs for goods considered necessity-goods or those with few readily available substitute-goods. Understanding price inelasticity of demand is crucial for businesses in setting prices and for governments in formulating tax policies.

History and Origin

The foundational concepts of demand and supply, which underpin price elasticity, were significantly advanced by Alfred Marshall. His seminal work, Principles of Economics, first published in 1890, introduced the formal definition of price elasticity of demand. Marshall emphasized that price and output are determined by the interplay of supply and demand, likening them to the "blades of a pair of scissors" in determining market-equilibrium.⁷ Prior to Marshall, economists understood the practical importance of how price changes affected quantities, but he was the first to quantify this sensitivity and provide a mathematical framework for elasticity.⁶

Key Takeaways

• Insensitivity to Price: Price inelasticity of demand means that a percentage change in price leads to a proportionally smaller percentage change in the quantity demanded.
• Essential Goods: Products with inelastic demand are often necessities or goods for which consumers have no close alternatives.
• Pricing Power: Businesses selling goods with inelastic demand may have more flexibility in their pricing-strategy as price increases are unlikely to significantly deter sales.
• Government Revenue: Goods with inelastic demand are often targets for excise taxes by governments because they can generate substantial revenue with minimal impact on consumption levels.

Formula and Calculation

The price elasticity of demand (PED) is calculated using the following formula:

Where:

• % Change in Quantity Demanded = (\frac{\text{New Quantity} - \text{Original Quantity}}{\text{Original Quantity}})
• % Change in Price = (\frac{\text{New Price} - \text{Original Price}}{\text{Original Price}})

For price inelasticity of demand, the absolute value of the PED will be between 0 and 1 (i.e., (0 < |PED| < 1)). A PED of 0 indicates perfectly inelastic demand, meaning no change in quantity demanded regardless of price.

Interpreting Price Inelasticity of Demand

When the price elasticity of demand for a good is inelastic, it implies that consumers consider the product essential, or they lack viable substitute-goods. For example, if the price of life-saving medication doubles, most patients will still purchase it because there are no alternatives and their health depends on it. This makes the demand for such medication highly inelastic. Conversely, if the demand for a product is elastic, consumers are highly responsive to price changes.⁵

Factors influencing price inelasticity include the availability of substitutes, whether the good is a necessity or a luxury-goods, the proportion of income spent on the good, and the time horizon over which consumers can adjust their behavior. Goods like gasoline, for instance, are often cited as having relatively inelastic demand in the short run because daily commuters have limited immediate alternatives.⁴

Hypothetical Example

Consider a local utility company that provides tap water to a city. Water is a fundamental necessity with no direct substitutes for essential uses like drinking, sanitation, and cooking.

Suppose the utility company decides to increase the price of water by 10%.

• Before the price increase: Consumers demand 10 million gallons of water per day at $0.005 per gallon.
• After the price increase: The price rises to $0.0055 per gallon. Due to the essential nature of water, the quantity demanded might only decrease slightly, say to 9.8 million gallons per day.

Calculating the price elasticity of demand:

• % Change in Quantity Demanded = (\frac{9.8 \text{M} - 10 \text{M}}{10 \text{M}} \times 100% = -2%)
• % Change in Price = (\frac{$0.0055 - $0.005}{$0.005} \times 100% = +10%)

The absolute value of the PED is 0.2. Since (0 < 0.2 < 1), the demand for water is price inelastic. This small change in quantity demanded despite a significant price increase demonstrates the concept of price inelasticity. This means the utility company would likely see an increase in total revenue from the price hike.

Practical Applications

Price inelasticity of demand has significant implications across various sectors:

• Business Strategy: Companies producing goods with inelastic demand, such as essential medications, specialized software, or certain foodstuffs, may have greater flexibility in raising prices without experiencing a substantial drop in sales volume. This allows for potentially higher profit margins and more stable revenue streams.
• Taxation and Government-Regulation: Governments often levy excise taxes on goods with inelastic demand, like tobacco, alcohol, and gasoline. Because consumers are less likely to reduce their consumption significantly due to price increases, these taxes can reliably generate substantial public revenue. For example, studies have shown that cigarette demand is generally inelastic, making tobacco taxes an effective fiscal tool for governments.³² While such taxes may aim to reduce consumption for public health reasons, the inelasticity ensures consistent tax income.
• Market Analysis: Investors and analysts use the concept of price inelasticity to assess the stability and growth potential of industries. Industries with a high proportion of inelastic products tend to be more resilient during economic-factors such as inflation or downturns, as consumer demand remains relatively stable.
• Monopolies and Utilities: Public utilities (like water, electricity, or natural gas) often operate as natural monopoly providers due to the high costs of infrastructure and lack of competition. Given the essential nature of their services, demand for these services is highly inelastic. This is why these industries are typically heavily regulated to prevent providers from exploiting their market power through excessive price increases.

Limitations and Criticisms

While price inelasticity of demand is a powerful analytical tool, it has limitations:

• Time Horizon: Elasticity can change over time. Demand that is inelastic in the short run may become more elastic in the long run as consumers find new substitute-goods or adapt their habits. For instance, while gasoline demand may be inelastic today, over a longer period, consumers might switch to electric vehicles or move closer to work, thereby reducing their reliance on gasoline.¹
• Definition of the Market: The breadth of the market definition impacts elasticity. The demand for "food" is highly inelastic, but the demand for a specific brand of cereal within the food market might be very elastic due to many alternatives.
• Income Effects: For very expensive items, even if they are necessities, a significant price increase might render them unaffordable for a segment of the population, leading to a greater drop in quantity demanded than a strict inelasticity interpretation would suggest.
• Data Accuracy: Accurate calculation of elasticity relies on precise and reliable data on price and quantity changes, which can be challenging to obtain in real-world scenarios. External economic-factors can also influence demand, making it difficult to isolate the impact of price alone.

Price Inelasticity of Demand vs. Price Elasticity of Demand

Price inelasticity of demand and price-elasticity-of-demand are two sides of the same coin within the broader concept of elasticity in economics. They describe the degree of responsiveness of quantity demanded to price changes, but in opposite ways.

The key distinction lies in the magnitude of the consumer's reaction to a price change. With price inelasticity, consumers face constraints (like necessity or lack of substitutes) that limit their ability to significantly alter their consumption patterns, even when prices fluctuate.

FAQs

What makes demand price inelastic?

Several factors contribute to price inelasticity. These include the product being a necessity-goods (e.g., insulin for a diabetic), the absence of close substitute-goods, the product representing a small portion of a consumer's budget, and the short time period for consumers to adjust their buying habits.

Can a product be perfectly price inelastic?

Theoretically, perfectly price inelastic demand means that the quantity demanded does not change at all, regardless of any price change. The PED value in this case is 0. While rare in the real world, life-sustaining items with no alternatives, like certain medications for which there are no complementary-goods or substitutes, can approach perfect inelasticity.

Why is price inelasticity important for businesses?

For businesses, understanding price inelasticity helps in setting optimal prices. If a product has inelastic demand, a business can consider raising prices to increase total revenue without fear of a drastic drop in sales. Conversely, if demand is elastic, a price increase would likely lead to a significant fall in sales and revenue.

How does price inelasticity affect government policy?

Governments often target goods with price inelastic demand for excise taxes (e.g., taxes on tobacco or gasoline) because these taxes generate predictable and substantial revenue. Even with increased prices due to taxes, consumers are unlikely to significantly reduce their consumption of these goods, thus ensuring a steady income for the government.