When demand for a product increases (or decreases) in excess of a change in price demand is said to be elastic. It means that people will buy proportionately more of the product if the price goes down, and less if the price goes up.
It’s important to note that the concept of perfect elasticity – where demand at a specific price is infinite, and any increase at all would see demand drop to zero – is theoretical. As long as the change in demand is larger than the change in price it is considered to be relatively elastic, and we usually just say “elastic”.
For example imagine that you sell, on average, twenty $40 flower bouquets every week. This would generate $800 in revenue.
If you increased the price by 20%, to $50, and sold only twelve as a result (a drop in demand of 40%) this would generate less total revenue (just $600) and demand would be said to be elastic. The decrease in demand (40%) is greater than the increase in price (20%). The higher price does not offset the decreased demand and you end up with less revenue.
Conversely it also means that a drop in price will result in higher demand. If for example you lowered the price of your bouquets by 20% to $32 (a discount of $8) demand would likely increase by the same degree and you would sell twenty-eight bouquets – generating $896 in total revenue.
What does this mean to the seller? It means that increases in price are dangerous, as the revenue added from the higher price is less than the revenue lost to the lower demand. On the other hand it also means that sales should be a very effective way of increasing sales.
Causes of Elasticity
The factors listed below contribute to demand being elastic, especially when two or more are at play.
Access to Alternatives
Discretionary (as opposed to Essential)
Expensive (relative to overall income)
Real World Examples of Elastic Price
Gasoline (Station Level)
While overall demand for gasoline is relatively inelastic, strong local competition between local filling stations makes demand elastic on the local level. If one filling station raises their price above that of a nearby competitor demand will drop significantly. This is one of the reasons filling stations compete with loyalty programs and better attached convenience stores – in the hope consumers will be less focussed on the price of gasoline and more focussed on accumulating points or picking up some groceries.
Brand Name Soda & Snacks
These are discretionary items, purchased frequently, with many substitutes. If the price of one brand of soda goes up demand will go down as consumers look to the many less expensive alternatives. At the same time sales are likely to be highly effective at increasing demand.
Recreation air travel is not essential but discretionary. It is also relatively expensive, and there are many competing providers. Increased prices will reduce demand significantly, and decreased prices will spur demand.
The pattern is easy to recognize. Discretionary goods with many alternatives tend to exhibit price elasticity.