Price Elasticity: How It Affects Supply and Demand

In economics, price elasticity is a measure of how reactive the marketplace is to a change in price for a given product. However, price elasticity works in two ways.

While the price elasticity of demand is a reflection of consumer behavior as a result of price change, the price elasticity of supply measures producer behavior. Each metric feeds into the other. Both are important when analyzing marketplace economics, but it is the price elasticity of demand that companies look to when establishing sales strategy.

Key Takeaways

• Price elasticity measures how the marketplace reacts to a change in price for a given product, and it works in two ways.
• Price elasticity of demand measures the change in consumption of a good as a result of a change in price.
• Price elasticity of supply measures the change in production relative to a change in price.

Price Elasticity of Demand

Price elasticity of demand measures the change in consumption of a good as a result of a change in price. It is calculated by dividing the percent change in consumption by the percent change in price.

For example, if the price of a name-brand microwave increases 20% and consumer purchases of this product subsequently drop by 25%, the microwave has a price elasticity of demand of 25% divided by 20%, or 1.25. This product would be considered highly elastic because it has a score higher than 1, meaning the demand is greatly influenced by price change.

A score between 0 and 1 is considered inelastic, since variation in price has only a small impact on demand. A product with an elasticity of 0 would be considered perfectly inelastic, because price changes have no impact on demand.

Many household items or bare necessities have very low price elasticity of demand, because people need these items regardless of price. Gasoline is an excellent example. Luxury items, such as big-screen televisions or airline tickets, generally have higher elasticity since they are not essential to day-to-day living.

Price Elasticity of Supply

Companies use price elasticity of demand to establish their optimal pricing strategy, but the relationship among supply, price, and demand can be complicated. If a product has a high elasticity of demand, can a change in production levels help the company selling the item maximize profits?

The change in production relative to a change in price is called price elasticity of supply, and it is influenced by many factors. Primary among them are the duration of the price change, the availability of substitutes from other sellers, the company’s capacity for increased production and delivery, stock availability, and complexity of production.

For example, woolen socks are not an overly complicated product to manufacture. Production requires few raw materials, and the item is lightweight and easy to ship. Therefore, if a company knows it can stimulate a 30% increase in sales by reducing the price by 20%, it is likely to increase production to reap the maximum profit.

However, a small business that sells handmade furniture may have a harder time ramping up production or dealing with increased shipping and delivery activity, so an increase in supply may not be feasible, regardless of price elasticity.

What Is Demand?

Demand is an economic concept that relates to a consumer’s desire to purchase goods and services and willingness to pay a specific price for them. An increase in the price of a good or service tends to decrease the quantity demanded. Likewise, a decrease in the price of a good or service will increase the quantity demanded.

What Is Supply?

Supply is an economic concept that describes the total amount of a specific good or service that is available to consumers. Supply can relate to the amount available at a specific price or the amount available across a range of prices if displayed on a graph. 

How Are Supply and Demand Related?

The law of supply and demand combines two fundamental economic principles that describe how changes in the price of a resource, commodity, or product affect its supply and demand. Supply rises while demand declines as the price increases. Supply constricts while demand grows as the price drops.

The Bottom Line

Subscription-based products such as streaming services and gym memberships can be real-life examples of price elasticity of demand. Consumers may cancel or adjust their subscriptions if prices change or alternatives become available.

A real-life example of price elasticity of supply occurred in 2022 after Russia invaded Ukraine. Crude oil prices jumped to as high as $110 per barrel in March of that year, as Russia cut supplies in response to economic sanctions. Gas prices averaged $3.95 per gallon in the United States in 2022—an increase of more than 31% from 2021.