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Price Elasticity of Demand Guide

Step 4 of 15 in the pathway Running a business by the numbers

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📊 What is Price Elasticity of Demand?

Price Elasticity of Demand (PED) measures how responsive the quantity demanded of a product is to a change in its price. It tells you: "If I change my price by 10%, how much will demand change?"

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                Key Point: PED helps businesses make smart pricing decisions. Should you raise prices to increase revenue, or lower them to boost sales? The answer depends on whether your product is elastic (sensitive to price changes) or inelastic (not very sensitive).
            

The PED Formula

PED = (% Change in Quantity Demanded) / (% Change in Price)

Using Midpoint Method (more accurate):

PED = [(Q2 - Q1) / ((Q2 + Q1)/2)] / [(P2 - P1) / ((P2 + P1)/2)]

Where:

Q1 = Original quantity demanded

Q2 = New quantity demanded

P1 = Original price

P2 = New price

Simple Example

A coffee shop raises price from $4 to $5. Sales drop from 200 to 160 cups per day.

% Change in Quantity = (160 - 200) / ((160 + 200)/2) = -40 / 180 = -22.2%

% Change in Price = (5 - 4) / ((5 + 4)/2) = 1 / 4.5 = 22.2%

PED = -22.2% / 22.2% = -1.0

PED = 1.0 (using absolute value)

Interpretation: PED of 1.0 means demand is unit elastic. A 1% price increase causes exactly 1% decrease in quantity demanded.

Interpreting PED Values

PED Value	Classification	What It Means	Example Products
PED > 1	Elastic	Demand very sensitive to price	Luxury cars, designer clothing, restaurant meals
PED = 1	Unit Elastic	Demand changes proportionally	Mid-range consumer goods
PED < 1	Inelastic	Demand not very sensitive	Petrol, electricity, basic groceries, medicine
PED = 0	Perfectly Inelastic	Demand unchanged regardless of price	Life-saving drugs, insulin (rare in reality)
PED = ∞	Perfectly Elastic	Any price increase kills all demand	Perfect competition markets (theoretical)

Why PED Matters for Business

Pricing Strategy:

Elastic products (PED > 1): Lower prices to increase revenue (volume gains beat price loss)
Inelastic products (PED < 1): Raise prices to increase revenue (price gains beat volume loss)

Revenue Impact Example:

Elastic Product (PED = 2.0):

Current: $50 price × 1,000 units = $50,000 revenue

Raise price 10% to $55

Demand falls 20% (PED of 2.0) to 800 units

New revenue: $55 × 800 = $44,000

Result: Lost $6,000! Wrong move.

Inelastic Product (PED = 0.5):

Current: $50 price × 1,000 units = $50,000 revenue

Raise price 10% to $55

Demand falls only 5% (PED of 0.5) to 950 units

New revenue: $55 × 950 = $52,250

Result: Gained $2,250! Good move.

💡 The Revenue Rule

For Elastic Products (PED > 1): Price ↑ → Revenue ↓ and Price ↓ → Revenue ↑
For Inelastic Products (PED < 1): Price ↑ → Revenue ↑ and Price ↓ → Revenue ↓
For Unit Elastic (PED = 1): Price changes don't affect total revenue

Factors That Affect Elasticity

1. Availability of Substitutes

More substitutes = more elastic demand. If Coca-Cola raises prices, you can switch to Pepsi easily.

Specific brands (Coke): Very elastic (many alternatives)
Product categories (soft drinks): Moderately elastic
Necessities with no substitutes (electricity): Inelastic

2. Necessity vs Luxury

Necessities are inelastic (you need them). Luxuries are elastic (you want them but can do without).

Bread, milk, petrol: Inelastic
Restaurant meals, holidays, jewellery: Elastic

3. Proportion of Income

Items that cost a small % of income are inelastic. Big purchases are elastic.

Salt, matches, toothpicks: Inelastic (too cheap to care)
Cars, houses, appliances: Elastic (major purchase decisions)

4. Time Horizon

Demand becomes more elastic over time as people find alternatives.

Short-term: Petrol is inelastic (must fill up today)
Long-term: Petrol is more elastic (can buy fuel-efficient car, move closer to work)

5. Brand Loyalty

Strong brands have more inelastic demand. People pay premium prices.

Apple products: Relatively inelastic (loyal customers)
Generic products: Very elastic (price-sensitive buyers)

Common PED Values by Product Type

Product Category	Typical PED	Elasticity Type
Salt	0.1	Highly inelastic
Petrol (short-term)	0.2-0.3	Inelastic
Electricity	0.5	Inelastic
Coffee	0.7	Moderately inelastic
Housing (owner-occupied)	1.0	Unit elastic
Restaurant meals	1.6	Elastic
Air travel (leisure)	1.5-2.0	Elastic
Luxury cars	2.5	Very elastic

⚠️ Important Notes

PED is always expressed as positive value (absolute value) for easier interpretation, even though technically it's negative (price up, quantity down).

PED varies along the demand curve. At high prices, demand is usually more elastic. At low prices, more inelastic.

PED is different from price elasticity of supply (PES), which measures seller responsiveness, not buyer responsiveness.

🔢 Calculating Price Elasticity of Demand

Example 1: Coffee Shop Price Change

Scenario: Local cafe changes coffee price

Data:

Original price (P1): $4.50

New price (P2): $5.00

Original quantity (Q1): 300 cups/day

New quantity (Q2): 270 cups/day

Step 1: Calculate % Change in Quantity (Midpoint Method)

% ΔQ = (Q2 - Q1) / ((Q2 + Q1)/2) × 100

% ΔQ = (270 - 300) / ((270 + 300)/2) × 100

% ΔQ = -30 / 285 × 100

% ΔQ = -10.53%

Step 2: Calculate % Change in Price

% ΔP = (P2 - P1) / ((P2 + P1)/2) × 100

% ΔP = (5.00 - 4.50) / ((5.00 + 4.50)/2) × 100

% ΔP = 0.50 / 4.75 × 100

% ΔP = 10.53%

Step 3: Calculate PED

PED = |% ΔQ / % ΔP|

PED = |-10.53% / 10.53%|

PED = 1.0

Interpretation: Coffee is unit elastic at this price point. A 10.53% price increase caused exactly 10.53% decrease in sales.

Revenue Impact:

Old revenue: $4.50 × 300 = $1,350/day

New revenue: $5.00 × 270 = $1,350/day

Change: $0 (unit elastic means revenue unchanged)

Example 2: Electronics Store Sale

Scenario: TV price drops during sale

Data:

Original price: $1,200

Sale price: $900

Original sales: 20 units/month

Sale period sales: 45 units/month

Calculation:

% ΔQ = (45 - 20) / ((45 + 20)/2) × 100 = 76.92%

% ΔP = (900 - 1200) / ((900 + 1200)/2) × 100 = -28.57%

PED = |76.92% / -28.57%|

PED = 2.69 (Elastic)

Interpretation: TVs are very elastic. A 28.57% price cut increased demand by 76.92%.

Revenue Impact:

Old revenue: $1,200 × 20 = $24,000

Sale revenue: $900 × 45 = $40,500

Increase: $16,500 (+68.75%)

                Strategy: For elastic products, lowering prices increases total revenue. The volume gain (125% more units) outweighs the price loss (25% lower price).
            

Example 3: Petrol Price Increase

Scenario: Petrol station raises prices

Data:

Price rises from $2.20 to $2.50 per litre

Weekly sales drop from 50,000L to 48,000L

Calculation:

% ΔQ = (48,000 - 50,000) / 49,000 × 100 = -4.08%

% ΔP = (2.50 - 2.20) / 2.35 × 100 = 12.77%

PED = |-4.08% / 12.77%|

PED = 0.32 (Inelastic)

Interpretation: Petrol demand is inelastic. People need to drive, so a 12.77% price increase only reduces demand by 4.08%.

Revenue Impact:

Old revenue: $2.20 × 50,000 = $110,000

New revenue: $2.50 × 48,000 = $120,000

Increase: $10,000 (+9.1%)

                Strategy: For inelastic products, raising prices increases total revenue. The price gain (13.6% higher) outweighs the volume loss (4% fewer litres).
            

Using PED for Pricing Decisions

Decision Framework:

Your PED	To Increase Revenue	Why
PED > 1 (Elastic)	Lower prices	Volume increase beats price decrease
PED < 1 (Inelastic)	Raise prices	Price increase beats volume decrease
PED = 1 (Unit)	Either (revenue stays same)	Changes cancel out

Estimating PED Without Data

If you don't have sales data, estimate PED based on product characteristics:

High PED (Elastic > 1.5) if product has:

Many close substitutes
Luxury/non-essential nature
High cost relative to income
Highly competitive market
Easy to delay purchase

Low PED (Inelastic < 0.5) if product has:

Few or no substitutes
Necessity/essential nature
Low cost relative to income
Strong brand loyalty or addiction
Immediate need (can't delay)

Testing Price Changes Safely

A/B Testing Method:

1. Select two similar customer groups

2. Keep price same for Group A (control)

3. Change price for Group B (test)

4. Compare demand changes

5. Calculate PED from results

Small Step Method:

1. Make small price change (5-10%)

2. Monitor demand for 2-4 weeks

3. Calculate PED

4. If profitable, continue; if not, revert

⚠️ Common Mistakes

Ignoring competitors: Your PED changes if competitors also change prices
Wrong time period: Measure demand after market adjusts (not day 1)
External factors: Season, economy, trends affect demand independently of price
Not using midpoint method: Simple % method gives different results for increases vs decreases

🌍 Real-World Price Elasticity Examples

Streaming Service Price Increase

Netflix NZ raises subscription price

The Situation:

Old price: $14.99/month

New price: $16.99/month (13.3% increase)

Subscribers before: 850,000

Subscribers after: 810,000

PED Calculation:

% ΔQ = (810k - 850k) / 830k × 100 = -4.82%

% ΔP = (16.99 - 14.99) / 15.99 × 100 = 12.51%

PED = |-4.82% / 12.51%|

PED = 0.39 (Inelastic)

Revenue Impact:

Metric	Before	After	Change
Subscribers	850,000	810,000	-40,000 (-4.7%)
Monthly revenue	$12.74M	$13.76M	+$1.02M (+8.0%)
Annual revenue	$152.9M	$165.1M	+$12.2M

                    Outcome: Despite losing 40,000 subscribers, Netflix increased revenue by $12.2M annually. This works because demand is inelastic (PED = 0.39). Customers with established viewing habits and family sharing don't easily cancel.
                

Why Inelastic?

Content library lock-in (favourite shows)
Shared accounts (multiple users per subscription)
Habit formation (part of daily routine)
Relative affordability ($17/month vs $20+ for cinema)
Switching costs (learning new interface, losing watchlist)

Airline Ticket Pricing

Air NZ adjusts domestic flight prices

Business vs Leisure Travellers:

Business Travellers (Wellington-Auckland):

Price increase: $180 → $220 (22% increase)

Weekly bookings drop: 1,200 → 1,140 (5% decrease)

PED = 5% / 22% = 0.23 (Very inelastic)

Leisure Travellers (Auckland-Queenstown):

Price increase: $150 → $190 (26.7% increase)

Weekly bookings drop: 800 → 600 (25% decrease)

PED = 25% / 26.7% = 0.94 (Nearly unit elastic)

Revenue Impact:

Segment	Old Revenue	New Revenue	Change
Business	$216,000	$250,800	+$34,800 (+16%)
Leisure	$120,000	$114,000	-$6,000 (-5%)

                    Strategy: Airlines use price discrimination. Business travellers (inelastic, must travel for meetings) get charged more. Leisure travellers (elastic, can choose not to go) get discounts and sales. This maximises revenue from each segment.
                

Why Different Elasticities?

Factor	Business	Leisure
Necessity	Must attend meeting	Optional holiday
Who pays	Company pays	Personal money
Flexibility	Fixed dates	Can reschedule
Substitutes	Limited (need direct flight)	Many (drive, different destination)

Supermarket Bread Pricing

Countdown tests bread price changes

Premium vs Budget Bread:

Premium Artisan Bread:

Price: $5.50 → $6.50

Daily sales: 200 → 140 loaves

% ΔQ = -30%, % ΔP = 18.2%

PED = 1.65 (Elastic)

Budget White Bread:

Price: $2.00 → $2.30

Daily sales: 1,000 → 950 loaves

% ΔQ = -5.1%, % ΔP = 14.3%

PED = 0.36 (Inelastic)

Revenue Results:

Product	Old Revenue	New Revenue	Decision
Premium bread	$1,100	$910	Revert price (lost $190/day)
Budget bread	$2,000	$2,185	Keep price (gained $185/day)

💡 Lesson Learned

Premium products are luxuries (elastic). Budget staples are necessities (inelastic). Different pricing strategies needed for different segments, even within the same product category.

Gym Membership Price Testing

Les Mills gym tests membership pricing

Market Research Results:

Option A: Lower Price

Price drop: $65 → $49/month

Memberships increase: 400 → 580

% ΔQ = +45%, % ΔP = -24.6%

PED = 1.83 (Elastic)

Revenue: $26,000 → $28,420 (+9.3%)

Option B: Raise Price

Price increase: $65 → $75/month

Memberships decrease: 400 → 360

% ΔQ = -10%, % ΔP = 14.3%

PED = 0.70 (Inelastic but close to 1)

Revenue: $26,000 → $27,000 (+3.8%)

Decision Analysis:

Consideration	Lower Price	Raise Price
Revenue gain	$2,420 (+9.3%)	$1,000 (+3.8%)
Members	580 (+45%)	360 (-10%)
Capacity strain	High (crowding)	Low (less crowded)
Wear & tear	Higher costs	Lower costs
Per-member profit	Lower margin	Higher margin

                    Final Decision: Gym chose to raise price to $75. Although lower revenue gain ($1,000 vs $2,420), they avoid crowding, reduce equipment wear, and maintain premium positioning. Sometimes the highest revenue isn't the best strategy when capacity is limited.
                

🎯 Test Your Knowledge

Complete this 10-question quiz on Price Elasticity of Demand

1. What does PED measure?

How much profit you make

How responsive demand is to price changes

How much to charge customers

How many units to produce

2. If PED = 2.5, the product is:

Elastic

Inelastic

Unit elastic

Perfectly inelastic

3. For an elastic product (PED > 1), to increase revenue you should:

Raise prices

Keep prices the same

Lower prices

Stop selling the product

4. Which product is most likely to be inelastic?

Insulin for diabetics

Designer handbags

Restaurant meals

Luxury cars

5. Price rises 20%, quantity demanded falls 10%. What is PED?

2.0 (elastic)

0.5 (inelastic)

10 (very elastic)

20 (perfectly elastic)

6. Products with many substitutes tend to have:

Inelastic demand

Zero elasticity

Negative elasticity

Elastic demand

7. For an inelastic product (PED < 1), raising prices will:

Decrease revenue

Not affect revenue

Eliminate demand

Increase revenue

8. Why is petrol typically inelastic in the short term?

It's very cheap

It's a luxury item

Few immediate substitutes, people need to drive

Strong brand loyalty

9. If PED = 1.0 and you raise price by 10%, revenue will:

Increase 10%

Stay approximately the same

Decrease 10%

Double

10. Over time, demand generally becomes:

More elastic (people find alternatives)

More inelastic

Stays exactly the same

Becomes zero

🧮 Try PED Calculator

Related guides

Price Elasticity of Supply Guide, a related guide in the same area.
How House Prices Are Measured NZ, a related guide in the same area.
How to Price a Job, a related guide in the same area.

Situations like yours. The 4 situations worked through above sit alongside 44 more about running a business, each with the sums shown.