Price Elasticity of Demand & Supply
Why Doesn’t a Price Rise Always Cut Demand by the Same Amount?
When a petrol station puts its prices up by 10%, most drivers still fill their tanks — they have little choice. But when a cinema raises ticket prices by 10%, some people decide to stay home or stream instead. The quantity demanded falls more sharply. This difference in how sensitive quantity demanded is to a price change is captured by the concept of price elasticity of demand (PED).
PED tells producers and governments something vital: if you raise the price of this good, how much will demand fall? The answer determines whether total revenue goes up or down, and whether a tax will raise money or simply cause people to stop buying the good altogether.
Calculating PED
The formula is straightforward:
PED = percentage change in quantity demanded ÷ percentage change in price
Percentage change is always calculated as: (change ÷ original value) × 100. So if the price of a cinema ticket rises from £10 to £12 (a 20% rise) and weekly admissions fall from 500 to 400 (a 20% fall), then PED = −20% ÷ 20% = −1. The answer is almost always negative because a price rise causes a fall in quantity demanded — they move in opposite directions. For simplicity, the negative sign is usually ignored and only the absolute value (the number without its sign) is compared.
PED = % change in quantity demanded ÷ % change in price. When PED is greater than 1 (ignoring the minus sign), demand is elastic — a price rise causes a proportionally bigger fall in quantity demanded. When PED is less than 1, demand is inelastic — a price rise causes a proportionally smaller fall in quantity demanded.
Elastic and Inelastic Demand
If PED = 2, a 10% price rise leads to a 20% fall in quantity demanded — demand is price elastic. Consumers are very sensitive to the price change. If PED = 0.3, a 10% price rise leads to only a 3% fall in quantity demanded — demand is price inelastic. Consumers barely change their behaviour. A PED of exactly 1 is called unit elastic — a 10% price rise causes a 10% fall in quantity demanded.
Availability of substitutes. The more substitutes a good has, the easier it is for consumers to switch away when the price rises, so demand is more elastic. Branded cola has close substitutes (own-brand cola, other soft drinks), so its demand is relatively elastic. Insulin for diabetics has no close substitute, so demand is highly inelastic.
Necessity versus luxury. Necessities like bread, heating, or prescription medicines have inelastic demand because consumers need them regardless of price. Luxuries like designer handbags or foreign holidays have more elastic demand — if the price rises sharply, consumers can simply go without or choose a cheaper option.
Proportion of income. When a good takes up a large share of a consumer’s income (a car, a house), even a small percentage price change feels significant, so demand tends to be more elastic. When the good costs very little (a box of matches, a bus timetable), consumers barely notice a price rise and demand is inelastic.
Time period. Demand becomes more elastic over time. In the short run, a driver who faces rising petrol prices has little choice but to pay — they still need to get to work. Over time, they might buy a more fuel-efficient car, move closer to work, or switch to public transport. The longer the time period, the more substitutes and adaptations become available.
PED and Total Revenue
The link between PED and total revenue (price × quantity sold) is one of the most useful applications of elasticity. Whether a price rise increases or decreases total revenue depends entirely on whether demand is elastic or inelastic.
If demand is inelastic (PED < 1): a price rise leads to only a small fall in quantity demanded, so total revenue rises. For example, a firm selling a necessity can raise its price by 20% and lose only 5% of its sales — revenue goes up. This is why governments tax petrol, alcohol and cigarettes so heavily: demand is inelastic, so the tax raises significant revenue without destroying sales.
If demand is elastic (PED > 1): a price rise leads to a proportionally bigger fall in quantity demanded, so total revenue falls. A firm that raises the price of a luxury good with many substitutes will find that so many customers switch away that its total income drops. In this case, cutting prices would actually increase total revenue because the gain in quantity more than offsets the lower price per unit.
PED and total revenue rule: inelastic demand (PED < 1) — a price rise increases total revenue. Elastic demand (PED > 1) — a price rise decreases total revenue. Firms use this to decide whether to raise or lower prices to maximise income.
Price Elasticity of Supply
Supply has its own elasticity measure. Price elasticity of supply (PES) tells us how readily producers can expand (or contract) output when the price changes:
PES = percentage change in quantity supplied ÷ percentage change in price
Unlike PED, PES is positive — a higher price gives producers an incentive to supply more, so both quantity supplied and price move in the same direction. If PES = 3, a 10% price rise causes a 30% increase in quantity supplied: supply is elastic. If PES = 0.2, a 10% price rise causes only a 2% increase in supply: supply is inelastic.
Spare capacity. A factory with spare capacity can quickly increase output when prices rise, so its supply is relatively elastic. A factory already at full capacity cannot easily produce more in the short run, making supply inelastic.
Stocks and storage. If a firm holds large stocks of finished goods, it can respond quickly to a price rise by releasing stock onto the market — supply is elastic. Goods that cannot be stored (fresh strawberries, live concerts) have inelastic supply because output cannot be easily scaled up.
Ease of switching production. Firms that can easily redirect their resources to produce a different good respond quickly to price signals — supply tends to be more elastic. A specialist defence manufacturer cannot easily switch to making consumer electronics, so its supply of its original product is inelastic.
Time period. Supply becomes more elastic over time, just as demand does. In the short run, a housebuilder cannot immediately put up hundreds more homes just because house prices have risen. Over several years, land can be bought, planning permission granted, and new homes built. Supply in the long run is almost always more elastic than in the short run.
Implications for Producers and Government
Understanding both PED and PES matters for real decisions. A firm setting prices needs to know whether its customers are sensitive to price changes. A coffee shop in a high street with five competitors will face elastic demand — cutting its prices slightly could attract many more customers and raise total revenue. A utility company supplying water faces highly inelastic demand and operates as a natural monopoly — consumers cannot switch supplier, and there is no effective competition. This monopoly structure, compounded by inelastic demand (which would allow an unregulated monopolist to raise prices sharply), is exactly why the government regulates water prices rather than leaving them to the market.
Governments rely on inelastic demand when taxing goods like fuel, tobacco and alcohol. The tax raises prices, but because demand is inelastic, the quantity sold barely falls — tax revenue flows in reliably. However, the government also knows that a tax on a good with elastic demand (a luxury item with many substitutes) would cause sales to collapse, raising little revenue and harming the industry.
On the supply side, PES matters when a price signal reaches a market. If supply is inelastic — as it is for housing in areas of high demand — a sharp rise in house prices may not quickly attract enough new supply to bring prices back down. That is why housing markets can remain expensive for many years even when demand is strong.