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Elasticity of demand, or more specifically price elasticity of demand, is a measure of percentage change in quantity demanded for 1 percentage change in price of the good. Thus:
Price elasticity of demand = (percentage change in quantity demanded)/(percentage change in price)
Please note that when price increases the quantity demanded decreases, and when price decreases the quantity demanded increases. Because of this, strictly speaking the value of ratio as per the above equation is negative, but for measuring demand elasticity we take the positive value.
When the demand elasticity is more than 1, we call the demand elastic. For such type of demands, a reduction in price results in increase in total revenue.
When the demand elasticity is less than 1, we call the demand inelastic. For such type of demands, a reduction in price results in decrease in total revenue.
When the demand elasticity is more than 1, we call the demand unit-elastic. For such type of demands, the total revenue does not change the total revenue.
Analysis of elasticity of demand helps management to take decisions on pricing of products. When price elasticity is less than 1, any increase in price will reduce the total revenue, but the costs will increase because of increased production. Therefore, the total profits will be reduced. In such cases it is best for management to not to reduce the price. Rather they may consider increase in price.
When elasticity of demand is more than 1, a reduction in price will increase the total revenue. At the same time,the costs will also increase because of increase in production volume. If this increase in the total cost is less than the increase in total revenue then the company can increase its profits by reducing price.
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