Price Elasticity of Demand (PED)

Definition & Formula

PED = % change in Quantity Demanded
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         % change in Price

The Elasticity Spectrum

Worked Example

PED = -20% / +20% = -1.0 (unit elastic)

PED = +25% / -25% = -1.0 (unit elastic)

Determinants of PED

1. Availability of substitutes - more substitutes = more elastic (e.g., cola brands)
2. Necessity vs. luxury - necessities (bread, insulin) are inelastic; luxuries (designer bags) are elastic
3. Time horizon - demand becomes more elastic over time as consumers adjust behavior
4. Proportion of income - goods that take up a large share of income tend to be more elastic
5. Breadth of market definition - "food" is inelastic, but "pizza" is elastic (can switch to pasta)
6. Habit/addiction - cigarettes, coffee tend to be inelastic

Real-World Examples

Revenue Implications

• Inelastic demand: Raising price increases total revenue (TR = P × Q; Q drops little)
• Elastic demand: Raising price decreases total revenue (Q drops a lot)
• Unit elastic: Price change has no effect on total revenue

Related Concepts

• Price Elasticity of Supply (PES): Same formula but for quantity supplied. Elastic supply = producers can respond quickly to price changes.
• Cross-Price Elasticity (XED): Measures how demand for Good A changes when Good B's price changes. Positive XED = substitutes; Negative XED = complements.
• Income Elasticity (YED): How demand changes with income. Positive = normal good; Negative = inferior good.
• Midpoint / Arc Elasticity: Uses the average of the two prices/quantities as the base to avoid directional bias in percentage calculations.

Arc (Midpoint) Formula

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

Price Elasticity in Health Economics

Why Healthcare Demand Is Special

1. Insurance - patients rarely pay the full price, so they respond to out-of-pocket cost, not sticker price
2. Information asymmetry - patients don't know what care they need; physicians decide demand on their behalf (supplier-induced demand)
3. Necessity - many services are not truly discretionary (emergency care, chronic disease management)
4. Moral hazard - insurance reduces the effective price to near zero at point of use, blunting price signals
5. Fear and urgency - a chest pain patient is not a rational price-comparing consumer

The Core Finding: Healthcare Demand Is Inelastic

The central estimate from the literature tends to converge on approximately -0.17 for overall healthcare. - JaypeeDigital, Health Economics textbook

The RAND Health Insurance Experiment (HIE)

• Overall PED for medical spending: approximately -0.2 (Manning et al., 1987)
• People with free care used about 45% more services than those with full cost-sharing
• Higher cost-sharing reduced both necessary and unnecessary care equally - patients could not distinguish
• Effect was stronger for outpatient care than inpatient emergency care
• The RAND HIE summary remains the gold standard reference, though scholars continue to debate whether a single elasticity number adequately summarizes responses to nonlinear insurance contracts

Elasticity Varies Widely by Service Type

• Emergency and life-critical care: people use it regardless of price - near-zero elasticity
• Prescription drugs: more discretionary, more substitutes available, more elastic
• Mental health services: intermediate - partly discretionary, stigma and access barriers also play a role

Market-Level vs. Firm-Level Elasticity: An Important Distinction

• Market-level (all hospitals together): inelastic (~-0.17), because there are few substitutes for "hospital care" as a category
• Firm-level (one specific hospital): elastic (~-1.4 or more), because patients can substitute between competing hospitals

Firm PED = Market PED / Firm's market share

Firm PED = -0.17 / 0.12 = -1.42 (elastic)

Elasticity of Demand for Health Insurance

Income Elasticity of Healthcare

• Healthcare is a normal good - consumption rises with income
• However, it rises more slowly than income, meaning it is an income-inelastic normal good at the individual level
• At the national level (GDP comparisons), health spending appears to have income elasticity > 1 (a luxury good), though this is debated
• Poor populations have higher elasticity responses to cost-sharing - price barriers hit lower-income groups harder, creating equity concerns

Policy Implications

Tobacco and Alcohol: High Elasticity Cases in Health

• Cigarettes: PED approximately -0.4 to -0.6 in high-income countries; up to -0.8 in low-income countries
• This elasticity underpins the WHO tobacco taxation strategy - price increases are an effective public health tool
• Cross-price elasticity research shows tobacco product substitution when one product's price rises (e.g., cigarette price up → e-cigarette demand rises)

Summary Table