# How is price elasticity determined in practice?

Price elasticity of demand and Price elasticity of supply are two of the most important concepts of microeconomics, but they're generally explained from a hypothetical standpoint, and little effort is given to explaining how they are measured, or how they fluctuate (specifically the scale of fluctuation, not the contributing causes).

Can anyone explain this, and/or point to studies that document the fluctuation of $PE_{d}$ and $PE_{s}$ over time?

• In real life, when you have lots of products for sale, you use expensive software to work it out. kssretail.com/resources has lots of brochures etc from one of the many companies that sell such software. Aug 3, 2015 at 15:16

In many practical instances, price elasticity of demand (PED) is calculated in a back of the envelope fashion, just as taught in the textbooks! Firms can adjust their price by some small amount and observe the demand response. For relatively small changes in price and quantity, little accuracy is lost by assuming that the demand function is locally linear, so that the change in price and demand jointly give an estimate for $$\frac{dQ}{dp}.$$ Since $p$ and $Q$ are already known, this is enough to calculate the PED: $$\eta=\frac{dQ}{dp}\frac{p}{Q}.$$

This method yields only a point estimate of elasticity at the current price. However, one can get an incredibly long way with just this estimate thanks to the so-called Lerner condition: that a firm with marginal cost $c$ facing a price elasticity of $\eta$ maximises profit when $$\frac{p-c}{p}=-\frac{1}{\eta}.$$ Once the price elasticity of demand is estimated in the above fashion, this formula can be used to infer if the firm's price is above or below its profit-maximising level (allowing a firm to correct towards that level). Alternatively, this kind of analysis is often used as a heuristic in competition policy (antitrust) because, by estimating the right hand side of the Lerner formula, competition authorities can get an estimate for the left hand side (i.e. for how much power the firm has to price above marginal cost).

One drawback of this approach is that, at least in its simplest implementation, it does not control for factors such as how a change in the price of a product affects the demand of other products sold by the same firm (and thus overall profit).

You can see a nice informal discussion of Amazon's book pricing based on this kind of back of the envelope work here.

For more formal purposes, and when data is readily available, the process is often similar but slightly more careful in the estimation of demand. An excellent example of this kind of work can be found in Ellison & Ellison's 2009 Econometrica Paper, Search, Obfuscation, and Price Elasticities on the Internet. They proceed by estimating the firm's demand function econometrically (rather than via the heuristic method described above), and then calculate the implied PED from this estimated demand. Using an equation analogous to the Lerner condition, they are able to infer how far from the competitive case the market is, and attribute this discrepancy to search obfuscation.

In practice, for economists working outside of a firm, the main difficulty is often obtaining the data necessary to estimate the PED (Ellison & Ellison had excellent data thanks to collaboration with a firm in the market).

The truth is that it's unclear if firms use the concept at all.
Alan Blinder wrote this wonderful little book called "Asking about prices". A survey of firms asking them how they set prices. And it's full of very puzzling finds.
Elasticity is one of them(Page 99). So they ask firms what is their price elasticity of demand:

This was a difficult question for many firms, who not only do not have an elasticity estimate handy but are unaccustomed to thinking in such terms.

And the results are: Which the author incredulously comment:

Can it really be true that firms that sell 40 percent of GDP believe that their demand is totally insensitive to price, and that only about one-sixth of GDP is sold under conditions of elastic demand?

My idea is that most people setting prices just don't understand or care about the idea of elasticity. A suspicion further compounded by the fact (underlined in the same book) that most firms seemed to have no understanding of marginal benefits and cost

• This assumes that most companies have the power to set prices, rather then just the option to stop trading if the price gets to low. Dec 30, 2014 at 14:06