THE ELASTICITY OF DEMAND
Price Elasticity of Demand : a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.
Price Elasticity of Demand and it’s Determinants
Necessities versus Luxuries: Necessities tend to have inelastic demand whereas luxuries have elastic demands.
Ex. Inelastic - The demand for milk will change little even if the price increases since it is a necessity. Elastic - The demand for air travel will decrease considerably if the price goes up since it is considered to a luxury.
Availability of Close Substitutes: Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.
Ex. Inelastic – that demand for eggs changes little since there are little substitutes. Elastic – that demand for butter will go down if the price goes up because margarine is a close substitute.
Definition of the Market: narrowly defined markets tend to have more elastic demand then broadly defined markets because it is easier to find close substitutes for narrowly defined goods.
Ex. Food a broad category has a fairly inelastic demand. Cheesecake a narrower category has a more elastic demand because there are substitutes for deserts, such as ice-cream.
Time Horizon: Goods tend to have more elastic demand over a longer time horizons.
Ex. When the price of gasoline rises, there is little change in demand initially, however in the long run people made by smaller cars or find other transportation means.
How Is Price Elasticity of Demand Calculated
Price Elasticity of Demand (E
d) = Percentage change in quantity demanded (Q
d) Percentage change in price (P)
Example,
If a price increase of 10% in ice cream results in a 20% decrease in demand, then the price elasticity of ice cream is,
Price elasticity (ice cream) = 20% = 2 10%
An elasticity of two indicates that that change in the quantity demanded is proportionally twice as large as the change in the price. Note that the negative sign associated with the decrease in demand is ignored in the calculations. Elasticity is reported as absolute values.
1
The midpoint method is a better way to calculate percentage changes and elasticity.
Ex. Point A: Price = $4 Quantity = 120
Point B: Price = $6 Quantity = 80
Note, the percentage change will be different if you’re going from point A to point B compared to going from point B to point A..
E
a-b =(80-120)/120 = 33% = 0.66
(6-4)/4 50%
E
b-a =(120-80)/80 = 50% = 1.5
(4-6)/6 33%
To avoid this, the midpoint between point A and B is used to calculate elasticity. You get the same answer no matter what direction you go.
Ex. The mid point between A and B, Price is $5 Quantity = 100
E= (80-120)/100 = 40% = 1.00
(6-4)/5 40%
or
E= (120-80)/100 = 40% = 1.00
(4-6)/6 40%
We can express the midpoint method with the following formula for the price elasticity of demand between two points (Q
1, P
1) and (Q
2, P
2).
(E
d) = (Q
2 -Q
1)/[ (Q
2 +Q
1)/2]
(P
2 -P
1)/[ (P
2 +P
1)/2]
The Variety of Demand Curves and Elasticity
3
Total Revenue And The Price Elasticity of Demand
Total Revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good multiplied by the quantity sold.
In the graph, below, the total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P X Q, If the price is $4 and the quantity sold is 100 units, ten the total revenue is $4 X 100 = $400
5
The following graph shows how total revenue changes when the price changes for an Inelastic Demand . Note that an increase in price leads to a decrease in quantity demanded that is proportionally smaller. Therefore, the overall effect is that total revenue increases. In this example, an increase in price from $1 to $3 causes quantity demanded to fall from 100 to 80, but note that the total revenue increases from $100 to $240
7
The following graph shows how total revenue changes when the price changes for an Elastic Demand . Note that an increase in price leads to a decrease in quantity demanded that is proportionally larger. Therefore, the overall effect is that total revenue decreases. In this example, an increase in price from $4 to $5 causes quantity demanded to fall from 50 to 20, note that the total revenue decreases from $200 to $100
SUMMARY
When a demand curve is inelastic (a price elasticity less than 1), a price increase raises total revenue, and a price decrease reduces total revenue.
When a demand curve is elastic (a price elasticity greater than 1), a price increase reduces total revenue, and a price decrease raises total revenue.