Price Elasticity of Demand

Price Elasticity of Demand

• Refers to how responsive the quantity demanded is to a change in a good or service's price.

Elastic Band Analogy

• Highly elastic bands stretch significantly with little force; similarly, a small price change leads to a large quantity change with elastic goods
• Inelastic bands stretch only a little, reflecting how a price change results in a smaller quantity change for inelastic goods.

Elastic Demand

• Demand is elastic when a price change leads to a larger proportional change in the quantity demanded

Inelastic Demand

• Demand is inelastic when a price change leads to a smaller proportional change in the quantity demanded
• Example: A 10% price increase causes only a 5% decrease in quantity demanded.

Demand Curve Shapes

• Elastic demand curves are relatively flat
• Inelastic demand curves are relatively steep

Extremes of Elasticity

• Perfectly elastic demand is represented by a horizontal straight line, where buyers will demand all of a good at a certain price and nothing at a slightly higher price
• Perfectly inelastic demand is represented by a vertical straight line, where quantity demanded does not change regardless of price

Unit/Unitary Elasticity

• Occurs when the quantity demanded changes by the same proportion as the price change

Factors Affecting Price Elasticity of Demand

• Availability of Substitutes: More substitutes lead to more elastic demand
• Necessity vs. Luxury: Luxury goods are more elastic than necessities
• Proportion of Income Spent: Higher proportion leads to more elastic demand
• Time: Demand becomes more elastic over time as consumers find alternatives
• Definition of the Market: The more specific the market, the more elastic

The Total Revenue Method

• Is straightforward way to determine if demand is elastic or inelastic
• Calculated by: Total Revenue = Price × Quantity
• If total revenue moves in the opposite direction of the price change, demand is elastic
• If total revenue moves in the same direction as the price change, demand is inelastic
• If total revenue remains the same when prices change, demand has unitary elasticity
• Price decreases to 99 cents and consumers demand 105 units, total revenue becomes $103.95. Since price decreased and revenue increased, demand is elastic

The Elasticity Coefficient: Point Method

• The point method compares the percentage change in quantity to the percentage change in price
• The Formula is:
  • Ed = (% Change in Quantity) / (% Change in Price.)
  • Ed = (Q/Q) / (P/P)
• The coefficient can be used to determine types of Demand
  • If Ed > 1, demand is elastic.
  • If Ed < 1, demand is inelastic.
  • If Ed = 1, demand has unit elasticity.
• Example: if 100 units are demanded at $5 and 90 units are demanded when the price increases to $6, the point coefficient is Ed = 0.5
• Due to the law of demand, Ed will always be negative, so the negative is simply removed from the final coefficient

Price Elasticity of Supply

• Measures the responsiveness of quantity supplied to a change in price
• Formula: Es = (% Change in Quantity Supplied) / (% Change in Price)
• Elasticity Classifications
  • Es > 1, Price elastic
  • Es < 1, Price inelastic
  • Es = 1, Unitary elasticity
• Inelastic supply curves have a steeper slope
• Elastic supply curves have a flatter slope

Determinants of Supply Elasticity

• Time: Short run supply is more inelastic, longer time periods allow for more elastic supply
• Nature of the industry: Industries with longer production times have inelastic supply
• Ability to store inventories: Ability to store goods for longer leads to more elastic supply

Applications of Elasticity

• The concept of elasticity explains how markets work and how consumers and producers respond to changes in both demand and supply. For example, increase in housing prices due to rising incomes and population
• Consumers benefit from price elasticity knowledge through better predictions for future purchases.

Applications to Businesses

• Elasticity is important to businesses to help understand market behavior

Government Taxes

• Placing a tax on a good creates a wedge between the price paid and the price received by producers.

Price Discrimination

• Occurs when firms adjust pricing to different consumer groups to maximize total revenue
• Firms base pricing on the different price elasticity of demand of each consumer group
• Example: Female haircuts are typically more expensive than male haircuts because females tend to have a more inelastic demand