Price Elasticity of Demand

Objectives of Unit 1

• Measures of the responsiveness of economic variables will be explored
• How to determine if a price change can raise or lower total revenue will be addressed
• Methods for estimating the degree of elasticity will be analyzed
• Reasons why prices in some markets are more volatile than others will be considered

Outline of Unit 1

• Price elasticity of demand is examined
• Determinants of elasticity are explored
• Applications of elasticity are discussed
• Additional types of elasticity are identified

1.1 Price Elasticity of Demand

• Elasticity measures the response of buyers and sellers to market condition changes
• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in its price.
• When price falls, the measure is of how much does quantity demanded rise?
• Elastic demand means that, as the price drops, the quantity demanded is increased
• Perfectly inelastic demand means that the quantity demanded does not change, regardless of price
• Perfectly elastic demand means that the quantity demanded is heavily changed by the price
• Price elasticity of Demand is ΔQ/Q midpoint divided by ΔP/P midpoint

1.1 Calculating Elasticity

• Elastic demand is >1
• Inelastic demand is <1
• The steeper the slope, the lower the elasticity

1.1 Price Elasticity and Total Revenue Relationship

• Rising prices will raise total revenue where demand is inelastic
• Rising prices will reduce total revenue where demand is elastic
• Elasticity is the responsiveness of quantity (such as quantity demanded) to a stimulus (such as a change in price)

1.2 Determinants of Elasticity

• Demand is more elastic for products that can be easily substituted or are discretionary.
• Demand is more elastic for products that occupy a large share of a consumer's budget.
• Availability of close substitutes is a determinant
• Necessities versus luxuries is a determinant
• Budget share is a determinant
• Time horizon is a determinant

Here are examples of estimated elasticity:

• Green peas 2.8
• Eating Out 1.6
• Air Travel 1.5
• Shoes 0.7
• Electricity 0.3
• Coffee 0.3
• Cigarettes 0.1

1.3 Applications of Elasticity

• The Russia-Ukraine war impacts gas prices
• If drug demand is elastic, interdiction will lower revenues to drug suppliers.
• Interdiction reduces Q and raises P
• Drug education shifts the demand curve to the left by reducing demand
• Governments often tax alcohol and cigarettes heavily

1.4 Other Types of Elasticity

• "Income elasticity of demand, cross-price elasticity of demand" are demand elasticities
• "Price elasticity of supply, determinants of price elasticity of supply" are supply elasticities
• There is also a method for calculating all elasticities

1.4 Elasticity of Demand

• Income elasticity of demand measures how much the quantity demanded responds to a change in consumers’ income.
• It is computed as the percentage change in quantity demanded divided by the percentage change in income.
• Most goods are normal goods, where income elasticity is > 0.
• Inferior goods have income elasticity < 0.

1.4 Cross Price Elasticity

• It is computed as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good.
• Substitutes have a cross price elasticity > 0.
• Complements are goods that are typically used together Cross price elasticity < 0.

1.4 Elasticity of Supply

• Price elasticity of supply is how much the quantity supplied responds to a change in price.
• Computed as the percentage change in quantity supplied divided by the percentage change in price
• Supply of a good is elastic if the quantity supplied responds greatly to these changes
• Supply is inelastic if the quantity supplied changes only slightly to changes in the price.

1.4 Determinants of Price Elasticity of Supply

• Flexibility of production is a determinant
• Number of producers is a determinant
• Time horizon is a determinant
• All of the key concepts of elasticity are to quantitative responses to changes in income and in the prices of other goods.