Price Elasticity of Demand

Price Elasticity of Demand

• Elasticity measures the responsiveness of quantity demanded to a change in price.
• According to the law of demand, an increase in price leads to a decrease in quantity demanded, and vice-versa.
• The price elasticity of demand coefficient (Ed) is calculated as the percentage change in quantity demanded of a product (X) divided by the percentage change in the price of product X.
• If the quantity demanded responds strongly to a price change, demand is elastic; if it responds weakly, demand is inelastic.
• The formula to calculate the percentage change in quantity demanded is: %∆Qd = ∆Qd/Q₀ x 100.
• The midpoint formula avoids confusion about start and end points by using the average change in quantity demanded.
• The price elasticity of demand is: Ed = (change in quantity / average quantity) ÷ (change in price / average price).
• Using percentages standardizes the responsiveness across products by providing a unit-free measure.
• The Ed will always be negative, because price and quantity are inversely related.
• To simplify comparison, the minus sign is eliminated.
• Demand is considered elastic when Ed > 1, unit elastic when Ed = 1, and inelastic when Ed < 1.
• In extreme cases, if Ed = 0, demand is perfectly inelastic, and if Ed < ∞, demand is perfectly elastic.

Total Revenue Test

• Total Revenue (TR) is calculated as Price (P) multiplied by Quantity (Q).
• If TR changes in the opposite direction from price, demand is elastic.
• If TR changes in the same direction as price, demand is inelastic.
• If TR does not change when price changes, demand is unit elastic.
• Demand is more elastic toward the upper left and less elastic toward the lower right on a linear demand curve.

Determinants of Price Elasticity of Demand

• The more substitute goods available, the greater the price elasticity of demand. Demand for specific brands is more elastic than for general product categories.
• The greater the proportion of income spent on a good, the greater the price elasticity of demand for it.
• The more a good is considered a luxury rather than a necessity, the greater the price elasticity of demand.
• Demand is more elastic the longer the period under consideration, because consumers need time to adjust to changes in prices.

Applications of Price Elasticity

• The inelastic demand for farm products suggests that a large crop may be undesirable for farmers.
• Legislatures often target products with inelastic demand to raise sales tax revenue.
• It has been argued that decriminalizing illegal drugs could reduce crime because the demand of addicts is highly inelastic.

Price Elasticity of Supply

• The price elasticity of supply (Es) is calculated as the percentage change in quantity supplied of a product, divided by the percentage change in the price of that product.
• The most important determinant of Es is the amount of time producers have to respond to a change in product price.
• The supply in short run is more elastic than it would be in the immediate market period.
• Another long run impact, supply is even more elastic than in the long-run.

Applications of Price Elasticity of Supply

• Antiques have high prices due to strong demand and limited, inelastic supply.
• Reproductions are more affordable as a result of increased demand and relatively elastic supply.
• Volatile gold prices result from shifts in demand interacting with a highly inelastic supply.

Cross Elasticity and Income Elasticity of Demand

• Cross elasticity of demand measures how the quantity demanded of product X changes in response to a change in the price of product Y
• This helps determine if the goods are independent, complement goods, or substitute goods
• Income elasticity of demand examines the correlation between quantity demanded of product X to the change in the average consumer income
• This metric helps determine normal versus inferior goods, where normal goods have positive signs, and inferior goods have negative signs.

Elasticity and Tax Incidence

• Harmonized sales tax exist in Ontario, New Brunswick, Nova Scotia, and Newfoundland and Labrador, but the HST varies across provinces, and is extended to provincial taxes on services
• A sales tax causes a division of the burden.
• When demand is elastic and supply is inelastic, the producer bears most of the tax burden
• Conversely, when supply is elastic and demand is inelastic, the consumer bears most of the tax burden
• A tax often results in an efficiency loss that could otherwise go to tax revenue, redistributive goals, etc.