5.1 The Elasticity of Demand
5.1 a. The Price Elasticity of Demand and Its Determinants
Price elasticity of demand is a measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. [1]
Determinants of Price elasticity: [2]
- A good with more substitutes will have a higher elasticity.
- The higher the percentage of income used to pay for the product, the higher the elasticity.
- For non- durable goods, the longer the price change holds, the higher the elasticity.
- The more necessary a good is, the lower the price elasticity.
Example: The demand of a soda decreases if the price increases.
Price Elasticity of Demand [3]
5.1 b. Computing the Price Elasticity of Demand
Price elasticity of demand = (Percentage Change in Quantity Demanded)/(Percentage Change in Price) [1]
Example: Suppose the price of apples increased by 10% and the demand fell by 15%
Price elasticity of demand = 15/10 = 1.5
Price Elasticity of Demand [3]
5.1 c. The Midpoint Method
A simple technique for calculating the coefficient of elasticity by estimating the average elasticity for discrete changes in two variables. [4]
Midpoint elasticity [4] = ((Q2-Q1)/((Q2+Q1)/2))/((P2-P1)/((P2+P1)/2))
Where P1 is the initial price before any changes, P2 is the ending value after price changes, Q1 is the initial quantity before any changes, and Q2 is the ending value after quantity changes. The numerator of each term on the right-hand side of the equation [(P2 – P1) and (Q2 – Q1)] is the discrete change in price and quantity, respectively. The denominator of each term [(P2 + P1)/2 and (Q2 + Q1)/2] is the base value from which the percentage change is calculated. [4]
Midpoint Formula [5]
5.1 d. Types of Demand Curves
Elastic: The means quantity demanded changes more than price. Elasticity > 1 [6]
Example: Increase in price of Coca-Cola
Inelastic: This means quantity does not change much relative to price. Elasticity < 1 [7]
Example: Increase in price of an essential medication.
Unit elastic: This means quantity demanded changes proportionally to price. Elasticity =1 [8]
Example: The unit elastic demand for a one dollar move higher in the price of a good will generally cause a one unit decrease in the demand of the same good, leaving revenues unchanged.
Perfectly Elastic: Perfectly elastic demand is represented graphically as a horizontal line. In this case, any increase in price will lead to zero units demanded. Elasticity = ∞ [2]
Perfectly Inelastic: Perfectly inelastic demand is graphed as a vertical line. This means that the same quantity will be demanded regardless of the price. Elasticity = 0 [2]
Type of Elasticity of Demand [9]
5.1 e. Total Revenue and the Price Elasticity of Demand
If the demand for a good is elastic, an increase in price reduces total revenue. If the demand for a good is inelastic, an increase in price increases total revenue. If the demand for the good is unit-elastic an increase in price does not change the total revenue. [10]
Example: Suppose the current toll on a bridge is $1.00 which then is increased to $1.10 to cover for road repairs. Suppose the revenue before the price hike is for 1000 cars was $1000. The elasticity would be = ((Q2-Q1)/Q1)/ (($1.10-$1)/$1). When the elasticity is inelastic (-0.5), Q2 = 950 and total revenue = $1045.00. Similarly, if the elasticity is elastic (2.0), Q2 = 800 and total revenue = $880.00. If the elasticity is unit-elastic (1.0), a one-percent increase in price leads to a one-percent decrease in quantity demanded. So, Q2 = 900 and total revenue = $1000.00 [10]
Total Revenue and Elasticity [11]
5.1 f. Elasticity and Total Revenue along a Linear Demand Curve
The elasticity of demand varies on the interval on which it is measured. At high prices and low quantities on upper part of the demand curve, the percentage change in quantity is relatively large and percentage change in price is relatively small. The absolute value of elasticity is relatively large. As we move down, equal changes in quantity represent smaller percent changes whereas equal changes in price represents larger percentage changes and the elasticity declines. The absolute value of the price elasticity of demand will fall as we move down and to the right along the curve. [12]
Example: Oil is a linear demand curve where the graph would be close to a straight vertical line as it is inelastic.
Elasticity of demand on a linear demand curve [13]
5.1 g. Other Demand Elasticities
Cross Elasticity of Demand: Cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demand of one good when a change in price takes place in another good. [14]
Example: Pepsi has a high cross-elasticity; if the price of Coca-Cola increases, the demand for quantity of Pepsi increases.
Cross Elasticity of Demand [15]
Income Elasticity of Demand: Income elasticity of demand refers to the sensitivity of the quantity demand for a certain good to a change in real income of consumers who buy this good, keeping all other things constant. [16]
Example: If there business cycle is in a downturn, the demand of premium cars decreases.
Income Elasticity of Demand [17]
