elasticity of demand responsiveness to price change or “so. how many more big macs would you buy...

ELASTICITY OF DEMAND

Responsiveness to price changeOr

“So. How many more Big Macs would you buy if they were

only $1??”

“How much LESS gas would you use if it was $10 a

gallon?”

ELASTICITY

The law of demand says that as prices change,

so does the quantity demanded; inverse

relationship.

Elasticity measures just HOW much the

price change affects the quantity.

Elasticity of demand varies greatly for

different type products.

3 METHODS

3 ways to help determine the elasticity of a product.

They vary from an exact mathematical calculation

( the most exact) to an approximation of relative

elasticity ( least exact, but pretty easy to guess).

I. The Coefficient Formula

II. The Total Revenue Test

III. The Determinants of Ed

THE COEFFICIENT FORMULA

This method assigns a coefficient ( a number) to measure the

elasticity :

Elastic ( very responsive to price change): Ed > 1

Inelastic ( not very responsive to price change): Ed < 1

Unit or Unitary elastic (response is in proportion to price

change): Ed = 1

This one’s easy to remember because “unit” usually

means one.

To get the coefficient:

take the % change in Qd /divide by the % change in Price

Ed = % Qd

% P

Remember : we are looking at the response to price

change, so we have two different prices ( P1 and P2, and two

different quantities Q 1 and Q2).

The answer is the coefficient.

Easy, right?


Not exactly…

Because the elasticity applies no matter if we raise

or lower the price ( which way we move on the

Demand curve), we need to have the Ed constant

between two prices.

To get the % change in price and quantity, we

have to use the Mid-Point

Formula


To get the %Qd : (Q2-Q1) (Q2 + Q1)/2 the average of the Qs

Do this for Price also: (P2-P1) (P2+P1)/2

Ed uses absolute values; NO NEGATIVE.

That means we can simply say, to get the % , use the

difference divided by the average for both the Quantity

demanded and the Price.

Then just plug those numbers into the coefficient formula

Ed = % Qd

% P

T H E C O E F F I C I E N T F O R M U L A :

MID-POINT FORMULA

THE TOTAL REVENUE TEST

We can also determine if an item is elastic ,

inelastic or unit by seeing what happens to total

revenue when the price changes.

Total revenue is measured by multiplying the price

and the quantity: P x Q = TR

If TR moves in same direction as P, it’s

Inelastic

If TR moves in the opposite direction as P,

( which means it’s moving with the Q) it’s

Elastic

If TR doesn’t change when the price changes,

it’s Unitary E.


Some examples: Let’s say I’m selling cookies for

$1 each. If I can sell 10 cookies @ $1 each, my TR is

$10. The law of demand says I’ll be able to sell

more cookies if I lower the price, but we now know

that depends on the Elasticity of the demand for

cookies!

I want to make more money, so I lower the price to

$ .50. If I sell 20 cookies, my TR is still only $10.

The demand for cookies is______?

Unitiary elastic because the

TR stayed the same when the price changed.

People “responded” in direct proportion to the

price change.


Well, suppose when I lowered the price to $ .50, I

sold 100 cookies. My TR would be ___________.

The demand for cookies is______?


Elastic, because the lower price

brought such an increase in the quantity demanded

that it raised the TR to $50.00!

Or to say it another way, the % Qd is greater

than the % P. In the coefficient formula, if the top

number is bigger, the answer will be >1, Elastic.


Next, let’s suppose that when I lower the price

from $1 to .$50, the quantity demanded increases

from 10 to 15. What will happen to my TR?

The demand for cookies is _________________?


Inelastic because the drop in price

pulled the TR down with it, even though there was an

increase in the quantity demanded. The consumers

were “not very” responsive to the price change. TR

dropped to $7.50 from $10.00.

Or to put it another way, the % Qd was smaller

than the % P. If the top number is smaller in the

coefficient formula, the answer ( the Ed) will be < 1,

Inelastic.


The results we got for Elasticity of

demand with this example would still be

the same if we raised prices instead of

lowering them. Just see what happens to

TR in relation to Price change! Easy!


DETERMINANTS OF ELASTICITY

This method won’t tell us the exact coefficient of

elasticity, or even if it’s definitely elastic or

inelastic as with the TR test. But it will give us an

idea of relative elasticity when compared to

something else.

There are 4 things that help DETERMINE Ed.


Necessity or a Luxury• Necessities tend to be more inelastic when

compared to luxuries because we need them more. Consumers won’t respond to price change as much. This doesn’t mean they won’t respond, just not as much as if the item is a luxury.

• Luxuries tend to be more elastic when compared to necessities. We can do without them (may not want to) if price is too high; we respond more.


Number of Substitutes• More substitutes there are for an item,

the more elastic it is. We can easily switch to another item when the price goes up.

• Fewer substitutes, less elastic, or more inelastic. It’s not easy to find another replacement for the item. This doesn’t mean it’s a necessity, however.


% of income an item makes up• The larger the % of income, the more elastic. If

something is very expensive, like a house or a car, consumers will respond more to a price change.

• The smaller the % of income, the more inelastic. If salt doubled or tripled in price, I’d probably buy pretty much the same amount; not because it’s a necessity, or there are no substitutes, but because it’s such a relatively small amount of my income that I’m not going to respond by buying less. It’s still pretty cheap!


The amount of time to respond• Less time, more inelastic: I’m out of

gas and have to be at work in 30 minutes. I have no time to find other solutions, so I buy the gas

even if it has gone up significantly in price.

• More time, more elastic: Over time, I can find alternative ways to use less gas. I might carpool, buy a more fuel efficient vehicle, use public transit, move, etc.

ELASTICITY AND THE DEMAND CURVE

Perfectly inelastic demand Perfectly elastic demand

P P

D

D

Q

Q

We don’t see curves like this very often.


Most Demand curves are downward slopping. That means that

there are areas that are Elastic, Unit, and Inelastic all on the same

curve.

The higher prices are ELASTIC

The lower prices are INELASTIC

Where they change is UNIT ELASTIC

To find the exact point they change requires some calculations,

but this gives you an idea of where you will find these elasticities

on the demand curve

P Elastic

Unit

Inelastic

D

Qd


elasticity of demand responsiveness to price change or “so. how many more big macs would you buy...

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