Elasticity
Price Elasticity of Demand
  • The response of consumers to a change in price is measured by the price elasticity of demand.
  • Price Elasticity of Demand – the percentage change in quantity demanded divided by the percentage change in price.
  • Formula:
                                 percent change in quantity demanded
       price elasticity (E)  =  -------------------------------------
                                      percent change in price
      
  • The law of demand implies that the price elasticity of demand will always be greater than zero.
  • Since quantity demanded decreases when prices increase (law of demand), E is always negative.
  • Elastic vs. Inelastic.
    • If E > 1, demand is called elastic in the immediate price range.  
    • If E < 1, demand is called inelastic  
    • note:  the numbers are in absolute values
  • Elasticity Extremes
    • A horizontal demand curve means that demand is perfectly elastic.  Any price increase would cause demand to fall to zero
    • A vertical demand curve means that demand is completely inelastic.  Demand will not change regardless of any change in price.
Determinants of Elasticity
  • The elasticity of demand is computed between points on a given demand curve.  Hence, the price elasticity of demand is influenced by all of the determinants of demand.
  • Four factors are particularly worth noting:
    1. Necessities vs. Luxuries
      • Demand for necessities, goods that are critical to our everyday life, is relatively inelastic.
      • Demand for luxury goods, goods we would like to have but are not likely to buy unless our income jumps or the ice declines sharply, is relatively elastic.
    2. Availability of Substitutes
      • The greater the availability of substitutes, the higher the price elasticity of demand.
    3. Time
      • The long-run price elasticity of demand is higher than the short-run elasticity
    4. Relative Price:   
      • The higher the price in relation to a consumer's income, the higher the elasticity of demand
Price Elasticity and Total Revenue 
  • A price hike increases total revenue only if demand is inelastic (E < 1)
  • A price hike reduces total revenue if demand is elastic (E > 1)
  • A price hike does not change total revenue if demand is unitary elastic (E = 1)
  • The reverse applies for price decreases
Income Elasticity of Demand
  • Income Elasticity of demand – Percentage change in quantity demanded divided by percentage change in income
  • Formula:
                                percentage change in quantity demanded
      elasticity of demand  =  ----------------------------------------
                                     percentage change in income

  • Normal Good - good for which demand rises when income rises.
    • A normal good has an income elasticity of demand greater than zero.
  • Inferior Good - good for which demand decreases when income rises.
    • An inferior good has an income elasticity of demand less than zero
Cross Price Elasticity
  • exists when the change in the price of one good affects the demand for another good.
  • Formula:
                          percentage change in quantity demanded of good X
     cross elasticity  =  ------------------------------------------------
                                  percent change in price of good Y

  • when the cross-price elasticity of demand has a negative sign the two goods are complementary goods
  • when the cross-price elasticity of demand has a positive sign the two goods are substitute goods



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this page is maintained by Reed Fisher
last updated January 15, 2011