Price Elasticity of Demand

Chapter 4 of PPM

Price Elasticity of Demand Definition

When price of a good inc. quantity demanded decr.

When price of a good decr. quantity demanded inc.

Units of price elasticity

No units as it’s a ratio, so use a percentage or proportionate changes

Price Elasticity Equation

% change in quantity demanded / % change in price

Why is price elasticity always -ve?

Price and quantity move in opposite directions

Arc Elasticity Equation

Perfectly Inelastic Demand

PE_D = 0

Inelastic Demand

PE_D < 1

Unit Elastic Demand

PE_D = 1

Elastic Demand

PE_D > 1

Perfectly Elastic Demand

PE_D = Infinity

How does the Price Elasticity of Demand change along a linear demand curve?

Prices above average are greater than 1, prices below average are less than 1

Total Revenue Equation

Price of a good/service multiplied by the quantity sold (TR = P*Q)

Impact of Elasticity of demand on total revenue

When demand is elastic, a price cut increases revenue

When demand is inelastic, a price cut decreases total revenue

When demand is unit elastic, it equals the maximum total revenue

Factors that Influence the Elasticity of Demand

• Closeness and availability of substitutes

  • Perfect substitutes e.g. printer paper, means when one place incr. price, overall demand falls as there’s a perfect alternative

  • Other things e.g. newspapers, not as easily substituted

• Time elapsed since a price change

• Proportion of income spent on a good

  • Price of a good in relation to a consumer’s budget

Cross elasticity of demand definition

It measures the responsiveness of demand for a good to a change in the price of a substitute or a complement, all other things remaining the same

• For a substitute good, it’s +ve

• For a complement good, it’s -ve

Cross elasticity of demand equation

Income elasticity of demand definition

Measures how the quantity demanded of a good changes in response to a change in income, all else being constant

Income elasticity of demand formula

What happens as the value of income elasticity changes?

If income elasticity >1:

• As income incr., income spent on goods incr.

In income elasticity is between 0-1:

• As income incr., income spent on good decr.

If income elasticity <0:

• Quantity demanded decr. and income incr.

Elasticity of supply definition

It’s a measure of the responsiveness of the quantity supplied to a change in the price of a good, when all other influences and selling plans remains the same.

Elasticity of supply equation

Determinants of elasticity of supply

• Resource substitution possibilities

  • The easier it is to substitute among the resources used to produce a good or service, the greater the elasticity of supply

• Time frame for supply decision

  • As more time passes after a price change, the greater the elasticity of supply

  • Momentary supply is perfectly inelastic, as the quantity supplied immediately following a price change is constant

  • Short-run supply is somewhat elastic

  • Long-run supply is mostly elastic