Micro 2.3-Price Elasticity of Demand

Elasticity

The concept used by economists to measure the magnitude of percentage changes in quantity owing to any given changes in the own-price

Price elasticity of demand

Measured by the percentage change in quantity demanded divided by the percentage change in price or the responsiveness of the quantity demanded to changes in price.

Elastic demand

When the magnitude of the value of elasticity is greater than 1

Inelastic demand

When the magnitude of the value of elasticity is less than 1

Unit elastic demand

When the magnitude of the value of elasticity is equal to 1

Total Revenue Test

A method to determine the relationship between price changes and total revenue: P↑ TR↑ for Price Inelastic

Elasticity Coefficient

A numerical measure of elasticity

Midpoint Formula for Coefficient

| %ΔQd / %ΔP | or | [(ΔQd)/(Avg Qd)] / [(ΔP)/(Avg P)] |.

Price Effect

The impact on quantity demanded resulting from a change in price.

Quantity Effect

The impact on quantity demanded resulting from a change in quantity.

Luxury Goods

Goods with a high percent of income spent on them; considered elastic.

Necessity Goods

Goods with a low percent of income spent on them; considered inelastic.

High Percent of Income

A characteristic of luxury goods

Low Percent of Income

A characteristic of necessity goods

Short Time Horizon

A factor making demand more elastic

Long Time Horizon

A factor making demand more inelastic

Low to No Substitutes

Characteristic leading to inelastic demand

Many Substitutes

Characteristic leading to elastic demand

Narrowly Defined

Leads to elastic demand; specific products with many substitutes (e.g.

Broadly Defined

Leads to inelastic demand; categories with few substitutes (e.g.

P Effect > Q Effect

Indicates inelastic demand

P Effect = Q Effect

Indicates unit elastic demand

P Effect < Q Effect

Indicates elastic demand

Relatively Price Elastic

Elasticity coefficient greater than 1 but less than infinity.

Relatively Price Inelastic

Elasticity coefficient greater than 0 but less than 1.

Ranges Along a Demand Curve

Upper range = Elastic

Perfectly Price Elastic Demand

All quantity effect and no price effect.

Perfectly Price Inelastic Demand

All price effect and no quantity effect.

Assume the original price is $4 and Q=10. The new price is $1 at a quantity of 20. Using the effect approach, total revenue approach and midpoint approach, determine if demand is price elastic, inelastic or unit elastic over this region.

QE=(20-10)*1; PE=(4-1)*10; QE=20 < 30=PE

Midpoint: |(20-10)/(15) / (1-4)/(2.5)| = 0.275 < 1

TR Test: P decreases from $4 to $1

TR decreases from $40 (4*10) to $20 (1*20)

All 3 approaches suggest that the demand curve is relatively price inelastic

Assume the original price is $4 and Q=100. The new price is $5 at a quantity of 80. Using the effect approach, total revenue approach and midpoint approach, determine if demand is price elastic, inelastic or unit elastic over this region.

QE=(100-80)*4; PE=(5-4)*80; QE=80=PE

Midpoint: |(100-80)/(90) / (4-5)/(4.5)| = 1

TR Test: P increases from $4 to $5

TR decreases stays the same at 100*$4=$400 and 80*5 = $400

All 3 approaches suggest that the demand is price unit elastic

Assume the original price is $2.50 and Q=3. The new price is $2.50 at a quantity of 4. Using the effect approach, total revenue approach and midpoint approach, determine if demand is price elastic, inelastic or unit elastic over this region.

QE=(4-3)*2.5=2.5; PE=(2.5-2.5)*3=0; PE=0

Midpoint: |(4-3)/(3.50) / (2.5-2.5)/(2.5)| = Undefined

TR Test: P stays constant from $2.5 to $2.5

TR increases from 3*$2.5=$7.5 to 4*$2.5=$10

All 3 approaches suggest that the demand is perfectly price elastic.

Assume the original price is $5 and Q=150. The new price is $10 at a quantity of 150. Using the effect approach, total revenue approach and midpoint approach, determine if demand is price elastic, inelastic or unit elastic over this region.

QE=(150-150)*5=0; PE=(10-5)*150=750; QE=0

Midpoint: |(150-150)/(150) / (10-5)/(7.5)| = 0

TR Test: P increases from $5 to $10

TR increases from 150*$5=$750 to 150*$10=$1500

All 3 approaches suggest that the demand is perfectly price inelastic.

Assume the original price is $100 and Q=200. The new price is $80 at a quantity of 360. Using the effect approach, total revenue approach and midpoint approach, determine if demand is price elastic, inelastic or unit elastic over this region.

QE=(360-200)*100=16,000; PE=(100-80)*200=4,000; QE = 16,000 > PE = 4,000

Midpoint: |(360-200)/(280) / (80-100)/(90)| = 2.59

TR Test: P decreases from $100 to $80

TR increases from 100*$200=$20,000 to 360*$80=$28,800

All 3 approaches suggest that the demand is relatively price elastic.