Lesson 3: Elasticity of Demand

3 ways to increase profits of a business

1. Selling more units

2. cut your costs

3. Raise price (not necessarily)

Why raising prices wont necessarily increase profits of business

The Law of Demand tells us that increased price causes a decrease in quantity demanded but it doesn’t tell us by how much (where the concept of elasticity comes in)

Elasticity

A measurement of how responsive one variable is to a change in another variable. It can be used with all sorts of variables

How does elasticity relate to increasing profits of a business

We look at the price elasticity of demand (how sensitive the quantity of a good that people demand is to a change in price of that good) when trying to increase profits

Price elasticity of demand (demand elasticity)

A measure of how much the quantity demanded changes when the price changes

Simple Price Elasticity of Demand Formula

Demand Elasticity Continuum

Perfectly inelastic demand

change in price results in NO change in quantity demanded of a product

elasticity coefficient=0

Inelastic Demand

when the % change in quantity demanded is less than the % change in price

Elasticity coefficient < 1

Unit Elastic Demand

when the % change in quantity demanded is equal to the % change in price

Elasticity coefficient = 1

Elastic Demand

when the % change in quantity demanded is more than the % change in price

Elasticity coefficient >1

Perfectly Elastic Demand

buyers will only buy at one price → small change in price → infinite change in quantity demanded

Elasticity Coefficient approaches infinity

Demand is inelastic when..

a given change in price causes a relatively smaller change in quantity demanded

Demand is unit elastic when..

a given change in price causes a proportional change in quantity demanded

Demand is elastic when..

a given change in price causes a relatively larger change in the quantity demanded

Problem of the simple Demand elasticity formula

The senstivity of the change in quantity shouldn’t depend on whether the price goes up or down

Midpoint Formula (Arc Method)

Calculates price elasticity across a price quantity range to overcome the problem of selecting the reference points for price and quantity. In this formula, the average of the 2 quantities and the average of the 2 prices are used as reference points. USE THE ABSOLUTE VALUE

Slope of Demand Curve and Elasticity

If we generalize: steeper slopes show inelastic demand while flatter slopes show elastic demand

Slope of Demand Curve…

DOES NOT MEASURE ELASTICITY (elastic at higher prices, changes in sensitivity to how much money lost differs from $1 to $100)

4 Determinants of Demand Elasticity (LIST)

1. Luxuries vs Necessities

2. Proportion of one’s Income used

3. Number of Substitutes

4. Time frame available to adjust the price change

Luxuries vs Necessities

Necessities tend to have inelastic demand whereas luxuries tend to have more elastic demand (ex. Diapers are a necessity for anyone with a baby and going out to dinner is NOT)

Is the good habit-forming?

Consumers become less sensitive to the price of the good if they buy something out of habit (it has become the default choice) (ex. Going to a pizza place everyday even when they raise their prices)

Addictive products

Tend to be more severe in their behavior results → these will be very inelastic

Proportion of One’s Income used

products that take up a high percentage of one’s income will have a more elastic demand

Number of Substitutes

The more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch

Breadth of the definition of the product

If the good is broadly defined (i.e., the demand for autos in general), demand is often inelastic, as opposed to a good that’s more narrowly defined (i.e., the demand for Honda Civic). Then the demand tends to be more elastic

Time frame to adjust to the price change

Demand is more price elastic the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending

Off-peak vs peak demand

Demand is more price inelastic at peak times and more elastic at off-peak times

Total Revenue Formula

Price x Quantity = Total Revenue

Total Revenue (TR) changes when..

Price changes

The total revenue test shows when demand is..

inelastic, unit elastic, and inelastic

The price effect dominates with..

Lower price and inelastic demand

The quantity effect dominates with..

Lower price and elastic demand

Increase in price for Inelastic demand

Increase in total revenue for Inelastic Demand

Decrease in Price for Inelastic Demand

Decrease in Total Revenue for Inelastic Demand

Increase/Decrease in Price of Unit Elastic Demand

No change in Total Revenue

Increase in Price of Elastic Demand

Decrease in Total Revenue of Elastic Demand

Decrease in Price of Elastic Demand

Increase in Total Revenue of Elastic Demand