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In-Depth Notes on Elasticity of Demand

Elasticity of Demand

Objectives

  • Understand how to calculate elasticity of demand.
  • Identify factors affecting elasticity.
  • Explain how firms utilize elasticity and revenue for decision-making.

Key Terms

  • Elasticity of Demand: A measure of how consumers react to price changes.
  • Inelastic Demand: Demand that is not significantly affected by price changes.
  • Elastic Demand: Demand that is highly affected by price changes.
  • Unitary Elastic Demand: Demand where elasticity equals 1.
  • Total Revenue: Total income a firm receives from selling its goods.

Understanding Elasticity

  • Elasticity describes how significantly consumers change their demand based on price fluctuations.
  • Inelastic Demand: Consumers buy roughly the same amount even after a price increase (e.g., necessities).
  • Elastic Demand: Consumers significantly reduce their demand with small price increases (e.g., luxuries).

Calculating Elasticity

  • Formula of Elasticity of Demand: \text{Elasticity} = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}
    • Percentage Change Calculation:
      \text{Percentage Change} = \frac{\text{Original Number} - \text{New Number}}{\text{Original Number}} \times 100

Values of Elasticity

  • Elastic Demand: Elasticity > 1
  • Inelastic Demand: Elasticity < 1
  • Unitary Elastic: Elasticity = 1

Factors Affecting Elasticity

  1. Availability of Substitutes:
    • Few substitutes lead to inelastic demand (e.g., unique concert tickets).
    • Many substitutes lead to elastic demand (e.g., branded apple juice).
  2. Relative Importance:
    • Goods that account for a large part of the budget can have elastic demand (e.g., clothing).
    • Items with small budget share (e.g., shoelaces) are often inelastic.
  3. Necessity vs. Luxury:
    • Necessities (e.g., milk) tend to have inelastic demand.
    • Luxuries (e.g., steak) are likely to have elastic demand.
  4. Change Over Time:
    • Demand can be inelastic in the short term, but may become more elastic over time as consumers find substitutes (e.g., gasoline).

Elasticity and Total Revenue

  • Total Revenue (TR):
    • Calculated as Price (P) x Quantity Sold (Q).
    • TR is affected by elasticity:
    • If demand is elastic:
      • Price increase leads to decreased total revenue due to significant drop in quantity sold.
      • Price decrease can lead to increased total revenue if quantity demanded increases substantially.
    • If demand is inelastic:
      • Price increase raises total revenue since quantity demanded does not decrease significantly.
      • Price decrease results in lower total revenue if increase in quantity demanded is less than the decrease in price.

Examples

  1. Elastic Demand:
    • Price decreased from $4 to $3 (25% decrease), Quantity increased from 10 to 20 (100% increase).\
    • Elasticity = \frac{100\%}{25\%} = 4.0 (Elastic)
  2. Inelastic Demand:
    • Price decreased from $6 to $2 (67% decrease), Quantity increased from 10 to 15 (50% increase).
    • Elasticity = \frac{50\%}{67\%} \approx 0.75 (Inelastic)

Conclusion

  • Understanding elasticity helps firms make informed pricing decisions to optimize revenue. Knowledge of demand elasticity informs strategic planning for products and pricing in different market conditions.