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.