Elasticity of Demand

Law of Demand

• Basic Concept: There is an inverse relationship between price and quantity demanded.

  • When price increases, quantity demanded decreases.

  • When price decreases, quantity demanded increases.

• Elasticity: Measures how sensitive quantity demanded is to price changes.

Inelastic Demand

• Definition: When quantity demanded changes very little in response to price changes.

• Example: Gasoline

  • When gasoline prices rise, quantity demanded decreases slightly.

  • When prices decrease, quantity demanded increases slightly.

  • Behavior: Consumers do not significantly change their purchasing habits with price changes.

• Reasons for Inelasticity:

  • Few substitutes available.

  • Necessity of the product (e.g., gasoline for transportation).

• Elasticity Coefficient:

  • Less than one (0 < coefficient < 1).

• Behavior:

  • Price increase leads to a significant decrease in quantity demanded.

  • Price decrease leads to a significant increase in quantity demanded.

Unit Elastic Demand

• Definition: The percent change in quantity demanded is equal to the percent change in price.

  • Example: Price goes up 20%, quantity goes down 20%.

  • Elasticity coefficient equals 1.

Perfectly Inelastic Demand

• Definition: Quantity demanded does not change regardless of price changes.

  • Elasticity coefficient equals 0.

  • Example: Essential medications.

Perfectly Elastic Demand

• Definition: Demand curve is horizontal; small changes in price lead to infinite changes in quantity demanded.

  • Elasticity coefficient is infinite.

Demand Curves Overview

• Five different demand curves:

  1. Perfectly inelastic (coefficient = 0)

  2. Relatively inelastic (coefficient < 1)

  3. Unit elastic (coefficient = 1)

  4. Relatively elastic (coefficient > 1)

  5. Perfectly elastic (coefficient = ∞)

• Key Insight: More substitutes = greater sensitivity to price changes.

Total Revenue Test

• Definition: Analyzes the effect of price changes on total revenue.

• Total Revenue Formula: Total Revenue = Price x Quantity.

• Inelastic Demand Behavior:

  • Price increase leads to total revenue increase; quantity decreases slightly.

  • Price decrease leads to total revenue decrease.

  • Example: Gas stations do not discount prices.

• Elastic Demand Behavior:

  • Price increase results in total revenue decrease; quantity decreases significantly.

  • Price decrease results in total revenue increase.

  • Products with elastic demand often go on sale.

• Test Question Example: If product price increases and total revenue decreases, demand is elastic.

Memory Aids for Total Revenue Test

• Hand Signals: To remember elasticity and total revenue relationship:

  • Price up, total revenue up = Inelastic (shape of "I").

  • Price down, total revenue down = Inelastic (still shape of "I").

  • Price up, total revenue down = Elastic (not shaped like "I").

  • Price down, total revenue up = Elastic (not shaped like "I").

Conclusion

• Understanding elasticity helps predict consumer behavior regarding price changes.

• Further concepts to explore include cross-price and income elasticity.