Elasticity

Overview of Price Elasticity of Demand

• Definition: The price elasticity of demand measures the percentage change in quantity demanded over a percentage change in price, indicating consumer responsiveness to price changes.

Importance of Elasticity

• Understanding elasticity is crucial for determining how price changes affect total revenue.

Calculation of Elasticity

• Elastic Demand: If the price elasticity is greater than 1, indicating the good is elastic.

• Inelastic Demand: If the price elasticity is less than 1, indicating the good is inelastic.

• Unit Elastic: If the price elasticity is equal to 1, indicating unit elastic demand.

Revenue Definition

• Revenue: The total price of a good times the quantity sold.

  • Example: Selling a good for $2 and selling 100 units results in revenue of $200 (not profit).

Relationship Between Elasticity and Revenue

• Examining elasticity is significant for businesses as it influences revenue during price adjustments.

  • Example 1: Toll crossing scenario with initial price of 90¢ and 1,100 cars passing through. Revenue calculated as:
    Revenue = 0.90 imes 1100 = 990 .

  • Price rise to $1.10 leads to quantity falling to 900 cars,

  • New Revenue:
    Revenue = 1.10 imes 900 = 990 .

  • Result: The price increase has no impact on revenue when demand is unit elastic (elasticity of 1).

  • Observation: When price elasticity of demand is unit elastic, an increase in price does not change revenue.

Example of Inelastic Demand

• Scenario: Price increase from 90¢ to $1.10 for 1,050 cars initially.

  • Initial Revenue:
    Revenue = 0.90 imes 1050 = 945 .

  • Price increase leads quantity to drop to 950 cars,

  • New Revenue:
    Revenue = 1.10 imes 950 = 1045 .

  • Conclusion: Increasing price results in increased revenue when demand is inelastic (elasticity of less than 1).

Example of Elastic Demand

• Scenario: Price of 90¢ with 1,200 cars, leading to revenue:
  Revenue = 0.90 imes 1200 = 1080 .

• Price increase to $1.10 results in decreased quantity to 880 cars;
  Revenue = 1.10 imes 880 = 968 .

• In this situation, an increase in price leads to a decrease in revenue (elasticity greater than 1).

Decision-Making Implications

• Revenue Maximization:

  • Increase Price: Only if demand is inelastic.

  • Decrease Price: If demand is elastic to increase revenue.

  • Real-world application: Department of Transportation must understand elasticity before changing toll prices to avoid loss in revenue.

Effects of Price Changes on Revenue

• Price Effect: Increasing price generally increases revenue (higher per unit price).

• Quantity Effect: Price increase causes a decrease in quantity demanded, which impacts revenue negatively.

• Role of Elasticity: Determines which effect dominates:

  • Unit Elastic Demand: Price changes do not affect revenue (both effects offset).

  • Elastic Demand: Quantity effect dominates, revenue drops with price increases.

  • Inelastic Demand: Price effect dominates, revenue increases with price increases.

Graphical Representation of Elasticity

• Elasticity changes across different price points.

  • Example: At $5, demand may be unit elastic.

  • Above $5, demand becomes elastic (revenue falls with price increase).

  • Below $5, demand is inelastic (reducing price decreases revenue).

Factors Influencing Elasticity

• Availability of Substitutes:

  • Goods with close substitutes show higher elasticity (e.g., Pepsi vs. Coca Cola).

• Nature of the Good:

  • Necessity goods tend to have inelastic demand; luxuries are generally elastic.

• Income Share:

  • Smaller share of income spent on a good means lower elasticity (e.g., salt).

• Time Frame:

  • More time to adjust to price changes leads to greater elasticity (e.g., adjusting to gasoline prices over time).

Example Cartoon

• A humorous example relates to pricing frustrations with gasoline.

  • Husband reacts to rising gas prices, while wife's suggestions imply alternative actions (e.g., public transport).