Price Elasticity of Demand

Measures the responsiveness of quantity demanded to price: how much quantity demanded changes (%) for each 1% change in the price. Calculated as the absolute value of:(% change in quantity demanded) / (%change in price) Arc formula: [Change in quantity/average quantity] / [change in price/average price] Price = 2, quantity demanded = 25 Price=4, quantity demanded = 15 Elasticity = [(15-25)/20] / [(4-2)/3] = 0.75

Elastic vs. Inelastic
Elasticity can vary from 0 to infinity Elastic (very responsive) if measured elasticity is greater than one. Example: Price elasticity of demand for pleasure boats = 1.3 Unitary elasticity if measured elasticity equals one. Ineleastic (not very responsive) if measured elasticity is less than one. Example: Price elasticity of demand for corn = 0.49

Elasticity and slope
Elasticity is NOT the same as slope. Elasticity equals [(change q)/q] / [(change p)/p] Slope equals (change p) / (change q) Elasticity equals (1/slope) x (p/q) Elasticity varies along a straight-line, downward-sloping curve.

Determinants
Price elasticity of demand will be larger (more elastic) The larger the number of available substitutes The longer the time period The larger the price relative to consumers' budgets For goods consumers consider "luxuries" than for good people think of as "necessities" For durable goods than for for non-durables and services

Uses of price elasticity of demand
1. To predict changes in quantity demanded. What will happen if we raise prices 5%? If elasticity =0.7 then 0.7 = % change in quantity demanded / % change in price 0.7 = % change in quantity demanded / 5 0.7 x 5 = % change in quantity demanded 0.7 x 5 = 3.5 = % change in quantity demanded Quantity demanded declines by 3.5%.

Uses of elasticity, continued

2. To predict the changein a seller's revenues If demand is price inelastic, then an increase in price results in an increase in revenues (as consumers buy almost as much as they did before at the new, higher price). If demand is price elastic, then an increase in price results in a decrease in revenues (the seller gets a higher price but on a much smaller quantity. If demand is unitary, then the sellers' revenues remain unchanges as the price increases. The effects are reversed for a price decrease: Inelastic demand: revenues fall Elastic demand: revenues increase Unitary demand: no change in revenues

Price elasticity of Supply

Measures the responsiveness of quantity supplied to changes in the price Equals the percentage change in quantity supplied for a 1 percent change in price; Es = % change in quantity supplied) / % change in price If greater than one, supply is price elastic; if less than one, supply is price inelastic Primary determinant is the time period: more elastic the longer the time period. Also more elastic the greater the number of alternatives in production (easy to switch to producing another product).

Making predictions
Once we have estimates of the price elasticity of demand and supply, we can predict how much the price will change due to a shift in either curve. Percentage change = percentage change in demand / (Es + Ed) If demand increases by 10% when the price elasticity of demand is 1.6 and the price elasticity of supply is 0.4, then the price should rise by 10% / (1.6 + 0.4) = 10% / 2 = 5%.