18. Price Elasticity of Demand
In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments.
Calculating the Price Elasticity of Demand
The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:
The demand elasticity formula yields a negative value, because price and quantity move in opposite directions. However, it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. So we use the magnitude or the absolute value of the price elasticity of demand.
The table to the right has two points on the demand curve for pizza from a particular pizza parlor.
The absolute value of the percent change in quantity demanded is [(500 400) 450] 100 = 22.2 percent.
The absolute value of the percentage change in price is [($14 $16) $15] 100 = 13.3 percent.
Between these two points on the demand curve, the price elasticity of demand is 22.2% 13.3% = 1.67.
19. Inelastic and Elastic Demand
If the price elasticity of demand is less than 1.0, the good is said to have an inelastic demand. In this case, the percentage change in the quantity demanded is less than the percentage change in price.
If the quantity demanded remains constant when the price changes, then the good is said to have perfectly inelastic demand. The price elasticity of demand is 0 and the good’s demand curve is a vertical line.
If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic demand. In this case, the percentage change in the quantity demanded equals the percentage change in price.
If the price elasticity of demand is greater than 1.0, the good is said to have an elastic demand. In this case, the percentage change in the quantity demanded exceeds the percentage change in price.
If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the good is said to have perfectly elastic demand. The price elasticity of demand is infinite.
The table has some “real-life” elasticities from the book.
Furniture |
1.26 |
Motor Vehicles |
1.14 |
Clothing |
0.64 |
Oil |
0.05 |
With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price elasticity of demand changes when moving along a linear demand curve.
As the figure illustrates, at points on the demand curve above the midpoint, the price elasticity of demand is elastic while at points below the midpoint, the price elasticity of demand is inelastic. At the midpoint, the price elasticity of demand is unit elastic.
Total Revenue and Elasticity
The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold.
If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases.
If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change.
If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.
The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price, when all other influences on the quantity sold remain the same.
If a price cut increases total revenue, demand is elastic. And if a price hike decreases total revenue, demand is elastic.
If a price cut does not change total revenue, demand is unit elastic. And if a price hike does not change total revenue, demand is unit elastic.
If a price cut decreases total revenue, demand is inelastic. And if a price hike increases total revenue, demand is inelastic.
Similarly, when a price changes, a consumer’s change in expenditure depends on the consumer’s elasticity of demand.
If demand is elastic, then a price cut means that expenditure on the item increases.
If demand is inelastic, then a price cut means that expenditure on the item decreases.
If demand is unit elastic, then a price cut means that expenditure on the item does not change.