Author: John Bouman

Price Elasticity of Demand Price elasticity of demand measures the responsiveness of buyers to a price change. If the price of gasoline increases by 10%, how will this affect the amount of gasoline purchased? Will the amount purchased decrease by more than 10%? Will the amount purchased decrease by less than 10%? Will the amount purchased decrease by exactly 10%? Or will the amount purchased not change at all? Once we know the price elasticity of demand, we can answer these questions, because price elasticity of demand measures the relationship between the percentage change in the amount purchased and the percentage change in the price. To calculate price elasticity of demand, we need to have price and quantity demanded data. A demand schedule and its corresponding demand curve give us the data. How do we know the location and shape of a product’s demand curve? The Derivation of a Demand Curve Economists who estimate the shape and the location of a product’s demand curve, usually look at the following: Historical data. Price and quantity data show how consumers have responded to past changes in the price and quantity demanded of the product. Price and quantity demanded changes must be looked at in isolation of other variables. Prices may change, but so may other variables, such as buyers’ incomes and prices of related products. It is, therefore, important to estimate...

Demand Curves and Elasticity Elasticity affects the slope of a product’s demand curve. A greater slope means a steeper demand curve and a less-elastic product. In the graph below, the steeper demand curve, D1, shows a change in quantity demanded of 8 products (from 60 to 68) when the price changes by one dollar (from $9 to $8). The flatter demand curve, D2, shows a change in quantity demanded of 40 products (from 60 to 100) when the price changes by $1 (from $9 to $8). Clearly, the flatter demand curve shows a much greater quantity demanded response to a price change. Therefore, it is more elastic. Video Explanation For an explanation of how elasticity and the slope of the demand curve are related, please watch this video: Perfect Elasticity and Perfect Inelasticity Perfect elasticity is when a product can only be sold at one price (as in the case of a perfectly competitive firm – see our Unit 6). If the price changes then the quantity demanded changes to zero. In the graph below, if the demand curve is D1 (perfect elasticity), buyers only buy the product at $9. They buy nothing at any other price. Perfect inelasticity is when buyers purchase a certain quantity (60 in the graph below), regardless of the price. They buy 60 products at $1 or $2 or $100 or any other price....

Elasticity Determinants Some products are elastic (buyers are price sensitive), and some products are inelastic (buyers are not price sensitive). What makes people more sensitive to one product’s price change compared to another product’s price change? Some people will choose to not buy a car if its price increases by 10%, but are unaffected by an increase of 10% in the price of a bag of salt. The three determinants of price elasticity of demand are: 1. The availability of close substitutes. If a product has many close substitutes, for example, fast food, then people tend to react strongly to a price increase of one firm’s fast food. For example, if Burger King increases its prices by 10% and competitors like Wendy’s, McDonald’s, Taco Bell, and Subway don’t, then many customers will switch to these competitors and Burger King’s quantity demanded will decrease significantly. Thus, the price elasticity of demand of this firm’s product is high.  2. The importance of the product’s cost in one’s budget. If a product, such as salt, is very inexpensive, consumers are relatively indifferent about a price increase. Therefore, salt has a low price elasticity of demand. Cars are expensive and a 10% increase in the price of a car may make the difference whether people will choose to buy the car or not. Therefore, cars have a higher price elasticity of demand. 3....

Definition of Elastic, Inelastic, and Unit Elastic Demand  By definition: 1. A product is elastic when its elasticity is greater than 1. When a product is elastic and its price changes, the percentage change in quantity demanded is greater than the percentage change in the price. For example, if buyers purchase 20% fewer products as a result of a 10% price increase, then the product is elastic. 2. A product is inelastic when its elasticity is less than 1. The numerator (percentage change in quantity demanded) of the elasticity formula is less than the denominator (percentage change in price). For example, if buyers purchase 6% fewer products as a result of a 15% price increase, then the product is inelastic. 3. A product is unit elastic when its elasticity is equal to 1. If a product’s price rises by 8% and its quantity demanded decreases by 8%, then the product is unit elastic. Elasticity and Revenue When a product is elastic, and its price rises, what happens to the firm’s total revenue? A firm’s total revenue is equal to the number of products it sells times the price of the product. Therefore: Total Revenue = Price times Quantity or TR = P x Q For example, if a store sells 30 pairs of shoes at $10 each, then its revenue equals 30 times $10, or $300. If the store...

Income Elasticity of Demand Income elasticity of demand measures the percentage change in a buyer’s purchase of a product as a result of a percentage change in her/his income. So income elasticity of demand is ei = the percentage change in demand / percentage change in income or ei = (change in demand / average demand) / (change in income / average income) Example 1 If a person decides to buy 20% more bananas because of a 10% income increase, the person’s income elasticity of demand for bananas is 20% / 10%, or 2. Example 2 If a person decides to buy 50% fewer boxes of spaghetti because of a 20% income increase, the income elasticity of demand for spaghetti is (-50%) / (+20%), or -2.5. Note that when income elasticity is negative, the product is an “inferior” product (see Unit 2 for the difference between inferior and normal products). A person may decide to buy fewer boxes of spaghetti after an income increase, because the person can now afford to buy more expensive substitutes. Unlike price elasticity of demand, we cannot ignore the minus sign for income elasticity of demand, because income elasticity of demand can be either positive (for a normal good), or negative (for an inferior product). Cross Price Elasticity of Demand In the case of a product that has a substitute (like oranges and apples),...