9/25/2011
Topic #4 Elasticity:
Price Elasticity of Demand
ECON 2420-003
Elasticity
• Is a measure of how much one economic
variable responds to changes in another
economic variable
• We have looked at how various things can shift
demand or supply (quantity demanded or
quantity supplied).
• Now we are interested in the sensitivity to
changes in other economic variables.
Price Elasticity of Demand
• The responsiveness of quantity demanded to a
change in prices.
• The calculation is always negative, but we will
take its absolute value to simplify analysis
• Magnitudes of changes don’t tell us much.
– Is a change of 1 million units due to a change a price
change of $1 significant?
– Can’t tell just given raw numbers.
1
9/25/2011
Elastic Demand
• When the percentage change in quantity
demanded is greater that the percentage
change in price.
• Example
– Price of an Iphone falls 10% resulting in quantity
demanded increasing by 15%
– What is the price elasticity of demand?
• Elastic demand on graph
Inelastic Demand
• When the percentage change in quantity
demanded is less than the percentage change in
price.
• Example
– Gasoline prices increase by 10% resulting in a
decrease in quantity demanded by 5%
– What is the price elasticity of demand?
• Inelastic demand on graph
Unit Elasticity
• When the percentage change in quantity
demanded is less than the percentage change in
price.
• Example
– Beer prices increase by 10% resulting in a decrease
in quantity demanded by 10%
– What is the price elasticity of demand?
• Unit-elastic demand on graph
2
9/25/2011
Polar Cases of Elasticity
• Perfectly elastic
– See graph on board
– Horizontal demand curve
• Perfectly inelastic
– See graph on board
– Vertical demand curve
Midpoint formula
• The price elasticity of demand can be different
between two points on the same curve
– See page. 170 in textbook
• Use the midpoint formula to ensure that we
have only one value for the price elasticity of
demand
Midpoint formula
• This is
– the ratio of the change in quantity demand to the
average quantity demand
– Divided by
– The ratio of the change in prices to the average price
• Let’s work some examples
– P1=7, P2=5 ; Q1=1, Q2=3
– P1=5, P2=3 ; Q1=3, Q2=5
3
9/25/2011
What determines PED?
• Availability of close substitutes
– If there are few close substitutes then demand is
less elastic
– If there are many close substitutes then demand is
more elastic
• Passage of time
– The more time that passes, the more elastic demand
becomes
• Luxuries vs. Necessities
• Definition of the marker
– Ex. Coke
Soft Drinks
All beverages
Relationship between price and TR
• Firms can use price elasticity of demand to see
how price changes may change total revenue
• See Graphs on board
• Elasticity and revenue with linear demand
curves
• Along the same demand curve, PED is not
constant
– When price is high and quantity demanded is low,
demand is elastic because a $1 drop in price is a
smaller percentage change when the price is high.
– By similar reasoning, demand is inelastic when the
price is low and quantity demanded is high.
4