Micro CHAPTER 2.3:

CHAPTER SUMMARY

Price elasticity of demand measures how much consumers respond to a change in price. If a small change in price leads to a big change in quantity demanded, then we say the demand is elastic (stretchy/flexible). If a big change in price only leads to a small change in quantity demanded, then we say the demand is inelastic (not stretchy/flexible). If the change in price and change in quantity demanded are proportional (equal to each other), then demand is unit elastic.

There can also be perfectly inelastic demand, which means that people will demand the same amount no matter how much the price changes. This would only occur for things that people absolutely have to have, but really does not exist in the world. There is also a theoretical concept called perfectly elastic demand, but it does not exist in real life either.

As you can see in the charts below, perfectly elastic demand is horizontal. As the demand becomes increasingly inelastic (people are less responsive to price), the curve becomes more and more vertical.

Price elasticity of demand can be calculated at certain areas of the curve, and when we do math we usually call it PED. To calculate PED, we select two points on the curve, find the price and quantity demanded at each point, then use the following formula, assuming we move from one point to the next:

(% Change in Quantity Demanded) / (% Change in Price).

As an example, see the chart below:

Using the formula, when we find the % change in quantity demanded, (50 - 100) / 100 = -50%. Then, we find the change in price (60p - 50p) / 50p = 20%. Finally, we put these two numbers in our formula, and get -50% / 20% = -2.5.

If the absolute value (we ignore the negative numbers) of our result is greater than 1, then demand is elastic. If the absolute value is less than 1, then demand is inelastic. In this case, -2.5 shows that demand is elastic, meaning that we have a small change in price leading to a big change in quantity demanded.

There is also a second way to calculate price elasticity of demand, called the Total Revenue Test. We can calculate the total revenue at a specific point on the chart by multiplying price and quantity demanded. By doing this calculation for two points, we can compare the total revenue at each point. If increasing the price leads to increased total revenue, then demand is inelastic. If increasing the price leads to decreased total revenue, then demand is elastic.

There are many determinants of PED, including:

• Substitutability: The easier it is to buy something else to satisfy the same want or need, the more elastic the demand.

• Timeframe: If people can wait to buy something or have more time to evaluate the purchase, demand should be more elastic (people will wait for the best price/value).

• Share of Income: If something takes up a large portion of your income/spending, you are more likely to care about the price, but if it takes up a tiny percent of your income/spending, you may not care as much about changes in price. So, demand for expensive items is generally more price elastic than demand for inexpensive items.

• Necessity: If people need something, demand is likely to be more inelastic, because people have to buy it regardless of the price.

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