Price elasticity of demand

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For the opposite, see Price elasticity of supply.

Price elasticity of demand is defined as the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity. It is a measure of how consumers react to a change in price. [1] In other words, it is percentage change in quantity demanded as per the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity, that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. In simpler words, demand for a product can be said to be very inelastic if consumers will pay almost any price for the product, and very elastic if consumers will only pay a certain price, or a narrow range of prices, for the product. Inelastic demand means a producer can raise prices without much hurting demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to.

Contents

[edit] Interpretation of elasticity

Perfectly Inelastic Demand
Perfectly Elastic Demand
Value Meaning
n = 0 Perfectly inelastic.
-1 < n < 0 Relatively inelastic.
n = -1 Unit (or unitary) elastic.
-∞ < n < -1 Relatively elastic.
n = -∞ Perfectly elastic.

A price drop usually results in an increase in the quantity demanded by consumers (see Giffen good for an exception). The demand for a good is relatively inelastic when the change in quantity demanded is less than change in price. Goods and services for which no substitutes exist are generally inelastic. Demand for an antibiotic, for example, becomes highly inelastic when it alone can kill an infection resistant to all other antibiotics. Rather than die of an infection, patients will generally be willing to pay whatever is necessary to acquire enough of the antibiotic to kill the infection.

Various research methods are used to calculate price elasticity:

[edit] Determinants

A number of factors determine the elasticity:

  • Substitutes: The more substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made
  • Percentage of income: The higher the percentage that the product's price is of the consumers income, the higher the elasticity, as people will be careful with purchasing the good because of its cost
  • Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it.
  • Duration: The longer a price change holds, the higher the elasticity, as more and more people will stop demanding the goods (i.e. if you go to the supermarket and find that blueberries have doubled in price, you'll buy it because you need it this time, but next time you won't, unless the price drops back down again)
  • Breadth of definition: The broader the definition, the lower the elasticity. For example, Company X's fried dumplings will have a relatively high elasticity, where as food in general will have an extremely low elasticity (see Substitutes, Necessity above)

[2][3]

[edit] Elasticity and revenue

See also: Total revenue test
A set of graphs shows the relationship between demand and total revenue. As price decreases in the elastic range, revenue increases, but in the inelastic range, revenue decreases.

When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa.

When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa.

When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in price.

When the price elasticity of demand for a good is perfectly elastic (Ed is undefined), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. A banknote is the classic example of a perfectly elastic good; nobody would pay £10.01 for a £10 note, yet everyone will pay £9.99 for it.

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. An example of a perfectly inelastic good is a human heart for someone who needs a transplant; neither increases nor decreases in price affect the quantity demanded (no matter what the price, a person will pay for one heart but only one; nobody would buy more than the exact amount of hearts demanded, no matter how low the price is).

[edit] Mathematical definition

The formula used to calculate coefficients of price elasticity of demand for a given product is

E_d = \frac{\%\ \mbox{change in quantity demanded}}{\%\ \mbox{change in price}} = \frac{\Delta Q_d/Q_d}{\Delta P_d/P_d}

Conventions differ regarding the minus sign, considering remarks like "price elasticity of demand is usually negative". (The sign of the coefficient should actually be determined by the directions in which price and quantity change; i.e. if the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the initial price and quantity = -5%/5% = -1. Note, however, that many economists will refer to price-elasticity of demand as a positive value although it is generally negative due to the negative relationship between price and quantity demanded.)

This simple formula has a problem, however. It yields different values for Ed depending on whether Qd and Pd are the original or final values for quantity and price. This formula is usually valid either way as long as you are consistent and choose only original values or only final values. (note that a percentage change is always calculated with the initial value in the denominator; if you are to use your final value in the denominator then you must treat that value as the initial value in the numerator. i.e. if price increases from $5 to $10, then the percentage increase is calculated as: ((10-5)/5)*100 = 100%. If price decreases from 10 to 5, the percent decrease = ((5-10)/10))*100 = -50%. If you throw 10 into the denominator without switching the terms in the numerator your product's price will appear to increase by 50% which is simply not true.)

Or, using the differential calculus form:

E_d = - \frac{P}{Q}\frac{dQ}{dP}

This can be rewritten in the form:

E_d = - \frac{d \ln Q}{d \ln P}

[edit] Point-price elasticity

  • Point Elasticity = (% change in Quantity) / (% change in Price)
  • Point Elasticity = (∆Q/Q)/(∆P/P)
  • Point Elasticity = (P ∆Q) / (Q ∆P)
  • Point Elasticity = (P/Q)(∆Q/∆P) Note: In the limit (or "at the margin"), "(∆Q/∆P)" is the derivative of the demand function with respect to P. "Q" means 'Quantity' and "P" means 'Price'.
  • Example
    Suppose a certain good (say, laserjet printers) has a demand curve Q = 1,000 - 0.6P. We wish to determine the point-price elasticity of demand at P = 80 and P = 40. First, we take the derivative of the demand function Q with respect to P:
    {{\partial Q}\over{\partial P}} = -0.6.
    Next we apply the equation for point-price elasticity, namely
    E_p={{\partial Q}\over{\partial P}}{P \over Q }
    to the ordered pairs (40, 976) and (80, 952). We have
    at P=40, point-price elasticity e = -0.6(40/976) = -0.02.
    at P=80, point-price elasticity e = -0.6(80/952) = -0.05.

[edit] See also

[edit] External links

[edit] References

[edit] Notes

  1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 90. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 
  2. ^ Economic Concepts
  3. ^ ECO 240 | Tutorial 4a

[edit] General references

  • Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
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