Chapter 6 Elasticity Defining and Measuring Elasticity Calculating the Price Elasticity of Demand price elasticity of demand the ratio of the percent change in the quantity demanded to the percent change in the price as we move along he demand curve dropping the minus sign to calculate the price elasticity of demand we first calculate the percent change in the quantity demanded and the corresponding percent change in the price as we move along the demand curve change in quantity demanded change in quantity demanded initial quantity demanded x 100 change in price change in price initial price x 100 price elasticity of demand change in quantity demanded change in price a positive percent change in a price rise in price leads to a negative percent change in the quantity demanded a negative change in price fall in price leads to a positive percent change in the quantity demanded the price elasticity of demand is a negative number but economists usually drop the minus sign the larger the price elasticity of demand the more responsive the quantity demanded is to the price when the price elasticity of demand is large economists say that demand is highly elastic An Alternative Way to Calculate Elasticities The Midpoint Method price elasticity of demand compares the percent change in quantity demanded with the percent change in price to avoid computing different elasticities for rising and falling prices we use the midpoint method midpoint method replaces the usual definition of the percent change in a variable X with a slightly different definition change in X change in x average value of x x 100 where the average value of x is defined as average value of x starting value of x final value of x 2 when calculating the price elasticity of demand using the midpoint method both the percent change in the price and the percent change in the quantity are found using this method Example Situation A Situation B Price 0 90 Quantity Demanded 1 100 Price 1 10 Quantity Demanded 900 change in quantity demanded 200 1 100 900 2 X 100 20 change in price 0 20 0 90 1 10 2 X 100 20 price elasticity of demand 20 20 1 price elasticity of demand Q2 Q1 Q1 Q2 2 P2 P1 P1 P2 2 Interpreting the Price Elasticity of Demand How Elastic is Elastic demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price when demand is perfectly inelastic the demand curve is a vertical line example consumers buy 1 000 doses of anti venom a year regardless of the price demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero when demand is perfectly elastic the demand curve is a horizontal line the price of elasticity of demand for the vast majority of goods is somewhere between these two extreme cases economists use one main criterion for classifying these intermediate cases they ask whether the price elasticity of demand is greater or less than 1 when the price of elasticity of demand is greater than 1 economists say that demand is elastic when the price of demand is less than 1 they say that demand is inelastic unity elastic demand is where the price elasticity of demand is exactly 1 total revenue is the total value of sales of a good or service It is equal to the price multiplied by the quantity sold total revenue price X quantity sold price effect after a price increase each unit sold sells at a higher price which tends to raise revenue quantity effect after a price increase fewer units are sold which tends to lower revenue the price elasticity of demand tells us what happens to total revenue when price changes its size determines which effect the price effect or the quantity effect is stronger specifically if demand for a good is unit elastic the price elasticity of demand is 1 an increase in price effect price does not change total revenue in this case the quantity effect and the exactly offset each other if demand for a good is inelastic the price elasticity of demand is less than 1 a higher price increases total revenue in this case the price effect is stronger than the quantity effect if demand for a good is elastic the price elasticity of demand is greater than 1 an increase in price reduces total revenue in this case the quantity effect is stronger than the price effect the price elasticity of demand also predicts the effect of a fall in price on total revenue when demand is unit elastic the two effects exactly balance so a fall in price has no when demand is inelastic the price effect dominates the quantity effect so a fall in effect on total revenue price reduces total revenue when demand is elastic the quantity effect dominates the price effect so a fall in price increases total revenue Price Elasticity Along the Demand Curve for the vast majority of demand curves the price elasticity of demand at one point along the curve is different from the price elasticity of demand at other points along the same curve for the vast majority of goods the price elasticity of demand changes along the demand curve so whenever you measure a good s elasticity you are really measuring it at a particular point or section of the good s demand curve What Factors Determine the Price Elasticity of Demand four main factors determine elasticity the availability of close substitutes whether the good is a necessity or a luxury the share of income a consumer spends on the good and how much time has elapsed since the price change instead The Availability of Close Substitutes the price elasticity or demand tends to be high if there are other readily available goods that consumers regard as similar and would be willing to consume the price elasticity of demand tends to be low if there are no close substitutes or they are very difficult to obtain Whether the Good Is a Necessity or a Luxury the price elasticity of demands tends to be low is a good is something you must have the price elasticity of demand tends to be high if the good is a luxury something you like a life saving medicine can easily live without Share of Income Spent on the Good the price elasticity of demands tends to be low when spending on a good accounts for a small share of a consumer s income a significant change in the price of the good has little impact on how much the consumer spends when a good accounts for a significant share of a consumer s spending the consumer is likely to be very responsive to a change in price therefore the price elasticity demand tends to be high of The Elapsed Since