CHAPTER 4: DEMAND. Lesson 3: elasticity of demand

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1 CHAPTER 4: DEMAND Lesson 3: elasticity of demand

2 3 CASES OF DEMAND ELASTICITY Because quantity demanded depends on its price, economists use a concept called elasticity. Elasticity is a measure of responsiveness that describes the way a dependent variable changes in response to a change in an independent variable. In economics, price is almost always the independent variable. Consumers react to a change in price by changing the quantity demanded. This response is known as demand elasticity the extent to which a change in price causes a change in the quantity demanded.

3 3 CASES OF DEMAND ELASTICITY 1) Elastic Demand Demand is elastic when a change in price causes a relatively larger change in quantity demanded. This is shown in Panel A of Figure 4.5. As we move from point a to point b, we see that price declines by one-third. At the same time, the quantity demanded doubles from two to four units. Because the percentage change in quantity demanded is relatively larger than the percentage change in price, demand between those two points is elastic. The key is that consumers have options and do not need any one vegetable urgently.


5 3 CASES OF DEMAND ELASTICITY 2) Inelastic Demand Demand is inelastic when a given change in price causes a relatively smaller change in quantity demanded. This is shown in Panel B of Figure 4.5, where a one-third drop in price from point a to b causes quantity demanded to increase by 25%. For example, a change in the price of a cancer drug may not bring about much change in the quantity purchased if patients need the medicine and don t have other options. Even if the price were cut in half, the quantity demanded might not increase if patients didn t need more.


7 3 CASES OF DEMAND ELASTICITY 3) Unit Elastic Demand Demand is unit elastic when a given change in price causes a proportional change in quantity demanded. For example, Panel C of Figure 4.5 shows that a drop in price from a to b causes an equal percentage increase in quantity demanded. Examples of unit elasticity are difficult to find because the demand for most products is either elastic or inelastic. Unit elasticity is more like a middle ground that separates the other two categories of price elasticity of demand: elastic and inelastic.

8 3 CASES OF DEMAND ELASTICITY To summarize, to measure the elasticity of demand, compare the percentage change in the dependent variable quantity demanded to the percentage in the independent variable price. Relatively smaller changes in quantity demanded indicate inelastic demand. Relatively larger changes in quantity demanded indicate elastic demand. Changes that are proportional to the change in price are unit elastic.


10 THE TOTAL EXPENDITURES TEST To estimate elasticity, compare the direction of a price change to the direction of the change in total revenue, or total expenditures. This is sometimes called total revenue or total expenditures. A) Determining Total Expenditures We find total expenditures (or total revenue) by multiplying the price of a product by the quantity demanded for any point along the demand curve. What consumers consider spending is revenue to the seller. Total Expenditures (Revenue) = P x Q

11 THE TOTAL EXPENDITURES TEST B) Estimating Elasticity We could summarize the changes among these relationships in the following way: Elastic demand a change in price and a change in revenue move in opposite directions (more flattened out demand curve) Unit elastic demand there is no change in revenue regardless of the change in price (our normal demand curve) Inelastic demand a change in price and a change in revenue move in the same direction (more vertical of demand curve)

12 THE TOTAL EXPENDITURES TEST C) Business Sales Knowledge of demand elasticity is extremely important to most businesses. Suppose, for example, that you run your own business and want to do something that will raise your revenues. You could try to stay open longer, or you could try to advertise in order to increase sales. You might, however, also be tempted to raise the price of your product in order to increase total revenue from sales. This might actually work in the case of medical services, because the demand for this product is generally inelastic. However, what would happen if you sold a product with elastic demand, such as burgers? If you raised the price, your total revenue which is the same as expenditures by the consumer would go down instead of up. That s exactly what you didn t want! Knowing the demand elasticity for a new product will allow a business to set (or change) the price to maximize total revenues.

13 DETERMINANTS OF DEMAND ELASTICITY A) Can the Purchase Be Delayed? Sometimes consumers cannot postpone the purchase of a product. This tends to make demand inelastic, meaning that the quantity of the product demanded is not especially sensitive to changes in price. For example, people who need to take a medication on a specific schedule will pay higher prices if they must. The demand for tobacco products also tends to be inelastic because the product is addictive. As a result, a sharp increase in price will lower the quantity purchased by consumers, but not by very much.


15 DETERMINANTS OF DEMAND ELASTICITY B) Are Adequate Substitutes Available? If adequate or similar substitutes are available, consumers can switch back and forth to take advantage of the best price. However, the fewer the substitutes available for a product, the more inelastic the demand. Note that the size of the market is also important. For example, the demand for gasoline at a particular station tends to be elastic because consumers can buy gas at another location. If we ask about the demand for gasoline in general, however, demand is much more inelastic because there are few adequate substitutes for either.

16 DETERMINANTS OF DEMAND ELASTICITY C) Does the Purchase Use a Large Portion of Income? The third factor is the amount of income required for you to make the purchase. If the amount is large, then demand tends to be elastic. If the amount of income is small, demand tends to be inelastic.