Elasticity of Demand

Elasticity of Demand

Elasticity of Demand The law of demand states that an increase in price causes a decrease in quantity demanded (and vice-versa) Question: How much quantity demanded changes in response to a change in price? Elasticity gives us a measure of responsiveness There are four main types of elasticity of demand: o Price elasticity of demand (PED) o Income elasticity of demand o Cross-price elasticity of demand

Price Elasticity of Demand Price Elasticity of Demand: measures the responsiveness of a product s quantity demanded to a change in its price Price elasticity of demand is always negative because of the law of demand o If price increases (+) then the quantity demanded falls (-) o If price decreases (-) then the quantity demanded increases (+) Elasticity should be measured over the range of change in quantity and price Elasticity can be different at every point along the demand curve

Elastic Demand Elastic demand: the demand for a good is elastic if a percentage change in the good s price causes a larger percentage change in quantity demanded o E d > 1 Example; Elastic demand for ice-cream cones

Inelastic Demand Inelastic demand: the demand for a good is inelastic if a percentage change in the good s price causes a smaller percentage change in the quantity demanded o E d < 1 Example; Inelastic demand for ice-cream cones

Unitary-Elastic Demand Unit Elastic Demand: the demand for a good is unit-elastic if a percentage change in the good s price causes an equal percentage change in quantity demanded o E d = 1

Perfectly Elastic Demand Perfectly Elastic Demand: the demand for a good is perfectly elastic if the demand curve is horizontal. o The price of the good remains constant regardless of the quantity demanded o E d = Example; Demand curve for soybeans o If price is higher, there is zero demand o If price is lower, there is infinite demand

Perfectly Inelastic Demand Perfectly Inelastic Demand: the demand for a good is perfectly inelastic if the demand curve is a vertical line. o The quantity demanded for a good remains constant regardless of price (people are willing to pay anything for the good) o E d = 0 Example; Demand curve for Insulin

Calculating Price Elasticity of Demand According to the definition of price elasticity of demand, the price elasticity of demand can be calculated using the following formula: Example; If the price of a product increases by 5% and the quantity demanded falls by 10% then the price elasticity of demand is, When economists talk about the price elasticity of demand, they usually drop the minus sign and report the absolute value of the elasticity

Example; Suppose that when the price increases from $3 to $5, the quantity demanded decreases 1500 to 500 units Now suppose that when the price decreases from $5 to $3, the quantity demanded increases from 500 to 1500 units

Midpoint Formula The values for elasticity should be the same whether prices rise or fall, we have the same problem with quantity as well The solution to this problem is to use the midpoint formula, where we calculate changes in the variable compared with the average (or midpoint) of the starting values Example; Suppose that when the price increases from $3 to $5, the quantity demanded decreases from 1500 to 500 units.

Summary Table The following table summarizes the price elasticities of demand, Elastic Demand E d > 1 Inelastic Demand E d < 1 Unit Elastic Demand E d = 1 Perfectly Elastic Demand E d = Perfectly Inelastic Demand E d = 0

Example 1; Elasticity and Hotels Question: Why does the weekly price of a hotel room in a popular holiday resort vary throughout the year? Solution- (10 Marks/10 Minutes) The supply curve for hotel rooms in the short-run, within the period of a year, is relatively inelastic. Inelastic supply occurs when a percentage change in the goods price causes a smaller percentage change in the quantity supplied With respect to hotel rooms, the quantity supplied is going to vary little regardless of fluctuations in prices.

Consequently, the supply curve is a relatively fixed vertical line. The price is determined by the market equilibrium where the demand curve interests the supply curve. The market for hotel room accommodations at a holiday resort is modeled in the diagram below.

Changes in demand are the primary cause of increases or decreases in price of hotel rooms. Increases in demand cause the demand curve to shift to the right from D 0 to D 1 and increase the price from P 0 to P 1 In contrast, a decrease in demand causes the demand to shift left from D 0 to D 2 and decreases the price from P 0 to P 2 These changes in demand are caused by the following factors. Changes in income o Increase in income causes an increase in demand since vacations and hotel rooms are a normal good Price of competing goods o If hotels in others regions decrease their price, demand decreases

Tastes and preferences o If consumers preferences to visit this holiday resort increase, the demand will increase which contributes to an increase in hotel room prices School holidays o Demand for hotels increases during school holidays as people take vacation Advertising o Improvements in advertising can lure people to the resort and increase the demand Weather o If the weather is attractive at the resort, this will increase demand o In contrast, if weather is adverse (Hurricane Season) it reduces demand