How Does Price Elasticity Affect Demand?

TL;DR

Demand elasticity measures how strongly quantity demanded responds to a price change, using the absolute value of percentage change in quantity divided by percentage change in price. A coefficient below one is inelastic, above one is elastic, one is unit elastic, zero is perfectly inelastic, and infinity is perfectly elastic. Elasticity also determines whether a price change raises or lowers total revenue.

Transcript

Hey, you already know the law demands says there's an inverse relationship between price and quantity So the price goes up for a product people buy less the price goes down people buy more but the question now is how much less or how much more they buy and that's the idea of elasticity Elasticity shows how sensitive quantity is to a change in price... Read More

Key Insights

• Demand elasticity is a measure of how sensitive quantity demanded is to a change in price. The law of demand establishes that price and quantity move in opposite directions, while elasticity identifies the magnitude of the resulting change in quantity.
• Inelastic demand is present when quantity demanded changes only slightly after a price change. Gasoline illustrates this category because it has few substitutes and is treated as a necessity, so consumers buy only a little less when its price rises.
• The elasticity coefficient is calculated by dividing the percentage change in quantity demanded by the percentage change in price. Because price and quantity move in opposite directions, the coefficient is discussed using its absolute value rather than its negative sign.
• Elastic demand is present when quantity demanded responds strongly to a price change. Products with many substitutes or products considered luxuries are more price-sensitive, producing a coefficient greater than one because quantity changes proportionally more than price.
• Unit elastic demand is present when the percentage change in quantity demanded exactly equals the percentage change in price. A 20 percent price increase paired with a 20 percent quantity decrease produces an elasticity coefficient of one.
• Perfectly inelastic demand is represented by a vertical demand curve and has an elasticity coefficient of zero. Quantity demanded remains unchanged when price changes, so the numerator in the elasticity calculation, the percentage change in quantity, is zero.
• Perfectly elastic demand is represented by a horizontal demand curve and has an infinite elasticity coefficient. A firm cannot raise its price without losing buyers, making quantity demanded completely sensitive to a departure from the established price.
• The total revenue test is a method for identifying elasticity from changes in price and revenue. Price and total revenue move together under inelastic demand, but they move in opposite directions under elastic demand because quantity responds much more strongly.

Questions & Answers

Q: What is the price elasticity of demand?

Price elasticity of demand measures how sensitive quantity demanded is to a change in price. It goes beyond the law of demand, which only says that price and quantity demanded move in opposite directions. Elasticity asks how much quantity changes. Its coefficient is the absolute value of the percentage change in quantity demanded divided by the percentage change in price.

Q: How is the elasticity of demand coefficient calculated?

The elasticity of demand coefficient is calculated by dividing the percentage change in quantity demanded by the percentage change in price. The result is treated as an absolute value because the law of demand means price and quantity normally move in opposite directions. A result below one is inelastic, one is unit elastic, and above one is elastic.

Q: What makes demand inelastic?

Demand is inelastic when quantity demanded responds only slightly to a change in price. Products in this category have few substitutes or are necessities. Gasoline is the example given: when its price rises, people purchase a little less, and when its price falls, they purchase a little more. Its elasticity coefficient is less than one.

Q: What makes demand elastic?

Demand is elastic when quantity demanded changes substantially in response to a price change. Products with many substitutes or products considered luxuries fit this category. A price increase causes quantity demanded to fall by a relatively large amount, while a price decrease causes it to rise substantially. The resulting elasticity coefficient is greater than one.

Q: What is unit elastic demand?

Unit elastic demand occurs when the percentage change in quantity demanded exactly matches the percentage change in price. For example, if price rises by 20 percent and quantity demanded falls by 20 percent, dividing the percentage quantity change by the percentage price change produces an absolute coefficient of one. That coefficient identifies demand as unit elastic.

Q: What are perfectly inelastic and perfectly elastic demand?

Perfectly inelastic demand is shown by a vertical demand curve. Price can change without changing quantity demanded, so the elasticity coefficient is zero. Perfectly elastic demand is shown by a horizontal demand curve. A firm cannot increase price without losing buyers, and the corresponding elasticity coefficient is described as infinite.

Q: How does inelastic demand affect total revenue?

With inelastic demand, price and total revenue move in the same direction. When price rises, quantity demanded falls only slightly, so total revenue, calculated as price multiplied by quantity, increases. When price falls, total revenue falls. This relationship explains the claim that gas stations have no reason to hold half-price gasoline sales to increase total revenue.

Q: How can the total revenue test identify elastic demand?

The total revenue test identifies elastic demand when price and total revenue move in opposite directions. If price rises and total revenue falls, the large decline in quantity demanded outweighs the higher price. If price falls and total revenue rises, the substantial increase in quantity outweighs the lower price. Either pattern indicates elastic demand.

Summary & Key Takeaways

• Elasticity of demand measures how sensitive quantity demanded is to a price change. Inelastic demand produces a relatively small quantity response, while elastic demand produces a relatively large response. Products with few substitutes or necessity status tend to be inelastic, whereas products with many substitutes or luxury status tend to be elastic.

• The elasticity coefficient equals the percentage change in quantity demanded divided by the percentage change in price, expressed as an absolute value. Values below one indicate inelastic demand, one indicates unit elastic demand, and values above one indicate elastic demand. Perfectly inelastic and perfectly elastic demand have coefficients of zero and infinity, respectively.

• The total revenue test connects elasticity with price and quantity because total revenue equals price multiplied by quantity. With inelastic demand, price and total revenue move in the same direction. With elastic demand, they move in opposite directions. Therefore, observing revenue after a price change can reveal the relevant elasticity category.