Topic: Elasticity of Demand

Topic: Elasticity of Demand

Objective:

The learner will understand the importance of the concept of elasticity to the demand for goods and services.

Learning Outcomes:

1. Using the appropriate elasticity formula, the learner will be able calculate the price elasticity of demand of a good or service.

2. The learner will be able to interpret the meaning of the elasticity value derived from the calculations performed.

3. The learner will be able to apply the knowledge of elasticity to practical uses.

Practical Illustration Exercise:

Decide on an item costing $1.00 that you and your class partner often purchase and write it on a piece of paper (for example, Snickers Bar: $1.00). Now reduce the price by 40 cents and write down how many bars each of you will buy at the new price. Assume that at $1.00 you normally will buy one Snicker Bar and when the price drops by 40 cents you by four bars instead. Your friend reacts differently to the same reduction in price by indicating that he/she will buy only two bars. (Note: if you both reacted the same, ask another person how they will react to the change in price). Lets calculate the difference in the response between you and your friend to the same change in price.

We will use the formula:

% change in quantity bought

-----------------------------------

% change in price

a) To calculate your change in quantity bought:

New quantity Original quantity (4 minus 1) = 3

b) % change in quantity bought is therefore:

(Change in quantity/Original quantity) x 100%

That is, 3/1 x 100% = 300%

c) To calculate the change in price:

New price Original price (1.00 minus .40) = .60

d) % change in price is therefore:

(Change in price/Original price) x 100%

That is, .60/1.00 x 100% = 60%

e) Now using the formula,

% change in quantity bought

-----------------------------------

% change in price

we can substitute the values we obtained above to get:

300%

-------- = 5

60%

Using the same procedure, we can calculate the extent of your friends reaction:

100%

-------- = 1.6

60%

From this, we see that you have a greater reaction than your friend to the same change in price. Your reaction was measured at 5 compared to 1.6 from your friend. You both show differing degrees of responsiveness in your buying to a change in the price of the commodity. This degree of responsiveness to a change in price is known as the elasticity of demand.

[Note: I have included a primer on calculating price elasticity at the end of this lesson.]

In economics, the price elasticity of demand measures the responsiveness of the quantity demanded of a good to change in its price. The formula used to calculate the price elasticity of demand is

Unitary Elastic:If the value obtained by the formula is equal to 1, demand is said to be unitary elastic, because demand expands the same amount as price.

Elastic:If the value obtained by the formula is greater than 1, demand is said to be elastic, because demand expands more than the price.

Inelasic:If the value obtained by the formula is less than 1, demand is said to be inelastic, because demand expands less than price.

From your calculations on the Snickers Bar, determine if your demand in unitary, elastic or inelastic.Graphical Illustration A: Unitary Elasticity

Notice the percentage change in the quantity denanded is the same as the percentage change in price.

Graphical Illustration B: Elastic Demand Graphical Illustration C: Inelastic Demand

Question:

Using the elasticity formula, can you calculate the elasticity values from graphs A, B and C above?

Perfect Elasticity:

Sometimes demand might be totally unresponsive to a change in price, causing the resulting elasticity value to be zero. This is known as perfectly inelastic demand.

So what do we do with these values?

Well, they are more useful to sellers than for us really. If a seller knows how we respond to different prices for its product, it is able to adjust the price in order to get the most sales revenue. Knowing elasticity helps because it tells the seller whether the total sales revenue will stay the same or go up or down when he changes the price. Lets look at some examples.

Unitary Elasticity: No Change in Revenue

Suppose the Starbucks in your area doubles the price of its basic house coffee from $1.50 to $3.00. As a response, people don't buy as much coffee as they used to. As a matter of fact, Starbucks finds that it sells only half as much coffee as it used to. Now, instead of selling 60 cups per hour at $1.50 each, Starbucks sells 30 cups per hour at $3.00 each.

Question 1: How much revenue (total sales) does Starbucks make per hour on its house coffee when it sells 60 cups at $1.50 each?

Question 2: How much revenue (total sales) does Starbucks make per hour on its house coffee when it sells 30 cups at $3.00 each?

If you answered questions one and two correctly, they should have the same answer for each question, which is $90.00. So, even though Starbucks doubled its price and now sells half as much coffee, it is still making the same amount of revenue (money sales) that it always did. Economists say that the demand for Starbucks coffee is UNITARY ELASTIC, meaning, if the price doubles, the quantity sold gets cut in half. Similarly, if the price triples, quantity sold is only one-third as much. If the price gets cut in half ($1.50 to $.75), the quantity sold doubles. Remember, unitary elasticity means an equal change in price and quantity sold, which results in sales revenue remaining the same.

Elastic: Change in Revenue

Sometimes you can change your selling price a little, and demand for your product will respond tremendously. For example, suppose you own a video rental store. Your basic video rental fee is $3.00. You decide to raise your rental price by 25 cents. You figure maybe you will rent a few less videos, but customers won't really get too upset. To your surprise, you start losing a lot of customers! "Hey, wait a minute," you think. "I only raised my price by a measly quarter. What's going on? I used to rent 40 videos an hour at $3.00. Now, at $3.25, I'm only renting 10 videos. I used to make $3.00 x 40 = $120 per hour. Now I'm only making 10 x $3.25 = $32.50 an hour. My total revenue has dropped a lot."

When customers respond really strongly to a price hike, the demand for your product (video rentals) drops tremendously, causing you to lose revenue. Demand for this product is said to be HIGHLY ELASTIC.But, don't worry, it works both ways. If demand is highly elastic, guess what happens if you DROP your price, say from $3.00 to $2.75? That's right. Customers will flock to your business and rent a lot more videos. So actually, you wind up making a lot more revenue if you drop your price. So, if you rent videos for $2.75, you will probably rent 60 videos an hour. 60 x $2.75 = $165. You make more revenue ($165) at $2.75 than you did at $3.00 ($120). You should definitely rent for $2.75, or maybe even lowermaybe $2.50 or $2.25.

Sometimes, you may sell a product whose demand is HIGHLY INELASTIC. When this happens, you can raise your price a lot, but customers will keep coming to you for your product. If you drop your price a lot, you don't get many additional customers. In other words, customer demand doesn't change very much even when your price does.

For example, suppose you own a gas station in a great location. There are no other gas stations near yours. You sell gas for $1.80 a gallon regular. One day you decide to raise your price to $2.20 a gallon regular. The price that you pay your supplier for your gas hasn't gone up; you just want to make more revenue. You're afraid that customers might stop coming to your station once they see the new $2.20 price, but they still buy gas from you. You haven't lost any customers, or maybe you've lost just a few. But your new $2.50 per gallon price is making you a lot more revenue. You don't worry about the few customers you have lost.

Now you start feeling guilty because you feel you are "ripping off" (gouging) your customers. You decide to drop your price to $1.60 a gallon. Of course you will keep all of your old customersthey will be very happy with you, but you hope you're going to get a lot of brand new customers as well. To your surprise, you get about the same number of customers you always did, maybe just a few more. Why? Because demand for your product, gasoline, is HIGHLY INELASTIC.

Question 3: Suppose you run a car detailing business. You detail 12 cars a week and charge $100 per car. What is your total revenue per week?

Question 4: You decide to cut your price in half, to $50 per car. Now you are getting 30 cars a week. Is the demand for your service unitary elastic or highly elastic? Hint: Figure out if your total revenue now is the same or higher. If demand is unitary elastic, then your total revenue stays the same.

The table below summarizes the relationship between elasticity and revenue:

Elasticity and Revenue

When elasticity is And price Then revenue

>1increasesdecreases

>1decreasesincreases

=1increasesdoesn't change

=1decreasesdoesn't change