Elasticity of Demand

Definitions

• Elasticity: – The extent to which changes in price cause

a change in quantity demanded or supplied.– How responsive quantity is to a price

change.– How much consumers or suppliers care

about price when making decisions.

Definitions, cont.• Elastic demand:

– A price change causes a significant change in quantity demanded.

– Price will considerably affect whether or not people buy, and how much they buy.

• Inelastic demand:– A price change causes a small change in quantity

demanded. – People feel that they must buy, even if the price goes

up considerably.• Price does not cause them to buy much more or much less.

Steepness of the Demand Curve

• Elastic demand:– Small price change (not much vertical movement)– Large quantity change in response (a lot of horizontal

movement)– Therefore, the curve is not particularly steep.

• Inelastic demand:– Large price change (a lot of vertical movement)– Small quantity change in response (not much horizontal

movement)– Therefore, the curve is steeper.

• Because of the degree of steepness, demand elasticity will determine how much the price changes.

Elastic Demand

Small price change

Large change in quantity

Original price and quantity

New price and quantity

Inelastic Demand

Large price change

Small change in quantity

Original price and quantity

New price and quantity

Demand Elasticity• Example of product with elastic demand:

automobiles.– People care very much about price when deciding to buy.– A price decrease usually leads to a significant increase in

quantity demanded.• Example of product with inelastic demand: table salt.

– People do not particularly care about price when deciding to buy.

– A price decrease usually leads to a barely noticeable increase in quantity demanded.

Estimating Demand Elasticity

• There are 3 determinants of demand elasticity:– Can purchase be delayed?– Are there adequate substitutes?– Does purchase require a large portion of income?

• Hess’s Rule: $1000 or more = yes, $100 or less = no– If it is in between, use your best judgment.

Estimating Demand Elasticityfor general market, cont.

• For each question, yes means elastic, no means inelastic.

• Overall, 2-3 answers of yes means elastic, 2-3 answers of no means inelastic.

• Note: For items (like clothing) that are reusable for a long time (therefore most people have some already):– Yes, purchase can be delayed.– Yes, adequate substitutes are available.

Why Demand Elasticity Matters

• WHEN THERE IS A CHANGE IN SUPPLY, demand elasticity will affect the degree of the price change .– If demand is elastic, the price will not change

much.• Example: Hamburgers

– If demand is inelastic, the price will change significantly.

• Example: Gasoline

Increase in Supply When Demand Is Elastic:

Small Price Change as a Result

D

S1

Original equilibrium

S2

New equilibrium

Increase in Supply When Demand Is Inelastic:

Large Price Change as a ResultD S1

Original equilibrium

S2

New equilibrium

Why Demand Elasticity Matters, cont.

• We tend to feel hurt by price increases more when demand is inelastic.– We feel that we must still buy, even at a higher price.– Sometimes these are the products that are taxed most

heavily, because people will still buy them (e.g. gasoline, cigarettes).

– Sometimes the government must approve price changes of these products to protect consumers (electricity, natural gas).

– A monopoly will lead to more inelastic demand, because of no adequate substitutes.