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Price Elasticity of DemandPrice Elasticity of Demand

Lecture 1Lecture 1

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Demand Curves Show How Sensitive Consumers are to Price Changes

P

Quantity Demanded/unit time

Demand

Relatively inelastic

1. Quantity demanded is not affected very much by price changes.

2. Therefore not very sensitive to price changes.

3. Not many substitutes, short period of time, and small proportion of budget.

4. Q is not as great as theP.

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Demand Curves Show How Sensitive Consumers are to Price Changes

P

Quantity Demanded/unit time

Demand

Relatively elastic

1. Quantity demanded is affected very much by price changes.

2. Therefore very sensitive to price changes.

3. Many substitutes, long period of time, and large proportion of budget.

4. Q is greater than theP.

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Elastic? or,Elastic? or,

0

1

2

3

4

5

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0 100 200 300 400 500

CornPrice

1000 bu./month

Here the slope relates that thequantity demanded is very sensitive to price changes

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Inelastic?Inelastic?

1

2

3

4

5

1 2 3 4 5

million bu/month

Price Corn6

BUT a change in the scale of measure changes the graphso as to make it look as though the quantity demandedis NOT very sensitive to changes in price !

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Calculating ElasticityCalculating Elasticity

Due to the problems with scaling depicted here, we rely on a mathematical determination of elasticity.

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Price Elasticity of Demand Price Elasticity of Demand (E(Edd))

Ed =

percentage change in quantity demanded

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

percentage change in price

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Calculating Ed:Calculating Ed:

Ed

= %Qd / %P

= (= (Qd / P) * P0 / Q0

== (1 / Slope) * (1 / Slope) * P0 / Q0

All 3 of these equationsyield the same answer

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Interpreting an Elasticity Estimate

If Ed were to = - .75, what does it tell us?

“For every 1% change in price, Qd will change .75% in the opposite direction”

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Example:Example:

P0 = 8 P1 = 7

Q0 = 40 Q1 = 48

Step 1: Q = 48 - 40 = 8 P = 7 - 8 = -1

Step 2: Use the formula for Ed.

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Step 3:

Ed = ((Qd / P) * P0 / Q0

= (8 /-1) * (8/40) = - 1.6

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Step 4:

This means that for every 1 % change in price that there is a 1.6 % change in quantity demanded in the opposite direction.

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Since we know that an Ed = - 1.6 means that a 1 % change in price results in a 1.6% change in quantity demanded in the opposite direction,

What would a 20% increase in price result in?

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Step 1: Ed = % Q / % P

Step 2: %Q = Ed * % P

Step 3: % Q = - 1.6 * +20% = - 32%

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What would a 20% increase in the quantity demanded result in ?

Step 1: Ed = % Q / % P

Step 2: % P = 1 / Ed * % Q

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Step 3:

% P = (1 / - 1.6) * +20% = - 12.5%

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If you have trouble with algebraic derivations of an equation then,

REMEMBER: % P X Ed = % Q

% Qd X (1 / Ed) = % P

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We now know how to mathematically determine Ed, what does it tell us about elasticity ?

Economist usually drop the negative sign of the elasticity of demand for they know that P Q.

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Ed > 1 elastic demand (very responsive to price changes).

Ed< 1 inelastic demand (not very sensitive to prices).

Ed = 1 unitary elastic (ratio of %s = 1).

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Ed > 1 %Q > %P

Ed< 1 %Q < %P.

Ed= 1 %Q = %P.

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1971 Estimates of Price 1971 Estimates of Price Elasticity of Demand at Elasticity of Demand at Retail in the USRetail in the US

Ed beef - .6438

pork -.4130 chicken -.7773 milk -.3455 sugar -.2419 bread -.1500 all foods -.2368 non foods -1.0179