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:

Using the appropriate elasticity formula, the learner will be able calculate the price elasticity of demand of a good or service.
The learner will be able to interpret the meaning of the elasticity value derived from the calculations performed.
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). Let’s 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 friend’s 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.

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Graphical Illustration B: Elastic DemandGraphical 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. Let’s 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 lower–maybe $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 customers–they 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
>1 / increases / decreases
>1 / decreases / increases
=1 / increases / doesn't change
=1 / decreases / doesn't change
<1 / increases / increases
<1 / decreases / decreases

To further illustrate the relationship between elasticity and revenue you can visit this website:

Determinants of Elasticity:

From the illustrations so far, you probably will have noticed that the elasticity of demand will be different for different goods and services. What determines the demand for a particular good or service?

The most important thing in determining whether the demand will be elastic or inelastic is the availability of substitutes. For example, we have reason to believe that the demand for public transportation is less elastic in New York City than it is in some other cities. The reason could be that there are fewer good substitutes for public transportation in New York City than in some smaller cities. The private car is the most important substitute for public transportation for most local traffic, and it is more expensive to keep a car in New York than it is most other places. Insurance is more costly and parking places are harder to get. For these and other reasons, there are a larger proportion of the population in New York than in most cities who do not have cars. In all cities, in increase in the price of a ride on public transportation will cause some riders to switch to cars. In New York the proportion that make this substitution–car instead of subway–is smaller than in most American cities, for the reasons we have seen. Thus, a 1% increase in the fare in New York causes a smaller (percent) cut in the number of riders; in other words, elasticity is smaller.

In general, the more substitutes there are for the good, and the better substitutes, the more elastic demand will be. The more substitutes, the more people switch, and so, the more elastic demand is.

Another important thing that affects the elasticity of demand is the proportion of income spent on the good. An increase in the price of a good or service reduces the purchasing power of income, and with less income (in purchasing power terms) people will cut back on purchases of all goods. If people spend a large part of their income on a particular good or service, then an increase in the price of that good or service reduces the purchasing power be a relatively great deal, causing a greater cutback than might otherwise occur. This means a bigger cutback when the price goes up–more elastic demand.

It will also make a difference how much time people have to adjust to the change in price, but this can work out in several different ways. For cigarettes, for example–a good for which habit formation is important–the elasticity will probably be greater in the long run, since it will take a long time for people to break their habits and not be replaced by new smokers. For cars it would work the other way. In a short period of time, if car prices go up, people can just keep driving their old clunkers. That is, the cars already on the road are substitutes for new cars. But in a longer period of time the old cars wear out and the elasticity of demand is less.

Even after all these things are considered, there is still a lot of variation in the elasticity of demand from good or service to good or service. The only way to answer the question is to look at the numbers, do the statistics, and let the evidence tell us what the elasticity of demand is for a particular good.

PRACTICE QUESTIONS

With your assigned class partner, answer the questions below:

1. When orange growers have a good harvest, they are faced with an oversupply of oranges. The growers want to sell them quickly, so they drop their price of oranges, say from 20 cents a pound to 10 cents a pound. Farmers figure that they will get a lot of new customers. People who normally don't drink orange juice will switch to OJ when they see how low the prices are. But, to the farmers' surprise, they don't get a lot more customers (not much increased demand for oranges).

In fact, the farmers find out that, if they just destroy most of the oranges instead of selling them on the open market, the supply of oranges becomes scarce (limited). Farmers can then actually raise the price of oranges, say from 20 cents a pound to 40 cents a pound. The farmers may lose a few customers, but most of the customers still buy at the higher price, and farmers make more total revenue.

a)a)Is the above example of changing orange prices an example of highly elastic or highly inelastic demand for oranges?

b)b)If you have a lot of competitors in your area, selling the same product as you are, will demand for that product probably be highly elastic or highly inelastic? Why? How are competition and elasticity related?

2. You own the only building materials store in town. One night the news weather report indicates that your town will probably be flooded by heavy rains tomorrow night. The next morning, you notice that a lot of your customers are buying sand bags; you have lots of bags in inventory. Your price is $2.00 a bag, and you're selling 200 an hour. You decide to double your price at noon time to $4.00 a bag. You figure that customers will pay this high price because they absolutely need the bags, and you have no competition. No other stores in your area sell sand bags. Even though you double your price, you are stillselling 200 bags an hour.

(a) Is the demand for sand bags unitary elastic, highly elastic, or highly inelastic?
(b) Name two other products (besides video rentals) that you believe are highly elastic.
(c) Name two other products (besides gasoline and sand bags during a flood) that you believe are highly inelastic.

3. Two drivers–Tom and Jerry–each drive up to a gas station. Before looking at the price, each places an order. Tom says, “I’d like 10 gallons of gas.” Jerry says, “I’d like $10 of gas.” Pick the correct answer from below:

(a) Tom has higher price elasticity of demand than Jerry.

(b) Tom has higher income elasticity of demand than Jerry.

(d) Tom’s price elasticity of demand is zero.

4. The price elasticity of demand of a good is 1.25. Pick the correct answer below:

(a) the demand for the good is elastic.

(b) the demand for the good is inelastic.

(d) the good is a luxury

5. The demand for a good is highly inelastic if

(a) the price elasticity of the good is close to zero.

(b) the income elasticity of the good is close to one

(d) both a and c.

6. The demand for a particular brand of tooth paste

(a) can be more elastic than the demand for tooth paste, because tooth paste is a necessity.

(b) can be less elastic than the demand for tooth paste, because tooth paste is a necessity.

(d) none of the above.

7. A perfectly inelastic demand curve

(a) is a vertical line parallel to Y-axis.

(b) is a vertical line parallel to X-axis.

(d) a and c.

(e) b and c.

8. If the price of steaks rises from $6 to $10 per pound, and the quantity purchased falls from 90 to 70 pounds, the price elasticity of demand (in absolute value) is

a) 0.333

b) 0.5

c) 2.0

d) 3.0

9. The price elasticity of demand for automobiles measures the responsiveness of