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Elasticity and Demand
Elasticity is defined as being
sensitive to a change in price….but
what does that mean?
Remember that whenever the price of a good
changes, buyers will react, and sometimes will
change their mind about buying a product
What would happen
if ONLY Hershey
chocolate bars
increase their price?
They would lose lots
of buyers to other
candy bars
But, what happens
when the price of
gasoline increases?
Do people stop buying
gasoline?
Of course not
The differences in the reaction of buyers to these
2 price increases can be explained by the
concept of Elasticity
Elasticity is actually a
mathematical calculation
that looks at the
Percentage Changes in
Price and Quantity when
the price of a good
changes
It is a formula that is set up like this:
In other words, what will
happen when the price of the
good changes?
If the Price of the good increases
•Will a large percentage of
buyers stop buying it because of
the higher price and choose
another good
•Or will a small percentage of
buyers stop buying, but most
buyers will pay the higher price
% change in Quantity
-------------------------------------------% change in Price
What if the opposite
situation were to happen?
If the Price of the good
decreases
•Will a large percentage of
buyers start to buy the good
because of the lower price?
•Or will only a small
percentage of buyers start to
buy the product
There are 2 categories to Elasticity…..
Elastic Demand
•The good is very
sensitive to a change in
price
•Many buyers change
their mind about
purchasing when the
good changes price
•The % change in
Quantity is greater than
the % change in Price
•On a graph, the Demand
curve is very flat looking
•If you were to calculate
the elasticity of Demand
using the formula, the
value would be greater
than 1.00
The % change in Quantity is a
much bigger movement than the
% change in Price
P1
% change in
Price
P
D
Q1
Q
% change in
Quantity
The second category is…..
Inelastic
Demand
•The good is not sensitive
to a change in price
•Few buyers change their
mind about purchasing
when the good changes
price
•The % change in Price is
greater than the % change
in Quantity
•On a graph, the Demand
curve is very steep looking
•If you were to calculate
the elasticity of Demand
using the formula, the
value would be smaller
than 1.00
The % change in Price is a much
bigger movement than the %
change in Quantity
P1
% change in
Price
P
D
Q1
Q
% change in
Quantity
What factors help determine Elasticity?
Availability of
Substitutes
•The more substitutes
available means Demand
is more elastic
•Think about the candy
bar vs gasoline example
•Candy bar: many
substitutes, so Demand
is Elastic
•Gasoline: no/few
substitutes, so Demand
is Inelastic
Percentage of
Budget
•Goods that are more
expensive make up a
larger percentage of a
person’s budget
•The greater the impact
on the budget, the more
elastic the Demand
•Example:
•if a $1 product
increases its price by
25%, it will cost $1.25
•If a $100 product
increases its price by
25%, it will cost $125
Amount of
Time to Adapt
•If you have more time
to find alternatives (or
adapt), Demand will be
more Elastic
•Less time means
Demand is more
Inelastic
There is one easy way for you to determine Elasticity…
It is the Total Revenue Test
Total Revenue is the
amount of money a firm
receives when it sells
products
You can calculate Total Revenue (TR) by
multiplying the Price of the good by the
number of units sold
Total Revenue = Price x Quantity sold
TR = P x Q
Notice that the two components of Total
Revenue are the two main components of
Elasticity: Price and Quantity
First you Calculate Total
Revenue,
then you look to see what
direction the Price moves
AND the Total Revenue
Moves
Elastic
Demand
Price and TR move
in OPPOSITE
DIRECTIONS
Inelastic
Demand
P and TR move in
the SAME
DIRECTION
Here’s an example….
Price changes from $5 to $8, and
Quantity changes from 100 to 80
Old
New
Price
Quantity
5
8
100
80
Total
Revenue
500
640
Price: Increases
TR: Increases
Demand for this good is INELASTIC since P
and TR move in SAME DIRECTION
Here’s another example….
Price changes from $10 to $7, and
Quantity changes from 30 to 40
Old
New
Price
Quantity
10
7
30
50
Total
Revenue
300
350
Price: Decreases
TR: Increases
Demand for this good is ELASTIC since P and
TR move in OPPOSITE DIRECTION
Need some tips for de-coding
Elasticity problems?
Is the question asking
you about whether the
Demand is Elastic or
Inelastic?
Figure out what direction
Price is moving and then
what direction TR is moving
Elastic: opposite
Inelastic: same
Is the question asking
you about what will
happen if you increase
or decrease the price
by a certain
percentage?
If Demand is Elastic, the
Quantity will increase by
more than that percentage
If Demand is Inelastic, the
Quantity will increase by
less than that percentage