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Module
9
Interpreting Price Elasticity
of Demand
Module Objectives
Students will learn in this module:
• The difference between elastic and inelastic demand.
• The relationship between elasticity and total revenue.
• Changes in the price elasticity of demand along a demand curve.
• The factors that determine price elasticity of demand.
Module Outline
I.Interpreting the Price Elasticity of Demand
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A.How elastic is elastic?
1. Definition: Demand is perfectly inelastic when the quantity demanded
does not respond at all to changes in the price. When demand is perfectly
inelastic, the demand curve is a vertical line.
2. Definition: Demand is perfectly elastic when any price increase will
cause the quantity demanded to drop to zero. When demand is perfectly
elastic, the demand curve is a horizontal line.
3. Definition: Demand is elastic if the price elasticity of demand is greater
than 1, inelastic if the price elasticity of demand is less than 1, and
unit-elastic if the price elasticity of demand is exactly 1.
4. Text Figure 9-2, shown on the next page, illustrates three demand curves
with different numerical values to show the difference between elastic
and inelastic demand.
module 9
interpreting Price elasticity of demand
Unit-Elastic Demand, Inelastic Demand, and Elastic Demand
(a) Unit-Elastic Demand:
Price Elasticity of Demand = 1
(b) Inelastic Demand:
Price Elasticity of Demand = 0.5
Price of
crossing
A 20%
increase
in the
price . . .
Price of
crossing
B
$1.10
0.90
A 20%
increase
in the
price . . .
A
$1.10
0.90
B
A
D1
D2
0
900 1,100
. . . generates a 20%
decrease in the quantity
of crossings demanded.
Quantity of
crossings
(per day)
0
950 1,050
. . . generates a 10%
decrease in the quantity
of crossings demanded.
(c) Elastic Demand:
Price Elasticity of Demand = 2
Price of
crossing
A 20%
increase
in the
price . . .
$1.10
0.90
B
A
D3
0
800
1,200
. . . generates a 40%
decrease in the quantity
of crossings demanded.
Quantity of
crossings
(per day)
B.Elasticity affects total revenue.
1. Definition: Total revenue is the total value of sales of a good or service.
It is equal to the price of a good multiplied by the quantity sold.
2. Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of a good, two effects are
present.
a.A price effect: After a price increase, each unit sold sells at a higher
price, which tends to raise revenue. The price effect is the change in
price times the new quantity.
b.A sales effect: After a price increase, fewer units are sold, which tends
to lower revenue. The sales effect is the change in quantity sold times
the original price.
3. The price elasticity of demand determines which effect predominates and
therefore, indicates what happens to total revenue when price changes.
a.If demand for a good is elastic, an increase in the good’s price reduces
total revenue; a fall in price increases total revenue. In this case, the
sales effect is stronger than the price effect.
Quantity of
crossings
(per day)
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interpreting price elasticity of demand
b.If demand for a good is inelastic, a higher price increases total revenue;
a fall in price results in a decrease in total revenue. The price effect in
this case is stronger than the sales effect.
c.If demand for a good is unit-elastic, an increase or a decrease in the
good’s price does not change total revenue. Here, the sales effect and
the price effect exactly offset each other.
4. Total revenue is illustrated as an area below a demand curve: price times
quantity sold.
Price
P
Total
revenue
D
Q
Quantity
C. Elasticity changes as you move along a linear demand curve.
1. At the top of a linear demand curve, the price elasticity of demand is
elastic between two price points. As you move to the bottom of a linear
demand curve, the price elasticity of demand is more inelastic.
2. At higher prices, consumers are more sensitive to a price change because
the purchase represents a larger share of the budget. At lower prices,
the purchase is a smaller share of the budget, and consumers are not as
responsive to a price change.
D.What factors determine the price elasticity of demand?
1. The availability of close substitutes
a.The price elasticity of demand will tend to be high if there are close
substitutes.
b.The price elasticity of demand will tend to be low if there are no close
substitutes.
2. Whether the good is necessary or a luxury
a.The price elasticity of demand tends to be low if the good is a necessity.
b.The price elasticity of demand tends to be high if the good is a luxury.
3. Time
a.The long-run price elasticity of demand is often higher than the shortrun elasticity.
module 9
interpreting Price elasticity of demand
Teaching Tips
Interpreting the Price Elasticity of Demand
Creating Student Interest
Ask students to identify some of the goods they buy that have inelastic demand. In other
words, when the price of that good goes up, the student still buys about the same quantity of the good. Students will probably suggest gas and other necessities. Now ask students
to name some of the goods they buy that have elastic demand. These are goods that they
buy a lot less of when the price goes up. They will probably suggest different luxury goods
(Starbucks coffee or meals eaten out), or perhaps expensive goods (cars and electronics).
Ask them what they think happens to a firm’s total revenue when price increases. You
will probably get some students who say increase, and some who say decrease. Ask them
if they think it would be a good idea for the firm to increase price. The answer is, it
depends on elasticity. If the firm increases price, and quantity demanded falls by a relatively small amount, then total revenue rises. Toll roads are a good example to use. If the
toll increases, what happens to the toll revenue collected? Another good example is the
price of an adult movie ticket. Could the theater earn more revenue by increasing the
price on some tickets and decreasing the price on other tickets? The answer is yes, if the
elasticity of demand is elastic for some movies and inelastic for other movies.
Presenting the Material
Students usually do not have trouble understanding the difference between elastic and
inelastic. Emphasize that if the percentage change in quantity demanded is greater than
the percentage change in price, demand is responsive or elastic. Students find the discussion of the factors that help determine whether a good is elastic or inelastic most interesting if you pick a varied selection of goods and use these to motivate the discussion. Some goods are suggested in the table that follows. Alternatively, ask students to suggest
goods they think are relatively elastic or inelastic.
Product
Eggs
Price elasticity of demand
0.1
Determinants of elasticity
a small part of the consumer’s budget
Beef
0.4
large category: not as many substitutes as
T-bone steak
Stationery
0.5
small part of the consumer’s budget
Gasoline
0.5
a necessity
Housing 1.2
a large proportion of a consumer’s budget
Restaurant meals
2.3
there are substitutes
Airline travel
2.4
there are many substitutes
Foreign travel
4.1
there are many substitutes
Once students have grasped the concept of elastic versus inelastic, you can discuss elasticity along the demand curve. Tell students that the elasticity, or price responsiveness,
depends on the current price. Use a bottle of water as an example. If the price of the
bottle is $1 and it increases by 10%, will there be a big change in quantity demanded? 47
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interpreting price elasticity of demand
What if the price is $100 and it increases 10%? Since the actual change in the price is
larger ($10 versus $1) at higher prices, demand will be more elastic. To get the students to understand what happens to total revenue when price changes,
they will need to see a few examples. Some students will conceptually grasp the idea,
some will understand the concept through the total revenue graph, and others will want
to see a more specific numerical example, such as the one provided here.
Price
Quantity
Total revenue
$195205 $19,475
105
195
20,475
95
220
20,900
105
180
18,900
The example in the table has price increasing by 10% ($95 to $105 using the midpoint
method), and quantity demanded either falling by 5% (205 to 195 using the midpoint
method) or 20% (220 to 180 using the midpoint method). Calculate the elasticity of
demand in each case (0.5 in the first case and 2.0 in the second case) and show them
what happens to total revenue. Next, you can plot these data points on two different
demand curves and draw the corresponding total revenue graph to show total revenue
either increasing or decreasing depending on whether you are on the inelastic or elastic
portion of the demand curve.
Common Student Pitfalls
• Interpreting elasticity. Students often focus on the formula and calculating elasticity and may not spend time thinking about what the values mean. Make sure
students understand that learning to calculate elasticities is important and will be
required, but that interpreting what the values mean and seeing how elasticities
figure into economic analysis is even more important.
• Total revenue and elasticity. Students may confuse total revenue with profits.
Clarify that revenue is the amount the firm “brings in” and is equal to P × Q.
Profit is TR – TC.
Case Studies in the Text
Economics in Action
Responding to Your Tuition Bill—This EIA uses elasticity of demand to explain how enrollment responds to tuition changes.
Ask students the following questions:
1. According to the 1988 study, a 10% increase in tuition at a four-year
university would decrease enrollment by how much? (Price elasticity of
demand was estimated to be .67, so a 10% increase in tuition would
decrease enrollment by 6.7%. X/10 = .67 so X = 6.7).
2. What do you estimate is the price elasticity of demand for your school?
(It should be near the estimates of .67 for 4-year schools and .9 for
2-year schools. Changes in the value of a college education and institutionspecific factors would change the estimate.)
module 9
interpreting Price elasticity of demand
Activities
Ranking Goods by Their Price Elasticity (5–10 minutes)
Pair students and put the following six goods in order of most elastic to least elastic:
Salt
Audi A4 car
A doctor’s visit
T-Bone steaks
A luxury room at the Crowne Plaza hotel
Electricity
The order will be close to:
Audi A4 car
A luxury room at the Crowne Plaza hotel
T-Bone steaks
Salt
A doctor’s visit
Electricity
Why Do Business Travelers Pay More? (3–5 minutes)
Here is a concrete example to illustrate the difference between elastic and inelastic
demand.
The elasticity of demand for airline travel differs when we look at business travelers
versus vacation travelers.
Vacation travelers
Business travelers
P1= $200 P1=$200
P2= $220 P2= $220
Q1 = 10,000 tickets
Q1 = 10,000 tickets
Q2= 8,000 tickets
Q2 = 9,500 tickets
The response of vacation travelers to an increase in the price of airline tickets from $200
to $220 results in a fall in quantity demanded from 10,000 tickets to 8,000 tickets. The
same increase in price for business travelers causes the quantity demanded to fall a little;
from 10,000 tickets to 9,500 tickets.
Ask students to calculate the price elasticity of demand for vacation travelers and for
business travelers, using the midpoint formula.
Calculating Total Revenue (5 minutes)
For vacation travelers:
10,000 – 8,000
(10,000 + 8,000)/2
220 – 220
(200 + 200)/2
= 2.33
10,000 – 9,500
For business travelers:
(10,000 + 9,500)/2
220 – 220
(200 + 200)/2
= 0.54
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interpreting price elasticity of demand
Use the previous example involving the demand for airline tickets to calculate the
change in total revenue resulting from the price increase from $200 to $220. Have
students calculate the price effect and the sales effect of the price change, and then use
that information to determine if demand is elastic or inelastic.
For vacation travelers: • Total revenue before the price change is: $200 × 10,000 tickets = $2 million
• Total revenue after the price change is $220 × 8,000 tickets = $1.76 million
• Price effect is $20 × 8,000 tickets = $160,000
• Sales effect is $200 × (–2,000 tickets) = –$400,000
• The sales effect dominates the price effect. Total revenues will fall after a price
increase, so demand is price elastic.
For business travelers:
• Total revenue before the price change is: $200 × 10,000 tickets = $2 million
• Total revenue after the price change is $220 × 9,500 tickets = $2.09 million
• Price effect is $20 × 9,500 tickets = $190,000
• Sales effect is $200 × (–500 tickets) = –$100,000
• The price effect dominates the sales effect. Total revenues will rise after a price
increase, so demand is price inelastic.
Determining Elasticity (3–5 minutes)
Form pairs of students and ask them to calculate the percent change in quantity
demanded for each of the goods on page 47 if the price of the product rises by 10%.
Web Resources
The following website provides data related elasticities.
The U.S. Department of Agriculture has elasticity estimates for food and commodities at
http://www.ers.usda.gov/Data/Elasticities/.