Download Suppose you run an ice cream store

Understanding Markets
Elasticity
Defining Elasticity
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Suppose you run an ice cream store. Right now you’re selling your ice cream cones for $2.00 apiece and you’re
selling 20 cones a day. Should you try to improve your business by putting your ice cream cones on sale for $1.00
apiece? In order to answer this question you’d need to know how your customers would respond to a change in your
price, and this brings up the question of the elasticity of demand.
Elasticity means responsiveness. Suppose you have a piece of elastic. If you stretch it, it responds and changes
shape. If it didn’t change shape, that is, if it were unresponsive to your pulling on it, it wouldn’t be elastic, would it?
Elasticity means the extent to which the quantity demanded changes when there’s a change in the price of a good.
We define elasticity as the percentage change in quantity demanded that results from a percentage change in the
price of a good.
Let’s look at those ice cream stores now. Suppose Angie runs an ice cream store where she charges $2.00 apiece
for her ice cream cones, and right now she’s selling 20 cones a day. If Angie puts her cones on sale at $1.00 apiece,
she discovers that her customers want to buy more cones, that is, as the price falls, the quantity demanded increases.
But they only want to buy 10 additional cones daily for a total of 30 cones per day at a price of $1.00 apiece. Angie’s
demand curve for ice cream cones looks something like this: her customers want to buy a few extra cones when the
price falls, but the demand curve is relatively steep. We’ll label this Da for the demand on the part of Angie’s
customers.
Across town Barney has an ice cream store. Barney starts, like Angie did, with a price of $2.00 apiece for his ice
cream cones. He’s also selling 20 cones per day. Now, when Barney puts his cones on sale at $1.00 apiece, his
customers get very exited and come in and buy 50 cones a day. That is, Barney’s customers are much more
responsive to a change in the price of cones than were Angie’s customers. If we connect these two dots for Barney,
we see that Barney’s customers demand curve is flatter. That is, for a given change in the price of ice cream,
Barney’s customers will buy many more additional cones than will Angie’s customers.
When the price goes from $2.00 to $1.00 at the two stands, Angie’s customers respond a little, but Barney’s
customers respond a lot. We say that Barney’s customers demand for ice cream is more elastic than Angie’s
customers demand for ice cream. Now, why should you care about this? See if you can answer this question. What
happens to the total revenue that Angie raises when she changes the price of her ice cream cones from $2.00 apiece
to $1.00 a piece. Does her total revenue increase, or does it decrease?
If you’ll look over on the white board, you can see my calculations. When the price of ice cream cones is $2.00, Angie
sells 20 cones for a total revenue of 20 cones times $2.00 apiece, or $40.00 in total sales. When she drops her price
to $1.00 per cone, she sells 30 cones. That means each day she earns 30 cones times $1.00 apiece, or $30.00 in
total revenue. When Angie drops the price of her ice cream cones from $2.00 apiece to $1.00 apiece, Angie’s total
revenue actually falls.
Now, what happens to Barney’s total revenue whenever he drops his price? You can see my calculations. Whenever
Barney is charging $2.00 apiece for ice cream cones, he’s also selling 20 cones. His total revenue is 20 cones times
$2.00 apiece or $40.00. When Barney drops the price of his cones to $1.00 apiece, he sells a total of 50 ice cream
cones. Fifty times $1.00 apiece gives a total revenue of $50.00 a day. Barney’s total revenue increases when he
drops his price, that is, when he has a sale on ice cream comes.
You can see it’s very important to know whether the demand for your product is elastic or inelastic, that is, by how
much the quantity will respond to a change in the price of a good. If the quantity demanded is very responsive, your
total revenue will increase when you reduce the price of your product. If, however, the quantity demanded is
unresponsive, or relatively inelastic, then when you reduce the price of the good, your total revenue will actually fall.