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: % change in Quantity % change in Price 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 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 D P1 P Q1Q The % change in Quantity is a much bigger movement than the % change in Price % change in Price % 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 D P1 P Q1Q The % change in Price is a much bigger movement than the % change in Quantity % change in Price % 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 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, Elastic Demand Price and TR move in OPPOSITE DIRECTIONS Inelastic Demand P and TR move in the SAME DIRECTION then you look to see what direction the Price moves AND the Total Revenue Moves

Here’s an example…. Price changes from $5 to $8, and Quantity changes from 100 to 80 PriceQuantity Total Revenue Old New Price: Increases TR: Increases INELASTIC SAME DIRECTION 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 PriceQuantity Total Revenue Old New Price: Decreases TR: Increases ELASTIC OPPOSITE DIRECTION 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