THE PRICE ELASTICITY OF DEMAND

Price Elasticity of Demand  Price elasticity of demand measures in a standardized way how responsive consumers are to price change  elasticity is another word for responsiveness Price Quantity $ $ DEDE DIDI

Does the demand curve for health care slope downward?  Are people sensitive to the price of health care?  Is demand for vaccines such that… P = $100, Q=1,000 P = $1, Q=1,000 i.e. demand is inelastic?  Is demand for band-aids such that… P = $100, Q = 1 P = $1, Q = 30 i.e. demand is elastic?  If people always obey their doctors, then demand should be inelastic!

Elasticity measures the degree of downward-sloping  Elastic demand D E  price sensitive: changes in price greatly affect the quantity demanded  Inelastic demand D I  Price insensitive: changes in price do not significantly change the quantity demanded

Price Elasticity of Demand  Own-Price Elasticity of Demand:  Example: If the elasticity of demand for physician visits is -.6, a 10% increase in price leads to a 6% decrease in the number of visits demanded  Elasticities are scale-free  We can compare the ED for physician visits vs. nursing home days, even though they are consumed in different units

Exhibit: Demand Curve for Tacos For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a. To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price  in this example the base used for price is the average of $1.10 and $0.90 = $1.00  the change in price is -$0.20 divided by $1.00  - 20% The same process should be used for changes in quantity demanded  the average quantity demanded is 100,000 and the change in quantity demanded is 10,000  10% change Price elasticity between a and b = 10% / - 20% = b Thousands per day D $1.10 a Price per taco

 E D is expected to be negative. Thus, own-price elasticities of demand are often quoted in terms of absolute value  The demand curve is inelastic if  0<|E D |<1  The demand curve is elastic if 1<|E D |<  Elasticities (cont.)

Health care has inelastic demand

Selected Price Elasticities of Demand Product Short RunLong Run Cigarettes (among adults)—0.4 Electricity (residential) Air travel Medical care and hospitalization Gasoline Milk0.4 — Fish (cod)0.5— Wine Movies Natural gas (residential) Automobiles Chevrolets —4.0

Elasticity and Total Revenue  Knowledge of price elasticity is especially valuable because it indicates the effect of a price change on total revenue  Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price  TR = p x q  What happens to total revenue when price decreases?

Total Revenue and Demand Elasticity Impact of lower price on total consumer expenditures or a firm’s total revenue increase decrease -- unchanged -- Price elasticity of demand Elastic Inelastic Unitary Elastic Elasticity coefficient (in absolute value) 1 to  0 to 1 1 Impact of higher price on total consumer expenditures or a firm’s total revenue decrease increase -- unchanged --

Price Qty sold Total revenue Price elasticity of demand $9 0 $0 x= $8 1 x= $7 2 $14 x= $6 3 $18 x= $5 4 $20 x= $4 5 $20 x= $3 6 $18 x= $2 7 $14 x= $1 8 $8 x= $0 9 x= ((0-1) / (0+1)) / ((9-8) / (9+8)) = ((1-2) / (1+2)) / ((8-7) / (8+7)) = 5.00 ((2-3) / (2+3)) / ((7-6) / (7+6)) = 2.60 ((3-4) / (3+4)) / ((6-5) / (6+5)) = 1.57 ((4-5) / (4+5)) / ((5-4) / (5+4)) = 1.00 ((5-6) / (5+6)) / ((4-3) / (4+3)) = 0.64 ((6-7) / (6+7)) / ((3-2) / (3+2)) = 0.38 ((7-8) / (7+8)) / ((2-1) / (2+1)) = 0.20 ((8-9) / (8+9)) / ((1-0) / (1+0)) = 0.06 Price elasticity P X Q = TR $9 x 0 = $0 $8 x 1 = $8 $7 x 2 = $14 $6 x 3 = $18 $5 x 4 = $20 $4 x 5 = $20 $3 x 6 = $18 $2 x 7 = $14 $1 x 8 = $8 $0 x 9 = $0 e = e = 5.00 e = 2.60 e = 1.57 e = 1.00 e = 0.64 e = 0.38 e = 0.20 e = 0.06 By tracing out the demand curve, one can see how changes in price (through changes in quantity demanded) change total revenue collected. By calculating the price elasticity of demand at different points along the demand curve, one can follow how and where total revenue is maximized. The Firm’s Demand Curve, Total Revenue, and Elasticity Quantity $ 9 $ 8 $ 7 $ 6 $ Price $ 5 $ 4 $ 3 $ 2 $ 1 Total revenue unchanged by price when demand is unitary elastic Here demand is inelastic so lower prices result in less revenue and higher prices result in more revenue Here demand is elastic so lower prices result in more revenue and higher prices result in less revenue