Interpreting Price Elasticity of Demand Micro: Econ: 11 47 Module Interpreting Price Elasticity of Demand KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: The purpose of this module is to show students how to interpret the numerical measure of price elasticity of demand, to show how price elasticity changes along a demand curve, and why this is important. The module also describes the various factors that determine whether demand for a good is price elastic or inelastic.

What you 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 The purpose of this module is to show students how to interpret the numerical measure of price elasticity of demand, to show how price elasticity changes along a demand curve, and why this is important. The module also describes the various factors that determine whether demand for a good is price elastic or inelastic.

Interpreting Price Elasticity of Demand What does the value of elasticity tell us? Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10   Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount.

Elasticity and the Demand Curve What does elasticity imply about the demand curve? It indicates how steep or flat the curve will be. What does inelastic imply about the demand curve? Vertical. This is an extreme case described as “perfectly inelastic”. For whatever reason, consumers have no response to higher or lower prices. In less than the extreme case, lower elasticity (less elastic/more inelastic) means steeper. Perfectly elastic = horizontal. This is an extreme case described as “perfectly elastic”. For whatever reason, consumers have an infinitely large response to higher or lower prices. In less than the extreme case, higher elasticity (more elastic) implies flatter.

Elasticity and Total Revenue Who cares about the price elasticity of demand for a product? Producers of those products would care! Why?   When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect. Total Revenue and Elasticity TR = P x Q Price effect (Price ↑ Revenue ↑) Quantity effect (Price ↑ Revenue ↓)

Elasticity and Total Revenue Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Who cares about the price elasticity of demand for a product? Producers of those products would care! Why?   When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

Elasticity and Total Revenue Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Who cares about the price elasticity of demand for a product? Producers of those products would care! Why?   When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

Elasticity and Total Revenue Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect. Who cares about the price elasticity of demand for a product? Producers of those products would care! Why?   When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

ElElasticity along the Demand Curve As the price rises, initially total revenue rises because of the inelastic response in quantity demand. However, further price increases eventually cause total revenue to decline because of a larger elastic response. Think about this intuitively: When prices are high, we are more responsive to price changes A 10% increase in a high price makes a BIG difference (e.g. a 10% of a $100 good is $10) , so our quantity is very responsive when prices are high. When prices are low, a 10% increase does not make a very big difference (e.g. 10% of a $1.00 good is only 10 cents), so our quantity is not very responsive.   Along the same demand curve, price elasticity is inelastic at low prices and grows more elastic at higher prices.

Determinants of Elasticity What Factors Determine the Price Elasticity of Demand? 1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products.   2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes. What Factors Determine the Price Elasticity of Demand? Number of substitutes Luxury or necessity? Share of income spent Time

Figure 47.2 (a) Unit-Elastic Demand, Inelastic Demand, and Elastic Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 47.2 (b) Unit-Elastic Demand, Inelastic Demand, and Elastic Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 47.2 (c) Unit-Elastic Demand, Inelastic Demand, and Elastic Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 47.3 Total Revenue Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Table 47.1 Price Elasticity of Demand and Total Revenue Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 47.4 The Price Elasticity of Demand Changes Along the Demand Curve Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers