Price Elasticity of Demand

If you were planning to have a pizza for dinner and saw a sign in your favorite pizza restaurant that read…

Would you still go in and order pizza for dinner? Due to increases in the cost of cheese - all items on the menu have been increased by $3.00 until further notice Would you still go in and order pizza for dinner?

Suppose you notice the fuel indicator on your car pointing to 'Empty’ Suppose you notice the fuel indicator on your car pointing to 'Empty’. As you pull into the gas station, you see the price of gasoline has risen by $.50 a gallon. Do you still get gas?

The answers to these questions may well depend on the price elasticity of demand.

In this lesson, you will learn about the law of demand, the definition of price elasticity of demand, how we measure price elasticity of demand some actual price-elasticity measurements for various goods, and why different goods have different goods differ in price elasticity.

I know that you have studied the law of demand? This economic principle says that we will buy less of a good if the price rises, and vice versa. You can probably think of many goods you buy that would meet the law of demand. There are other goods that seem to defy the law of demand, but this may be due to the price elasticity of the good.

What is the price elasticity of demand? It is a measure of the responsiveness of quantity demanded to a price change. In other words, if the price of a good changes, do we change the quantity we buy?

In the pizza example, many of us would not get pizza but would go to another restaurant (or eat at home) if prices increased by $3.00. But we probably would still fill up our car with gasoline even if the price were increased by 50 cents per gallon.

Why? Because restaurant meals and gasoline have very different price elasticity. Gasoline is considered inelastic (meaning price changes have little effect on the quantity we buy). Inelastic demand curves tend to be more vertical.

Restaurant meals, on the other hand, are very elastic (meaning price changes greatly affect our purchase of them). Elastic demand curves are more horizontal

There are several factors that affect the price elasticity of a good. These include the following: Availability of substitutes The degree of necessity The proportion of a purchaser's budget consumed by the item The time period involved.

Substitutes If a good has a large number of substitutes, we can pick a substitute if the price rises on the good. For example, if beef has a price increase, we might substitute chicken, pork or fish.

Perfume is not considered something that you need for survival but if you're a diabetic, insulin is.

If the good consumes a relatively small proportion of your budget, price changes do not greatly affect the amount you buy. For example, if you buy a couple of packages of gum every month and that represents a very small percentage of your budget- Then, a price increase of 20 percent (say from $1 to $1.20) probably would not affect your quantity purchased.

The time period involved is also a factor in price elasticity. If you have a short period to make a decision, you may have to accept price changes. But in the long run, you can change your consumption of this good or brand in some cases. In other words, you have time to vary the amount purchased or the price you pay.

Now let's compare gasoline and restaurant meals. Elasticity worksheet http://www.econedlink.org/lessons/EconEdLink-flash-interactive.php?filename=em551_comparing_list2.swf&lid=551 ---

How does a person calculate elasticity?

If you calculate the elasticity ratio using that formula, then… If the elasticity ratio is less than 1, the demand for the good is considered inelastic. If the elasticity ratio is greater than 1, the demand for the good is elastic. Unitary elasticity is when the elasticity ratio is approximately 1 (which means the percentage change in quantity demanded is about the same as the percentage change in price).

ASSESSMENT ACTIVITY Look at elasticity of the various goods on the Mackinac Center for Public Policy, and see if you can determine if they are inelastic, elastic, or unitary elastic, and why-- http://www.mackinaw.org/article.aspx?ID=1247

Here is a short video describing elasticity http://www.youtube.com/watch?v=4oj_lnj6pXA