One source of confusion in the calculation of elasticity is how to calculate the percentage changes in price and quantity. Since the objective of the elasticity calculation is to obtain a specific measure of the sensitivity of consumers, which is measured by quantity responses to price changes, is important that one method be used consistently. For small price changes, the most sought out use method of calculating the elasticity coefficient uses the average of the two prices and the two quantities (Appendix, Figure 2.) By using this formula, there will be an elimination of questions on how the procedure will work. Concentration can then be placed on the implications of the estimate, rather than its validity.
Elastic versus Inelastic Demand
In one extreme, the quantity demanded of a good may be insensitive to a change in price. Consumers will purchase the same quantity of the good no matter how high or low the price is. In this case, the percentage change in quantity demanded is zero, regardless of the value of the percentage change in price. Therefore, the coefficient of elasticity is zero (Appendix, Figure 3.) In this case, the demand is perfectly inelastic. For example, a person addicted to cigarettes might have a demand curve for the addictive good that is perfectly inelastic, at least over a range of prices. The same is true of individuals who require specific medications, such as cynthroid (hypoactive thyroidism) to maintain their health.
The other extreme is perfectly elastic demand. When demand is perfectly elastic, the value of the coefficient of elasticity is infinity (Appendix, Figure 4.) Consumers will purchase all available quantity at one price, but purchase none at a higher price and an infinite number at a lower price. A good example of such a demand curve is the demand for milk. A dairy farmer faces a perfectly elastic demand curve because he can sell any amount of milk he produces at the market price, but no one will offer more than the market price.
A third elasticity coefficient divides all other elasticity coefficients into one of two categories: inelastic and elastic. When the percentage change in quantity demanded is equal to the percentage change in price, the coefficient if elasticity is equal to one Appendix, Figure 5.) In this unique case, the demand is unitary elastic.
When the elasticity coefficient is between zero and one, the demand is inelastic. Consumers are insensitive to price changes. Examples of goods and services for which demand is inelastic include medical care, electricity, and bread. When the elasticity coefficient is greater than one, the demand is elastic. Consumers are relatively sensitive to price changes. Examples of goods and services for which demand is elastic include Internet, restaurant meals, and fancy purses.
The Difference between Price Elasticity and Slope
An understanding of the technical side of the price elasticity of demand is enhanced by special consideration. The price elasticity of demand along a segment of a demand curve is not the same thing as the slope of that segment of the demand curve. A slope calculation incorporates only information about the extent of change in one variable as the other variable changes. An elasticity coefficient incorporates both the values of the two variables, price and quantity, at a particular point, and information about the extent of change in quantity demanded as price changes.
For a demand curve that is a straight line, the slope is constant. Therefore the slope does not change as it moves along the demand curve. However, for the same demand curve, price elasticity varies depending upon the range of the demand curve in question.
Point Elasticity
Price elasticity focuses on the calculation of arc elasticity, which is the elasticity between two points on a demand curve. It is also possible to calculate the price elasticity of demand at a single point on the demand curve. This value is known as the point elasticity of demand. The formula for calculating the point elasticity of demand is derived from the same premise as the arc elasticity of demand. The calculation of the point elasticity requires both the slope of the demand curve and the values of price and quantity for the point in question on the demand curve.
Determinants of Price Elasticity of Demand
Price elasticity of demand factors vary widely, depending the specific good or service and the consumers purchasing the specific good or service. Due to the varying factors, the estimates can also vary.
Available Substitutes
The most important influence on the price elasticity of demand is the availability of substitutes for a good. When substitutes for a good or service exist, a consumer has consumption alternatives. Depending on how close these substitutes are, even a small price increase can prompt consumers to switch to one of the alternatives. A very good example of this is purchasing sugar. If the price of a five pound bag of Domino’s Sugar is $2.99, and the store brand five pound bag of sugar is $2.79, then the consumer will most likely switch to the substitute sugar, due to the slight pay decrease.
There are may other goods in which the price elasticity of demand is relatively high. There are a number of close substitutes in the pizza market- Papa John’s, Domino’s, Little Caesar’s, and Pizza Hut, to name a few. Consumers are sensitive to a change in the price of a given product in this market, due to the wide variety of available substitutes.
The inelastic demand category includes such goods as coffee and cigarettes. Consumers are insensitive to price changes for those goods because there are very few close substitutes. Coffee drinkers drink coffee because of the caffeine content and flavor, and there are a few good substitutes. Cigarette smokers are extremely insensitive to cigarette price changes because there are no good alternatives.
The availability of substitutes also depend on the definition of the product or service category. Generally, price elasticity of demand is greater for the narrower, specifically defined categories of goods and services. For example, the demand for salt is very inelastic because is has very few substitutes. The demand for Morton salt is less inelastic because other brands of salt are available. Even less inelastic is the demand for Morton salt in a specific store. Alternatives include Morton salt sold at other stores.
Cost of the Good Relative to Total Income
Another influence on price elasticity of demand is the size of the expenditure on a good relative to the consumer’s total income. For example, the price of milk is relatively low and price is insignificant to most family or individual incomes. Even if the price were to double, it would still have almost on impact on the impact of quantities consumed. On the other hand, if the price of a restaurant meal were to double, which would take up more of the household’s income, then it would lead to a percentage reduction in the quantity demanded. This proves that there is a positive relationship between the cost of a good relative to total income and the price elasticity of demand.
Time and the Availability of Substitutes
Time can affect price elasticity of demand in two ways. First, the adjustments that consumers wish to make in response to price change can take some time. Second, the full adjustment to a price change can take a longer amount of time. In the end, the longer the period of time available for adjustments to take place, the more elastic the demand for the good or service.
For example, the full response to an increase in the price of fresh vegetables takes little time. There is little difference between the short- run and long- run price elasticity for vegetables. On the other hand, the adjustment to an increase in the price of oil takes much longer for consumers to adjust to. A relatively rapid increase in the price of oil can force consumer’s to use different substitutes available, such as portable space heaters, install insulation and wood- burning stoves.
Luxuries versus Necessities
Consumers are more or less sensitive to a change in the price of a good depending on whether they consider the good to be a luxury or a necessity. The price elasticity of demand tends to be relatively low for necessities, such as basic food items and hygiene products, where as the demand tends to be relatively high for luxuries, such as fancy purses, clothes, and massages.
Price Elasticity and Total Revenue
When the price of goods change, the quantity demanded changes in the opposite direction. A price change can cause total expenditures (total spending) on a good to increase or decrease. In almost all cases, a price change will cause the amount of total revenue received from the sale of a good to increase or decrease in price. Total revenue from a good is the product of its market price and the quantity of the good or service demanded. This, in turn, will equal to the total expediters. The price elasticity demand allows the determination of a specific relationship between price changes and the changes in total revenue.
A price increase with no change in quantity demanded will cause an increase in total expenditures, as well as total revenues. However, according to the law of demand, a price increase leads to a reduction in the quantity demanded is smaller than the percentage change in price. This means that the change in price has the greater effect on total revenue. However, when demand is price inelastic, total revenue moves in the same direction as price and in the opposite direction of quantity demanded. When demand in price is elastic, total revenue moves in the opposite direction of price and the same direction as quantity demanded. When demand is unitary elastic, the percentage change in quantity demands exactly offsets the percentage change in price, because the two are equal. When demand is unit elastic, a price change has no effect on total revenue (Appendix, Figure 6.)
The relationship between elasticity, price changes, and changes in total revenue present a very important fact: Higher prices do not always mean an increase in total revenue. The impact of a price change on total revenue depends upon the price elasticity of demand for the product. This relationship implies that an understanding of consumer sensitivity to price is important to different firms attempting to maximize profits.
Price Discrimination
The practice of charging different customers different prices for the same good or service, when price differences are not justified on the basis of cost differences, is called price discrimination. One of the best examples is renting a car. When renting a car, the lowest fare might be less than half the highest fare, even though the cost of carrying another passenger will remain constant. The price on which a person is eligible depends on the length of time to have the car, where they plan to travel, and how early they make the reservation. Many firms attempt to price discriminate because willingness to pay for a service and price elasticity varies from consumer to consumer. Firms also price discriminate because raising the price to some consumers and lowering it for others can increase total revenue.
Some consumers, like businesspeople, who must travel on short notice, have an inelastic demand for car travel. Other people, such as consumers who are taking trips for pleasure or who have the opportunity to plan a trip well in advance, have an elastic demand. If the firm raises car rental fares for those whose demand is inelastic, it increases total revenue. The firm can lower those rental fares for those whose demand is elastic, thus increasing total revenue further.
Price discrimination is based on the fact that certain groups of people are more sensitive to price and, therefore, reduced prices have a bigger impact on the quantity consumed by that certain group of consumers. In the case of children, requiring them to pay a regular price for a restaurant meal would be too expensive for many families to dine out. Firms that do not price discriminate lose sales not only to children, but to their parents as well. If these firms would have price discriminated, these parents would have purchased the good or service. Senior citizens are also another case to point out. Many seniors are on low, fixed incomes, which restricts quantity demanded. A reduction in price for these and other certain groups of consumers increases the total quantity demanded without requiring the firm to reduce price on the pervious units sold.
Price Elasticity and the Incidence of a Tax
Yet another important factor of the price elasticity of demand concerns the effect that imposing a tax on a good will have on the equilibrium between the demand of price and quantity. Federal, state, and local governments tax many goods and services to raise needed revenues. For example, the tax on cigarettes is considered a “sin tax.” The tax, in most cases, is calculated as either a percentage of the price or a flat amount, and then is imposed on the seller of the good. The seller than tries to pass the tax along to the buyer in the form of a higher price. The question of how much of the tax is ultimately paid by the consumer, rather than the seller, is called the incidence of the tax, which ultimately depends on the price elasticity of demand.
The extent to which a tax can be passed on to consumers depends on the consumers quantity responses to price changes. When demand is inelastic, as it is for such products as gasoline, consumers absorb most of the tax increase. Suppliers pay for part of the tax, unless demand is perfectly inelastic. When the demand is elastic, consumers do not pay as much of the tax on a specific good. Suppliers can not shift the burden to consumers because an elastic demand means that consumers have alternative goods that they can substitute for the good being taxed.
Summary
Three important characteristics of determining demand are the relationships between market price, quantity, and demand and consumer expenditure. There are many different variables that account for price elasticity of demand, including change in price, consumer demand, size of expenditure, and the law of demand. Other important factors that effect price elasticity of demand include demands that are elastic, inelastic, and unitary, as well as price discrimination and whether the good is considered a luxury or a necessity to the consumer. Price elasticity of demand is part of many consumers’ day to day routines. When you see a change in price of gas, a restaurant meal, or milk, just know that you are contributing to the economy and the price elasticity of demand.
Definitions
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Arc Elasticity: The price elasticity if demand between any two points in a demand curve.
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Coefficient of Elasticity: The ratio of the percentage change in quantity demanded to the percentage change in price.
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Elastic Demand: Quantity demanded is relatively responsive to a change in price. The coefficient of elasticity is greater than one.
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Inelastic Demand: Quantity demanded is relatively responsive to a change in price. The coefficient of elasticity is greater than zero, but less than one.
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Law of Demand: The relationship between the price of a good and the quantity demanded.
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Perfectly Elastic Demand: The percentage change in quantity demanded is infinite for a price decrease, regardless of the value of the percentage change in price. The coefficient of elastic equals infinity.
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Perfectly Inelastic Demand: The percentage change in quantity demanded is zero, regardless of the value of the percentage change in price. The coefficient of elasticity equals zero.
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Point Elasticity of Demand: Price elasticity at a single point on a demand curve.
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Price (P): the amount of money given or set as consideration for the sale goods.
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Price Discrimination: the practice of charging different prices to different consumers of the same good or service.
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Price Elasticity of Demand: The relationship between a change in quantity demanded of a good or service and a change in price.
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Quantity (Q): Total amount or number of goods.
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Total Revenue: The product of a good’s market price and the quantity of the goods purchased.
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Unitary Elastic Demand: The percentage change in quantity demanded is exactly equal to the percentage change in price. The coefficient of elasticity equals one.
Appendix
Figure 1: ed= -(%change in quantity demanded)/ (%change in price)
Figure 2: ed= [(old Q - new Q)/ (old Q + new Q)] / [(old P- new P) / (old P + new P)]
Figure 3:
Figure 4:
Figure 5:
Figure 6:
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Talley, Louis Alan. Gasoline Excise Tax: Historical Revenues Fact Sheet. 16 September 1997. Economics Division of NCSE. 6 October 2003.
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Schenk, Robert. Elasticity and Revenue. 1997-1998. Economics Department of Saint Joseph’s University. 6 October 2003.