Price Elasticity of Demand.

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Price Elasticity of Demand

Eco 203- 27

Victoria P. Panna

October 13, 2003

Principals of Microeconomics

Table of Contents

  1. Overview

  2. Changes in Price and Quantity Demanded
  1. Consumer Responsiveness to Price Changes
  2. Calculating the Coefficient of Price Elasticity
  3. Elastic Versus Inelastic Demand
  4. The Difference between Price Elasticity and Slope
  5. Point Elasticity
  1. Determinants of Price Elasticity of Demand
  1. Available Substitutes
  2. Cost of the Good Relative to Total Income
  3. Time and the Availability of Substitutes
  4. Luxuries Versus Necessities
  1. Price Elasticity and Total Revenue
  1. Price Discrimination
  1. Price Elasticity and the Incidence of a Tax
  2. Summary
  3. Definitions
  4. Appendex
  5. Works Cited

Overview

Three important characteristics of determining demand are the relationships between market price, quantity, and demand and consumer expenditure.  To predict consumer behavior, economists use well-defined techniques evaluating the sensitivity of consumers to changes in price.  The most commonly used measure of consumers' sensitivity to price is known as price elasticity of demand.  Price elasticity of demand is the change in quantity demanded of a good or service and a change in price. The relative response of a change in quantity demanded to a relative change in price. More specifically the price elasticity of demand can be defined as the percentage change in quantity demanded due to a percentage change in demand price. Price elasticity can be used to determine how much a company should increase / decrease prices to maximize profits.  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, among other things.  As you read on, you will become familiar with these terms and how they affect price elasticity of demand.

Changes in Price and Quantity Demanded

        What is the general relationship between price and the quantity of demanded goods?  According to the law of demands, quantity demanded and price are related.  The theory behind the law of demands is seen in everyday life.  Sales events by merchants, such as clothing stores, are used to reduce inventory of good, in this case seasonal clothing.  Policymakers also recognize the importance of the law of demand.  Taxes are often used to raise the effective price of many goods, such as gasoline.  Among other things, the price increase that results from the tax is intended to raise revenue for the government and induce people to reduce the quantity purchased.  As seen, changes in price and the quantity demanded go hand in hand in everyday situations.

Consumer Responsiveness to Price Changes

        It is useful to watch the consumer as the demand for a product or service change.  The knowledge that quantity demand decreases when price increases, and quantity increases when the price decreases, is helpful to retailers and producers, to see predict consumer behavior.  Knowing the specific degrees of change within the price and quantity are even better.  Consumer responsiveness to price changes is measured by the price elasticity of demand.

        Consumer responses to price change depend on the specific product or service and the amount of the price change. An individual’s responses to changes in price vary.  For example, if the price of Diet Coke tripled, the consumer might not purchase as much as they would before.  On the flip side, if the price of regular No. 2 pencils tripled in price, it may have no effect on how much the consumer buys.  As said earlier, it all depends on the individual consumer.  The responses of different individuals to a change in the price of a specific good vary as well.  A relative measure is needed to calculate the changes in different measures that are being compared.  

Economists measure the relative changes in quantity demanded and price by comparing the percentage change in quantity to the percentage change in price.  This resulting ratio is called the coefficient of elasticity (Appendix, Figure 1.)

Calculating the Coefficient of Price Elasticity

        Calculating the price elasticity of demand can be thought of as a two- step process.  The first step involves calculating the percentage changes in price and quantity demanded from information on the old and new prices and quantities.  In the second step, the ratio of the percentage change in quantity demanded to the percentage change in price is calculated.

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        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 ...

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